I. Overview
Also published by United Press International (UPI)
The recent implosion of the global equity markets - from Hong Kong
to New York - engendered yet another round of the semipternal
debate: should central banks contemplate abrupt adjustments in the
prices of assets - such as stocks or real estate - as they do
changes in the consumer price indices? Are asset bubbles indeed
inflationary and their bursting deflationary?
Central bankers counter that it is hard to tell a bubble until it
bursts and that market intervention bring about that which it is
intended to prevent. There is insufficient historical data, they
reprimand errant scholars who insist otherwise. This is
disingenuous. Ponzi and pyramid schemes have been a fixture of
Western civilization at least since the middle Renaissance.
Assets tend to accumulate in "asset stocks". Residences built in the
19th century still serve their purpose today. The quantity of new
assets created at any given period is, inevitably, negligible
compared to the stock of the same class of assets accumulated over
decades and, sometimes, centuries. This is why the prices of assets
are not anchored - they are only loosely connected to their
production costs or even to their replacement value.
Asset bubbles are not the exclusive domain of stock exchanges and
shares. "Real" assets include land and the property built on it,
machinery, and other tangibles. "Financial" assets include anything
that stores value and can serve as means of exchange - from cash to
securities. Even tulip bulbs will do.
In 1634, in what later came o be known as "tulipmania", tulip bulbs
were traded in a special marketplace in Amsterdam, the scene of a
rabid speculative frenzy. Some rare black tulip bulbs changed hands
for the price of a big mansion house. For four feverish years it
seemed like the craze would last forever. But the bubble burst in
1637. In a matter of a few days, the price of tulip bulbs was
slashed by 96%!
Uniquely, tulipmania was not an organized scam with an identifiable
group of movers and shakers, which controlled and directed it. Nor
has anyone made explicit promises to investors regarding guaranteed
future profits. The hysteria was evenly distributed and fed on
itself. Subsequent investment fiddles were different, though.
Modern dodges entangle a large number of victims. Their size and
all-pervasiveness sometimes threaten the national economy and the
very fabric of society and incur grave political and social costs.
There are two types of bubbles.
Asset bubbles of the first type are run or fanned by financial
intermediaries such as banks or brokerage houses. They consist of
"pumping" the price of an asset or an asset class.
The assets concerned can be shares, currencies, other securities and
financial instruments - or even savings accounts. To promise
unearthly yields on one's savings is to artificially inflate the
"price", or the "value" of one's savings account.
More than one fifth of the population of 1983 Israel were involved
in a banking scandal of Albanian proportions. It was a classic
pyramid scheme. All the banks, bar one, promised to gullible
investors ever increasing returns on the banks' own publicly-traded
shares.
These explicit and incredible promises were included in prospectuses
of the banks' public offerings and won the implicit acquiescence and
collaboration of successive Israeli governments. The banks used
deposits, their capital, retained earnings and funds illegally
borrowed through shady offshore subsidiaries to try to keep their
impossible and unhealthy promises. Everyone knew what was going on
and everyone was involved. It lasted 7 years. The prices of some
shares increased by 1-2 percent daily.
On October 6, 1983, the entire banking sector of Israel crumbled.
Faced with ominously mounting civil unrest, the government was
forced to compensate shareholders. It offered them an elaborate
share buyback plan over 9 years. The cost of this plan was pegged
at $6 billion - almost 15 percent of Israel's annual GDP. The
indirect damage remains unknown.
Avaricious and susceptible investors are lured into investment
swindles by the promise of impossibly high profits or interest
payments.
The organizers use the money entrusted to them by new investors to
pay off the old ones and thus establish a credible reputation.
Charles Ponzi perpetrated many such schemes in 1919-1925 in Boston
and later the Florida real estate market in the USA. Hence a "Ponzi
scheme".
In Macedonia, a savings bank named TAT collapsed in 1997, erasing
the economy of an entire major city, Bitola. After much wrangling
and recriminations - many politicians seem to have benefited from
the scam - the government, faced with elections in September, has
recently decided, in defiance of IMF diktats, to offer meager
compensation to the afflicted savers. TAT was only one of a few
similar cases. Similar scandals took place in Russia and Bulgaria in
the 1990's .
One third of the impoverished population of Albania was cast into
destitution by the collapse of a series of nation-wide leveraged
investment plans in 1997. Inept political and financial crisis
management led Albania to the verge of disintegration and a civil
war. Rioters invaded police stations and army barracks and
expropriated hundreds of thousands of weapons.
Islam forbids its adherents to charge interest on money lent - as
does Judaism. To circumvent this onerous decree, entrepreneurs and
religious figures in Egypt and in Pakistan established "Islamic
banks". These institutions pay no interest on deposits, nor do they
demand interest from borrowers. Instead, depositors are made
partners in the banks' - largely fictitious - profits. Clients are
charged for - no less fictitious - losses. A few Islamic banks were
in the habit of offering vertiginously high "profits". They went the
way of other, less pious, pyramid schemes.
They melted down and dragged economies and political establishments
with them.
By definition, pyramid schemes are doomed to failure. The number of
new "investors" - and the new money they make available to the
pyramid's organizers - is limited. When the funds run out and the
old investors can no longer be paid, panic ensues. In a classic "run
on the bank", everyone attempts to draw his money simultaneously.
Even healthy banks - a distant relative of pyramid schemes - cannot
cope with such stampedes. Some of the money is invested long-term,
or lent. Few financial institutions keep more than 10 percent of
their deposits in liquid on-call reserves.
Studies repeatedly demonstrated that investors in pyramid schemes
realize their dubious nature and stand forewarned by the collapse of
other contemporaneous scams. But they are swayed by recurrent
promises that they could draw their money at will ("liquidity") and,
in the meantime, receive alluring returns on it ("capital gains",
"interest payments", "profits").
People know that they are likelier to lose all or part of their
money as time passes. But they convince themselves that they can
outwit the organizers of the pyramid, that their withdrawals of
profits or interest payments prior to the inevitable collapse will
more than amply compensate them for the loss of their money. Many
believe that they will succeed to accurately time the extraction of
their original investment based on - mostly useless and
superstitious - "warning signs".
While the speculative rash lasts, a host of pundits, analysts, and
scholars aim to justify it. The "new economy" is exempt from "old
rules and archaic modes of thinking". Productivity has surged and
established a steeper, but sustainable, trend line. Information
technology is as revolutionary as electricity. No, more than
electricity. Stock valuations are reasonable. The Dow is on its way
to 33,000. People want to believe these "objective, disinterested
analyses" from "experts".
Investments by households are only one of the engines of this first
kind of asset bubbles. A lot of the money that pours into pyramid
schemes and stock exchange booms is laundered, the fruits of illicit
pursuits. The laundering of tax-evaded money or the proceeds of
criminal activities, mainly drugs, is effected through regular
banking channels. The money changes ownership a few times to obscure
its trail and the identities of the true owners.
Many offshore banks manage shady investment ploys. They maintain two
sets of books. The "public" or "cooked" set is made available to the
authorities - the tax administration, bank supervision, deposit
insurance, law enforcement agencies, and securities and exchange
commission. The true record is kept in the second, inaccessible, set
of files.
This second set of accounts reflects reality: who deposited how
much, when and subject to which conditions - and who borrowed what,
when and subject to what terms. These arrangements are so stealthy
and convoluted that sometimes even the shareholders of the bank lose
track of its activities and misapprehend its real situation.
Unscrupulous management and staff sometimes take advantage of the
situation. Embezzlement, abuse of authority, mysterious trades,
misuse of funds are more widespread than acknowledged.
The thunderous disintegration of the Bank for Credit and Commerce
International (BCCI) in London in 1991 revealed that, for the better
part of a decade, the executives and employees of this penumbral
institution were busy stealing and misappropriating $10 billion. The
Bank of England's supervision department failed to spot the rot on
time. Depositors were - partially - compensated by the main
shareholder of the bank, an Arab sheikh. The story repeated itself
with Nick Leeson and his unauthorized disastrous trades which
brought down the venerable and veteran Barings Bank in 1995.
The combination of black money, shoddy financial controls, shady
bank accounts and shredded documents renders a true account of the
cash flows and damages in such cases all but impossible. There is no
telling what were the contributions of drug barons, American off-
shore corporations, or European and Japanese tax-evaders - channeled
precisely through such institutions - to the stratospheric rise in
Wall-Street in the last few years.
But there is another - potentially the most pernicious - type of
asset bubble. When financial institutions lend to the unworthy but
the politically well-connected, to cronies, and family members of
influential politicians - they often end up fostering a bubble.
South Korean chaebols, Japanese keiretsu, as well as American
conglomerates frequently used these cheap funds to prop up their
stock or to invest in real estate, driving prices up in both markets
artificially.
Moreover, despite decades of bitter experiences - from Mexico in
1982 to Asia in 1997 and Russia in 1998 - financial institutions
still bow to fads and fashions. They act herd-like in conformity
with "lending trends". They shift assets to garner the highest
yields in the shortest possible period of time. In this respect,
they are not very different from investors in pyramid investment
schemes.
II. Case Study - The Savings and Loans Associations Bailout
Also published by United Press International (UPI)
Asset bubbles - in the stock exchange, in the real estate or the
commodity markets - invariably burst and often lead to banking
crises. One such calamity struck the USA in 1986-1989. It is
instructive to study the decisive reaction of the administration and
Congress alike. They tackled both the ensuing liquidity crunch and
the structural flaws exposed by the crisis with tenacity and skill.
Compare this to the lackluster and hesitant tentativeness of the
current lot. True, the crisis - the result of a speculative bubble -
concerned the banking and real estate markets rather than the
capital markets. But the similarities are there.
The savings and loans association, or the thrift, was a strange
banking hybrid, very much akin to the building society in Britain.
It was allowed to take in deposits but was really merely a mortgage
bank. The Depository Institutions Deregulation and Monetary Control
Act of 1980 forced S&L's to achieve interest parity with commercial
banks, thus eliminating the interest ceiling on deposits which they
enjoyed hitherto.
But it still allowed them only very limited entry into commercial
and consumer lending and trust services. Thus, these institutions
were heavily exposed to the vicissitudes of the residential real
estate markets in their respective regions. Every normal cyclical
slump in property values or regional economic shock - e.g., a plunge
in commodity prices - affected them disproportionately.
Interest rate volatility created a mismatch between the assets of
these associations and their liabilities. The negative spread
between their cost of funds and the yield of their assets - eroded
their operating margins. The 1982 Garn-St. Germain Depository
Institutions Act encouraged thrifts to convert from mutual - i.e.,
depositor-owned - associations to stock companies, allowing them to
tap the capital markets in order to enhance their faltering net
worth.
But this was too little and too late. The S&L's were rendered unable
to further support the price of real estate by rolling over old
credits, refinancing residential equity, and underwriting
development projects. Endemic corruption and mismanagement
exacerbated the ruin. The bubble burst.
Hundreds of thousands of depositors scrambled to withdraw their
funds and hundreds of savings and loans association (out of a total
of more than 3,000) became insolvent instantly, unable to pay their
depositors. They were besieged by angry - at times, violent -
clients who lost their life savings.
The illiquidity spread like fire. As institutions closed their
gates, one by one, they left in their wake major financial
upheavals, wrecked businesses and homeowners, and devastated
communities. At one point, the contagion threatened the stability of
the entire banking system.
The Federal Savings and Loans Insurance Corporation (FSLIC) - which
insured the deposits in the savings and loans associations - was no
longer able to meet the claims and, effectively, went bankrupt.
Though the obligations of the FSLIC were never guaranteed by the
Treasury, it was widely perceived to be an arm of the federal
government. The public was shocked. The crisis acquired a political
dimension.
A hasty $300 billion bailout package was arranged to inject
liquidity into the shriveling system through a special agency, the
FHFB. The supervision of the banks was subtracted from the Federal
Reserve. The role of the the Federal Deposit Insurance Corporation
(FDIC) was greatly expanded.
Prior to 1989, savings and loans were insured by the now-defunct
FSLIC. The FDIC insured only banks. Congress had to eliminate FSLIC
and place the insurance of thrifts under FDIC. The FDIC kept the
Bank Insurance Fund (BIF) separate from the Savings Associations
Insurance Fund (SAIF), to confine the ripple effect of the meltdown.
The FDIC is designed to be independent. Its money comes from
premiums and earnings of the two insurance funds, not from
Congressional appropriations. Its board of directors has full
authority to run the agency.
The board obeys the law, not political masters. The FDIC has a
preemptive role. It regulates banks and savings and loans with the
aim of avoiding insurance claims by depositors.
When an institution becomes unsound, the FDIC can either shore it up
with loans or take it over. If it does the latter, it can run it and
then sell it as a going concern, or close it, pay off the depositors
and try to collect the loans. At times, the FDIC ends up owning
collateral and trying to sell it.
Another outcome of the scandal was the Resolution Trust Corporation
(RTC). Many savings and loans were treated as "special risk" and
placed under the jurisdiction of the RTC until August 1992. The RTC
operated and sold these institutions - or paid off the depositors
and closed them. A new government corporation (Resolution Fund
Corporation, RefCorp) issued federally guaranteed bailout bonds
whose proceeds were used to finance the RTC until 1996.
The Office of Thrift Supervision (OTS) was also established in 1989
to replace the dismantled Federal Home Loan Board (FHLB) in
supervising savings and loans. OTS is a unit within the Treasury
Department, but law and custom make it practically an independent
agency.
The Federal Housing Finance Board (FHFB) regulates the savings
establishments for liquidity. It provides lines of credit from
twelve regional Federal Home Loan Banks (FHLB). Those banks and the
thrifts make up the Federal Home Loan Bank System (FHLBS). FHFB gets
its funds from the System and is independent of supervision by the
executive branch.
Thus a clear, streamlined, and powerful regulatory mechanism was put
in place. Banks and savings and loans abused the confusing overlaps
in authority and regulation among numerous government agencies. Not
one regulator possessed a full and truthful picture. Following the
reforms, it all became clearer: insurance was the FDIC's job, the
OTS provided supervision, and liquidity was monitored and imparted
by the FHLB.
Healthy thrifts were coaxed and cajoled to purchase less sturdy
ones. This weakened their balance sheets considerably and the
government reneged on its promises to allow them to amortize the
goodwill element of the purchase over 40 years. Still, there were
2,898 thrifts in 1989. Six years later, their number shrank to 1,612
and it stands now at less than 1,000. The consolidated institutions
are bigger, stronger, and better capitalized.
Later on, Congress demanded that thrifts obtain a bank charter by
1998. This was not too onerous for most of them. At the height of
the crisis the ratio of their combined equity to their combined
assets was less than 1%. But in 1994 it reached almost 10% and
remained there ever since.
This remarkable turnaround was the result of serendipity as much as
careful planning. Interest rate spreads became highly positive. In a
classic arbitrage, savings and loans paid low interest on deposits
and invested the money in high yielding government and corporate
bonds. The prolonged equity bull market allowed thrifts to float new
stock at exorbitant prices.
As the juridical relics of the Great Depression - chiefly amongst
them, the Glass-Steagall Act - were repealed, banks were liberated
to enter new markets, offer new financial instruments, and spread
throughout the USA. Product and geographical diversification led to
enhanced financial health.
But the very fact that S&L's were poised to exploit these
opportunities is a tribute to politicians and regulators alike -
though except for setting the general tone of urgency and
resolution, the relative absence of political intervention in the
handling of the crisis is notable. It was managed by the autonomous,
able, utterly professional, largely a-political Federal Reserve. The
political class provided the professionals with the tools they
needed to do the job. This mode of collaboration may well be the
most important lesson of this crisis.
III. Case Study - Wall Street, October 1929
Also published by United Press International (UPI)
Claud Cockburn, writing for the "Times of London" from New-York,
described the irrational exuberance that gripped the nation just
prior to the Great Depression.
As Europe wallowed in post-war malaise, America seemed to have
discovered a new economy, the secret of uninterrupted growth and
prosperity, the fount of transforming technology:
"The atmosphere of the great boom was savagely exciting, but there
were times when a person with my European background felt alarmingly
lonely. He would have liked to believe, as these people believed, in
the eternal upswing of the big bull market or else to meet just one
person with whom he might discuss some general doubts without being
regarded as an imbecile or a person of deliberately evil intentsome
kind of anarchist, perhaps."
The greatest analysts with the most impeccable credentials and track
records failed to predict the forthcoming crash and the
unprecedented economic depression that followed it. Irving Fisher, a
preeminent economist, who, according to his biographer-son, Irving
Norton Fisher, lost the equivalent of $140 million in today's money
in the crash, made a series of soothing predictions. On October 22
he uttered these avuncular statements: "Quotations have not caught
up with real values as yet ... (There is) no cause for a slump ...
The market has not been inflated but merely readjusted..."
Even as the market convulsed on Black Thursday, October 24, 1929 and
on Black Tuesday, October 29 - the New York Times wrote: "Rally at
close cheers brokers, bankers optimistic".
In an editorial on October 26, it blasted rabid speculators and
compliant analysts: ``We shall hear considerably less in the future
of those newly invented conceptions of finance which revised the
principles of political economy with a view solely to fitting the
stock market's vagaries.'' But it ended thus: "(The Federal Reserve
has) insured the soundness of the business situation when the
speculative markets went on the rocks.''
Compare this to Alan Greenspan Congressional testimony this summer:
"While bubbles that burst are scarcely benign, the consequences need
not be catastrophic for the economy ... (The Depression was brought
on by) ensuing failures of policy".
Investors, their equity leveraged with bank and broker loans,
crowded into stocks of exciting "new technologies", such as the
radio and mass electrification. The bull market - especially in
issues of public utilities - was fueled by "mergers, new groupings,
combinations and good earnings" and by corporate purchasing for
"employee stock funds".
Cautionary voices - such as Paul Warburg, the influential banker,
Roger Babson, the "Prophet of Loss" and Alexander Noyes, the eternal
Cassandra from the New York Times - were derided. The number of
brokerage accounts doubled between March 1927 and March 1929.
When the market corrected by 8 percent between March 18-27 -
following a Fed induced credit crunch and a series of mysterious
closed-door sessions of the Fed's board - bankers rushed in. The New
York Times reported: ``Responsible bankers agree that stocks should
now be supported, having reached a level that makes them
attractive.'' By August, the market was up 35 percent on its March
lows. But it reached a peak on September 3 and it was downhill since
then.
On October 19, five days before "Black Thursday", Business Week
published this sanguine prognosis:
"Now, of course, the crucial weaknesses of such periods -- price
inflation, heavy inventories, over-extension of commercial credit --
are totally absent. The security market seems to be suffering only
an attack of stock indigestion... There is additional reassurance in
the fact that, should business show any further signs of fatigue,
the banking system is in a good position now to administer any
needed credit tonic from its excellent Reserve supply."
The crash unfolded gradually. Black Thursday actually ended with an
inspiring rally. Friday and Saturday - trading ceased only on
Sundays - witnessed an upswing followed by mild profit taking. The
market dropped 12.8 percent on Monday, with Winston Churchill
watching from the visitors' gallery - incurring a loss of $10-14
billion.
The Wall Street Journal warned naive investors:
"Many are looking for technical corrective reactions from time to
time, but do not expect these to disturb the upward trend for any
prolonged period."
The market plummeted another 11.7 percent the next day - though
trading ended with an impressive rally from the lows. October 31 was
a good day with a "vigorous, buoyant rally from bell to bell". Even
Rockefeller joined the myriad buyers. Shares soared. It seemed that
the worst was over.
The New York Times was optimistic:
"It is thought that stocks will become stabilized at their actual
worth levels, some higher and some lower than the present ones, and
that the selling prices will be guided in the immediate future by
the worth of each particular security, based on its dividend record,
earnings ability and prospects. Little is heard in Wall Street these
days about 'putting stocks up.'"
But it was not long before irate customers began blaming their
stupendous losses on advice they received from their brokers. Alec
Wilder, a songwriter in New York in 1929, interviewed by Stud Terkel
in "Hard Times" four decades later, described this typical exchange
with his money manager:
"I knew something was terribly wrong because I heard bellboys,
everybody, talking about the stock market. About six weeks before
the Wall Street Crash, I persuaded my mother in Rochester to let me
talk to our family adviser. I wanted to sell stock which had been
left me by my father. He got very sentimental: 'Oh your father
wouldn't have liked you to do that.' He was so persuasive, I said
O.K. I could have sold it for $160,000. Four years later, I sold it
for $4,000."
Exhausted and numb from days of hectic trading and back office
operations, the brokerage houses pressured the stock exchange to
declare a two day trading holiday. Exchanges around North America
followed suit.
At first, the Fed refused to reduce the discount rate. "(There) was
no change in financial conditions which the board thought called for
its action." - though it did inject liquidity into the money market
by purchasing government bonds. Then, it partially succumbed and
reduced the New York discount rate, which, curiously, was 1 percent
above the other Fed districts - by 1 percent. This was too little
and too late. The market never recovered after November 1. Despite
further reductions in the discount rate to 4 percent, it shed a
whopping 89 percent in nominal terms when it hit bottom three years
later.
Everyone was duped. The rich were impoverished overnight. Small time
margin traders - the forerunners of today's day traders - lost their
shirts and much else besides. The New York Times:
"Yesterday's market crash was one which largely affected rich men,
institutions, investment trusts and others who participate in the
market on a broad and intelligent scale. It was not the margin
traders who were caught in the rush to sell, but the rich men of the
country who are able to swing blocks of 5,000, 10,000, up to 100,000
shares of high-priced stocks. They went overboard with no more
consideration than the little trader who was swept out on the first
day of the market's upheaval, whose prices, even at their lowest of
last Thursday, now look high by comparison ...
To most of those who have been in the market it is all the more awe-
inspiring because their financial history is limited to bull
markets."
Overseas - mainly European - selling was an important factor. Some
conspiracy theorists, such as Webster Tarpley in his "British
Financial Warfare", supported by contemporary reporting by the likes
of "The Economist", went as far as writing:
"When this Wall Street Bubble had reached gargantuan proportions in
the autumn of 1929, (Lord) Montagu Norman (governor of the Bank of
England 1920-1944) sharply (upped) the British bank rate,
repatriating British hot money, and pulling the rug out from under
the Wall Street speculators, thus deliberately and consciously
imploding the US markets. This caused a violent depression in the
United States and some other countries, with the collapse of
financial markets and the contraction of production and employment.
In 1929, Norman engineered a collapse by puncturing the bubble."
The crash was, in large part, a reaction to a sharp reversal,
starting in 1928, of the reflationary, "cheap money", policies of
the Fed intended, as Adolph Miller of the Fed's Board of Governors
told a Senate committee, "to bring down money rates, the call rate
among them, because of the international importance the call rate
had come to acquire. The purpose was to start an outflow of gold -
to reverse the previous inflow of gold into this country (back to
Britain)." But the Fed had already lost control of the speculative
rush.
The crash of 1929 was not without its Enrons and World.com's.
Clarence Hatry and his associates admitted to forging the accounts
of their investment group to show a fake net worth of $24 million
British pounds - rather than the true picture of 19 billion in
liabilities. This led to forced liquidation of Wall Street positions
by harried British financiers.
The collapse of Middle West Utilities, run by the energy tycoon,
Samuel Insull, exposed a web of offshore holding companies whose
only purpose was to hide losses and disguise leverage. The former
president of NYSE, Richard Whitney was arrested for larceny.
Analysts and commentators thought of the stock exchange as decoupled
from the real economy. Only one tenth of the population was invested
- compared to 40 percent today. "The World" wrote, with more than a
bit of Schadenfreude: "The country has not suffered a catastrophe
... The American people ... has been gambling largely with the
surplus of its astonishing prosperity."
"The Daily News" concurred: "The sagging of the stocks has not
destroyed a single factory, wiped out a single farm or city lot or
real estate development, decreased the productive powers of a single
workman or machine in the United States." In Louisville, the "Herald
Post" commented sagely: "While Wall Street was getting rid of its
weak holder to their own most drastic punishment, grain was
stronger. That will go to the credit side of the national prosperity
and help replace that buying power which some fear has been gravely
impaired."
During the Coolidge presidency, according to the Encyclopedia
Britannica, "stock dividends rose by 108 percent, corporate profits
by 76 percent, and wages by 33 percent. In 1929, 4,455,100 passenger
cars were sold by American factories, one for every 27 members of
the population, a record that was not broken until 1950.
Productivity was the key to America's economic growth. Because of
improvements in technology, overall labour costs declined by nearly
10 percent, even though the wages of individual workers rose."
Jude Waninski adds in his tome "The Way the World Works" that
"between 1921 and 1929, GNP grew to $103.1 billion from $69.6
billion. And because prices were falling, real output increased even
faster." Tax rates were sharply reduced.
John Kenneth Galbraith noted these data in his seminal "The Great
Crash":
"Between 1925 and 1929, the number of manufacturing establishments
increased from 183,900 to 206,700; the value of their output rose
from $60.8 billions to $68 billions. The Federal Reserve index of
industrial production which had averaged only 67 in 1921 ... had
risen to 110 by July 1928, and it reached 126 in June 1929 ... (but
the American people) were also displaying an inordinate desire to
get rich quickly with a minimum of physical effort."
Personal borrowing for consumption peaked in 1928 - though the
administration, unlike today, maintained twin fiscal and current
account surpluses and the USA was a large net creditor.
Charles Kettering, head of the research division of General Motors
described consumeritis thus, just days before the crash: The key to
economic prosperity is the organized creation of dissatisfaction.
Inequality skyrocketed. While output per man-hour shot up by 32
percent between 1923 and 1929, wages crept up only 8 percent. In
1929, the top 0.1 percent of the population earned as much as the
bottom 42 percent. Business-friendly administrations reduced by 70
percent the exorbitant taxes paid by those with an income of more
than $1 million. But in the summer of 1929, businesses reported
sharp increases in inventories. It was the beginning of the end.
Were stocks overvalued prior to the crash? Did all stocks collapse
indiscriminately? Not so. Even at the height of the panic, investors
remained conscious of real values. On November 3, 1929 the shares of
American Can, General Electric, Westinghouse and Anaconda Copper
were still substantially higher than on March 3, 1928.
John Campbell and Robert Shiller, author of "Irrational Exuberance",
calculated, in a joint paper titled "Valuation Ratios and the Lon-
Run Market Outlook: An Update" posted on Yale University' s Web
Site, that share prices divided by a moving average of 10 years
worth of earnings reached 28 just prior to the crash. Contrast this
with 45 on March 2000.
In an NBER working paper published December 2001 and tellingly
titled "The Stock Market Crash of 1929 - Irving Fisher was Right",
Ellen McGrattan and Edward Prescott boldly claim:
"We find that the stock market in 1929 did not crash because the
market was overvalued. In fact, the evidence strongly suggests that
stocks were undervalued, even at their 1929 peak."
According to their detailed paper, stocks were trading at 19 times
after-tax corporate earning at the peak in 1929, a fraction of
today's valuations even after the recent correction. A March 1999
"Economic Letter" published by the Federal Reserve Bank of San-
Francisco wholeheartedly concurs. It notes that at the peak, prices
stood at 30.5 times the dividend yield, only slightly above the long
term average.
Contrast this with an article published in June 1990 issue of the
"Journal of Economic History" by Robert Barsky and Bradford De Long
and titled "Bull and Bear Markets in the Twentieth Century":
"Major bull and bear markets were driven by shifts in assessments of
fundamentals: investors had little knowledge of crucial factors, in
particular the long run dividend growth rate, and their changing
expectations of average dividend growth plausibly lie behind the
major swings of this century."
Jude Waninski attributes the crash to the disintegration of the pro-
free-trade coalition in the Senate which later led to the notorious
Smoot-Hawley Tariff Act of 1930. He traces all the important moves
in the market between March 1929 and June 1930 to the intricate
protectionist danse macabre in Congress.
This argument may never be decided. Is a similar crash on the cards?
This cannot be ruled out.
The 1990's resembled the 1920's in more than one way. Are we ready
for a recurrence of 1929? About as we were prepared in 1928. Human
nature - the prime mover behind market meltdowns - seemed not to
have changed that much in these intervening seven decades.
Will a stock market crash, should it happen, be followed by another
"Great Depression"? It depends which kind of crash. The short term
puncturing of a temporary bubble - e.g., in 1962 and 1987 - is
usually divorced from other economic fundamentals. But a major
correction to a lasting bull market invariably leads to recession or
worse.
As the economist Hernan Cortes Douglas reminds us in "The Collapse
of Wall Street and the Lessons of History" published by the
Friedberg Mercantile Group, this was the sequence in London in 1720
(the infamous "South Sea Bubble"), and in the USA in 1835-40 and
1929-32.
The Shadowy World of International Finance
Strange, penumbral, characters roam the boardrooms of banks in the
countries in transition. Some of them pop apparently from nowhere,
others are very well connected and equipped with the most excellent
introductions. They all peddle financial transactions which are too
good to be true and often are. In the unctuously perfumed
propinquity of their Mercedesed, Rolex waving entourage - the
polydipsic natives dissolve in their irresistible charm and the
temptations of the cash: mountainous returns on capital, effulgent
profits, no collaterals, track record, or business plan required.
Total security is cloyingly assured.
These Fausts roughly belong to four tribes:
The Shoppers
These are the shabby operators of the marginal shadows of the world
of finance. They broker financial deals with meretricious sweat only
to be rewarded their meagre, humiliated fees. Most of their deals do
not materialize. The principle is very simple:
They approach a bank, a financial institution, or a borrower and
say: "We are connected to banks or financial institutions in the
West. We can bring you money in the form of credits. But to do that
- you must first express interest in getting this money. You must
furnish us with a bank guarantee / promissory note / letter of
intent that indicates that you desire the credit and that you are
willing to provide a liquid financial instrument to back it up.".
Having obtained such instruments, the shoppers begin to "shop
around". They approach banks and financial institutions (usually, in
the West). This time, they reverse their text: "We have an excellent
client, a good borrower. Are you willing to lend to it?" An informal
process of tendering ensues. Sometimes it ends in a transaction and
the shopper collects a small commission (between one quarter of a
percentage point and two percentage points - depending on the
amount). Mostly it doesn't -and the Flying Dutchman resumes his
wanderings looking for more venal gulosity and less legal probity.
The Con-Men
These are crooks who set up elaborate schemes ("sting operations")
to extract money from unsuspecting people and financial
institutions. They establish "front" or "phantom" firms and offices
throughout the world. They tempt the gullible by offering them
enormous, immediate, tax-free, effort-free, profits. They let the
victims profit in the first round or two of the scam. Then, they
sting: the victims invest money and it evaporates together with the
dishonest operators.
The "offices" are deserted, the fake identities, the forged bank
references, the falsified guarantees are all exposed (often with the
help of an inside informant).
Probably the most famous and enduring scam is the "Nigerian-type
Connection". Letters - allegedly composed by very influential and
highly placed officials - are sent out to unsuspecting businessmen.
The latter are asked to make their bank accounts available to the
former, who profess to need the third party bank accounts through
which to funnel the sweet fruits of corruption.
The account owners are promised huge financial rewards if they
collaborate and if they bear some minor-by-comparison upfront costs.
The con-men pocket these "expenses" and vanish. Sometimes, they even
empty the accounts of their entire balance as they evaporate.
The Launderers
A lot of cash goes undeclared to tax authorities in countries in
transition. The informal economy (the daughter of both criminal and
legitimate parents) comprises between 15% (Slovenia) and 50%
(Russia, Macedonia) of the official one. Some say these figures are
a deliberate and ferocious understatement. These are mind boggling
amounts, which circulate between financial centres and off shore
havens in the world: Cyprus, the Cayman Islands, Liechtenstein
(Vaduz), Panama and dozens of aspiring laundrettes.
The money thus smuggled is kept in low-yielding cash deposits. To
escape the cruel fate of inflationary corrosion, it has to be
reinvested. It is stealthily re-introduced to the very economy that
it so sought to evade, in the form of investment capital or other
financial assets (loans and credits). Its anxious owners are
preoccupied with legitimising their stillborn cash through the
conduit of tax-fearing enterprises, or with lending it to same. The
emphasis is on the word: "legitimate". The money surges in through
mysterious and anonymous foreign corporations, via off-shore banking
centres, even through respectable financial institutions (the Bank
of New York we mentioned?). It is easy to recognize a laundering
operation. Its hallmark is a pronounced lack of selectivity.
The money is invested in anything and everything, as long as it
appears legitimate. Diversification is not sought by these nouveau
tycoons and they have no core investment strategy. They spread their
illicit funds among dozens of disparate economic activities and show
not the slightest interest in the putative yields on their
investments, the maturity of their assets, the quality of their
newly acquired businesses, their history, or real value. Never the
sedulous, they pay exorbitantly for all manner of prestidigital
endeavours. The future prospects and other normal investment
criteria are beyond them. All they are after is a mirage of
lapidarity.
The Investors
This is the most intriguing group. Normative, law abiding,
businessmen, who stumbled across methods to secure excessive yields
on their capital and are looking to borrow their way into increasing
it. By cleverly participating in bond tenders, by devising ingenious
option strategies, or by arbitraging - yields of up to 300% can be
collected in the immature markets of transition without the normally
associated risks. This sub-species can be found mainly in Russia and
in the Balkans.
Its members often buy sovereign bonds and notes at discounts of up
to 80% of their face value. Russian obligations could be had for
less in August 1998 and Macedonian ones during the Kosovo crisis. In
cahoots with the issuing country's central bank, they then convert
the obligations to local currency at par (=for 100% of their face
value). The difference makes, needless to add, for an immediate and
hefty profit, yet it is in (often worthless and vicissitudinal)
local currency.
The latter is then hurriedly disposed of (at a discount) and sold to
multinationals with operations in the country of issue, which are in
need of local tender. This fast becomes an almost addictive
avocation.
Intoxicated by this pecuniary nectar, the fortunate, those privy to
the secret, try to raise more capital by hunting for financial
instruments they can convert to cash in Western banks. A bank
guarantee, a promissory note, a confirmed letter of credit, a note
or a bond guaranteed by the Central Bank - all will do as deposited
collateral against which a credit line is established and cash is
drawn. The cash is then invested in a new cycle of inebriation to
yield fantastic profits.
It is easy to identify these "investors". They eagerly seek
financial instruments from almost any local bank, no matter how
suspect. They offer to pay for these coveted documents (bank
guarantees, bankers' acceptances, letters of credit) either in cash
or by lending to the bank's clients and this within a month or more
from the date of their issuance. They agree to "cancel" the locally
issued financial instruments by offering a "counter-financial-
instrument" (safe keeping receipt, contra-guarantee, counter
promissory note, etc.). This "counter-instrument" is issued by the
very Prime World or European Bank in which the locally issued
financial instruments are deposited as collateral.
The Investors invariably confidently claim that the financial
instrument issued by the local bank will never be presented or used
(which is true) and that this is a risk free transaction (which is
not entirely so).
If they are forced to lend to the bank's clients, they often ignore
the quality of the credit takers, the yields, the maturities and
other considerations which normally tend to interest lenders very
much.
Whether a financial instrument cancelled by another is still valid,
presentable and should be honoured by its issuer is still debated.
In some cases it is clearly so. If something goes horribly (and
rarely, admittedly) wrong with these transactions - the local bank
stands to suffer, too.
It all boils down to a terrible hunger, the kind of thirst that can
be quelled only by the denominated liquidity of lucre. In the post
nuclear landscape of this part of the world, a fantasy is shared by
both predators and prey. Circling each other in marble temples, they
switch their roles in dizzying progression. Tycoons and politicians,
industrialists and bureaucrats all vie for the attention of Mammon.
The shifting coalitions of well groomed man in back stabbed suits,
an hallucinatory carousel of avarice and guile. But every circus
folds and every luna park is destined to shut down. The dying music,
the frozen accounts of the deceived, the bankrupt banks, the
Jurassic Park of skeletal industrial beasts - a muted testimony to a
wild age of mutual assured destruction and self deceit. The future
of Eastern and South Europe. The present of Russia, Albania and
Yugoslavia.
Treasure Island Revisited
On Maritime Piracy
The rumors concerning the demise of maritime piracy back in the 19th
century were a tad premature. The scourge has so resurged that the
International Maritime Board (IMB), founded by the International
Chamber of Commerce (ICC) in 1981, is forced to broadcast daily
piracy reports to all shipping companies by satellite from its Kuala
Lumpur Piracy Reporting Center, established in 1992 and partly
funded by maritime insurers. The reports carry this alarming
disclaimer:
"For statistical purposes, the IMB defines piracy and armed robbery
as: An act of boarding or attempting to board any ship with the
apparent intent to commit theft or any other crime and with the
apparent intent or capability to use force in the furtherance of
that act. This definition thus covers actual or attempted attacks
whether the ship is berthed, at anchor or at sea. Petty thefts are
excluded, unless the thieves are armed."
The 1994 United Nations Convention on the Law of the Sea defines
piracy as "any illegal acts of violence or detention, or any act of
depredation, committed by individuals (borne aboard a pirate vessel)
for private ends against a private ship or aircraft (the victim
vessel)." When no "pirate vessel" is involved - for instance, when
criminals embark on a ship and capture it - the legal term is
hijacking.
On July 8, seven pirates, armed with long knives attacked an officer
of a cargo ship berthed in Chittagong port in Bangladesh, snatched
his gold chain and watch and dislocated his arm. This was the third
such attack since the ship dropped anchor in this minacious port.
Three days earlier, in Indonesia, similarly-armed pirates escaped
with the crew's valuables, having tied the hands of the duty
officer. Pirates in small boats stole anodes from the stern of a
bulk carrier in Bangladesh. Others, in Indonesia, absconded with a
life raft.
The pirates of Guyana are either unlucky or untrained. They were
consistently scared off by flares hurled at them and alarms set by
vigilant hands on deck. A Colombian band, riding a high speed boat,
attempted to board a container ship. Warring parties in Somalia
hijacked yet another ship last month.
A particularly egregious case - and signs of growing sophistication
and coordinated action - is described in the July 1-8 report of the
IMB:
"Six armed pirates boarded a chemical tanker from a small boat and
stole ship's stores. Another group of pirates broke in to engine
room and stole spare parts. Thefts took place in spite of the ship
engaging three shore security watchmen." Piracy incidents have been
reported in India, Malaysia, Philippines, Thailand, Vietnam, the Red
Sea, the Gulf of Aden, Nigeria, Brazil, Colombia, Dominican
Republic, Ecuador, Peru, Venezuela.
According to the ICC Year 2001 Piracy Report, more than 330 attacks
on seafaring vessels were reported last year - down by a quarter
compared to 2000 but 10 percent higher than 1999 and four times the
1991 figure. Piracy rose 40 percent between 1998 and 1999 alone.
Sixteen ships - double the number in 2000 - were captured and taken
over. Eighty seven attacks were reported during the first quarter of
this year - up from 68 in the corresponding period last year. Seven
of these were hijackings - compared to only 1 in the first quarter
of 2001. Nine of every 10 hijacked ships are ultimately recovered,
often with the help of the IMB.
Many masters and shipowners do not report piracy for fear of delays
due to protracted investigations, increased insurance premiums, bad
publicity, and stifling red tape. The number of unreported attacks
in 1999 was estimated by the World Maritime Piracy Report to be 130.
According to "The Economist", the IMO believes that half of all
incidents remain untold. Still, increased patrols and international
collaboration among law enforcement agencies dented the clear upward
trend in maritime crime - even in the piracy capital, Indonesia.
The number of incidents in the pirate-infested Malacca Straits
dropped from 75 to 17 last year - though the number of crew "kidnap
and ransom" operations, especially in Aceh, has increased. Owners
usually pay the "reasonable" amounts demanded - c. $100,000 per
ship. Contrary to folklore, most ships are attacked while at anchor.
Twenty one people, including passengers, were killed last year - and
210 taken hostage. Assaults involving guns were up 50 percent to 73
- those involving mere knives down by a quarter to 105. Piracy seems
to ebb and flow with the business cycles of the host economies. The
Asian crisis, triggered by the freefall of the Thai baht, gave a
boost to East Asian maritime robbers. So did the debt crises of
Latin America a decade earlier. Drug transporters - armed with light
aircraft and high speed motorboats - sometimes double as pirates
during the dry season of crop growth.
Pirates endanger ship and crew. But they often cause collateral
damage as well. Pirates have been known to dump noxious cargo into
the sea, or tie up the crew and let an oil tanker steam ahead, its
navigational aides smashed, or tamper with substances dangerous to
themselves and to others, or cast crew and passengers adrift in tiny
rafts with little food and water.
Many shipowners resorted to installing on-board satellite tracking
systems, such as Shiploc, and aircraft-like "black boxes". A
bulletproof life vest, replete with an integral jagged edged knife,
was on display in the millennium exhibition at the Millennium Dome
two years ago. The International Maritime Organization (IMO) is
considering to compel shipowners to tag their vessels with visibly
embossed numbers in compliance with the Safety of Life at Sea
Convention.
The IMB also advises shipping companies to closely examine the
papers of crew and masters, thousands of whom carry forged
documents.
In 54 maritime administrations surveyed last year by the Seafarers'
International Research Centre, Cardiff University in Wales, more
than 12,000 cases of forged certificates of competency were
unearthed.
Many issuing authorities are either careless or venal or both. The
IMB recently accused the Coast Guard Office of Puerto Rico for
issuing 500 such "suspicious" certificates. The Chinese customs and
navy - especially along the southern coast - have often been accused
of working hand in glove with pirates.
False documents are an integral - and crucial - part of maritime
piracy. The IMB says:
"Many of the phantom ships that set off to sea with a cargo and then
disappear are sailed by crewmen with false passports and competency
certificates. They usually escape detection by the port authorities.
In a recent case of a vessel located and arrested in South-East Asia
further to IMB investigations, it has emerged that all the senior
officers had false passports. The ship's registry documents were
also false."
As documents go electronic and integrated in proprietary or common
cargo tracking systems, such forgery will wane. Bolero - an
international digital bill of lading ledger - is backed by the
European Union, banks, shipping and insurance companies. The IMO is
a proponent of a technology to apply encrypted "digital signatures"
to electronic bills of lading. Still, the industry is highly
fragmented and many ships and ports don't even possess rudimentary
information technology.
The protection afforded by the likes of Bolero is at least a decade
away.
Pirates sometimes work hand in hand with conspiring crew members
(or, less often, stowaways). In many countries - in East Asia, Latin
America, and Africa - Coast Guard operatives, corrupt drug agents,
and other law enforcement officials, moonlight as pirates. Renegade
members of British trained Indonesian anti-piracy squads are still
roaming the Malacca Straits.
Pirates also enjoy the support of an insidious and vast network of
suborned judges and bureaucrats. Local villagers along the coasts of
Indonesia and Malaysia - and Africa - welcome pirate business and
provide the perpetrators with food and shelter.
Moreover, large tankers, container ships, and cargo vessels are
largely computerized and their crew members few. The value of an
average vessel's freight has increased dramatically with
improvements in container and oil storage technologies. "Flag of
convenience" registration has assumed monstrous proportions,
allowing ship owners and managers to conceal their identity
effectively. Belize, Honduras, and Panama are the most notorious, no
questions asked, havens.
Piracy has matured into a branch of organized crime. Hijacking
requires money, equipment, weapons, planning, experience and
contacts with corrupt officials. The loot per vessel ranges from $8
million to $200 million.
Pottengal Mukundan, Director of ICC's Commercial Crime Services
states, in a recent IMB press release:
"(Piracy) typically involves a mother ship from which to launch the
attacks, a supply of automatic weapons, false identity papers for
the crew and vessel, fake cargo documents, and a broker network to
sell the stolen goods illegally. Individual pirates don't have these
resources. Hijackings are the work of organized crime rings."
The IMB describes the aftermath of a typical hijacking:
"The Global Mars has probably been given a new name and repainted.
Armed with false registration papers and bills of lading, the
pirates - or more likely the mafia bosses pulling the strings - will
then try to dispose of their booty. The vessel has probably put in
to a port where the false identity of vessel and cargo may escape
detection. Even when identified, the gangs have been known to bribe
local officials to allow them to sell the cargo and leave the port."
Such a ship is often "recycled" a few times. It earns its operators
an average of $40-50 million per "cycle", according to "The
Economist". The pirates contract with sellers or shipping agents to
load it with a legitimate consignment of goods or commodities. The
sellers and agents are unaware of the true identity of the ship, or
of its unsavory "owners/managers".
The pirates invariably produce an authentic vessel registration
certificate that they acquired from crooked officials - and provide
the sellers or agents with a bill of lading. The payload is then
sold to networks of traders in stolen merchandise or to gullible
buyers in a different port of destination - and the ship is ready
for yet another round.
This January, the Indonesian Navy has permanently stationed six
battleships in the Malacca Straits, three of them off the coast of
the secessionist region of Aceh. A further 20-30 ships and 10
aircraft conduct daily patrols of the treacherous traffic lane. Some
200-600 ships cross the Straits daily. A mere 50 ships or so are
boarded and searched every month.
The Greek government has gunboats patrolling the 2 miles wide Corfu
Channel, where yachts frequently fall prey to Albanian pirates.
Brazil has imposed an unpopular anti-piracy inspection fee on
berthing vessels and used the proceeds to finance a SWAT team to
protect ships and their crews while in port. Both India and Thailand
have similar units.
International cooperation is also on the rise. About one third of
the world's shipping traffic goes through the South China Sea. A
conference convened by Japan in March 2000 - Japanese vessels have
become favored targets of piracy in the last few years - pushed for
the ratification of the International Maritime Organisation's (IMO)
1988 Rome Convention on the Suppression of Unlawful Acts against the
Safety of Maritime Navigation by Asian and ASEAN countries.
The Convention makes piracy an extraterritorial crime and, thus,
removes the thorny issue of jurisdiction in cases of piracy carried
in another country's territorial waters or out on the high seas. The
Comite Maritime International - the umbrella organization of
national maritime law associations - promulgated a model anti-piracy
law last year.
Though it rejected Japan's offer for collaboration, in a sharp
reversal of its previous policy, China started handing down death
sentences against murderous pirates. The 13 marauders who seized the
Cheung Son and massacred its 23 Chinese sailors were executed two
years ago in the southern city of Shanwei. Another 25 people
received long prison sentences. The - declared - booty amounted to a
mere $300,000.
India and Iran - two emerging "pirates safe harbor" destinations -
have also tightened up sentencing and port inspections. In the
Alondra Rainbow hijacking, the Indian Navy captured the Indonesian
culprits in a cinematic chase off Goa. They were later sentenced
severely under both the Indian Penal Code and international law.
Even the junta in Myanmar has taken tentative steps against
compatriots with piratical predilections.
Law enforcement does not tolerate a vacuum. "The Economist" reports
about two private military companies - Marine Risk Management and
Satellite Protection Services (SPS) - which deploy airborne
mercenaries to deal with piracy. SPS has even suggested to station
2500 former Dutch marines in Subic Bay in the Philippines - for a
mere $2500 per day per combatant.
Shipowners are desperate. Quoted by "The Economist", they "suggest
that the regions governments negotiate the right for navies to
chase pirates across national boundaries: the so-called right of
hot pursuit. So far, only Singapore and Indonesia have negotiated
limited rights. Some suggest that the American navy should be
invited into territorial waters to combat piracy, a live exercise
it might relish. At the very least, countries such as Indonesia
should advertise which bits of their territorial waters at any time
are patrolled and safe from pirates. No countries currently do
this."