Speculative industries exploit novel technologies subject to two risks: First, there is uncertainty about the fundamental value of the innovation: is it strong or fragile? We study how investors learn about that aspect of the industry. Second, it is difficult to monitor managers, which creates moral hazard. We study how the magnitude of this problem evolves as learning occurs. Because of moral hazard, managers earn agency rents in equilibrium. As time goes by and profits are observed, beliefs about the industry are rationally updated. If the industry is strong, confidence builds up. Initially this spurs growth. But increasingly confident managers end up requesting very large rents, which curb the growth of the speculative sector. If rents become too high, investors may give up on incentives, and risk and failure rates rise. Furthermore, if the innovation is fragile, eventually there is a crisis, and the industry shrinks. Our model thus captures important stylized facts of the financial innovation wave which took place at the beginning of this century.
(Joint work with J.C. Rochet and P. Woolley.)