I. Overview
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 to 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 intent-some 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.
IV. Britain's Real Estate
The five ghastly "Jack the Ripper" murders took place in
an area less than a quarter square mile in size. Houses in
this haunting and decrepit no man's land straddling the
City and metropolitan London could be had for 25-50,000
British pounds as late as a decade ago. How things
change!
The general buoyancy in real estate prices in the capital
coupled with the adjacent Spitalfields urban renewal
project have lifted prices. A house not 50 yards from the
scene of the Ripper's last - and most ghoulish - slaying
now sells for over 1 million pounds. In central London,
one bedroom apartments retail for an outlandish half a
million.
According to research published in September 2002 by
Halifax, the UK's largest mortgage lender, the number of
1 million pound homes sold has doubled in 1999-2002 to
2600. By 2002, it has increased elevenfold since 1995.
According to The Economist's house price index, prices
rose by a further 15.6% in 2003, 10.2% in 2004 and a
whopping 147% in total since 1997. In Greater London,
one in every 90 homes fetches even a higher price. The
average UK house now costs 100,000 pounds. In the
USA, the ratios of house prices to rents and to median
income are at historic highs.
One is reminded of the Japanese boast, at the height of
their realty bubble, that the grounds of the royal palace in
Tokyo are worth more than the entire real estate of
Manhattan. Is Britain headed the same way?
A house - much like a Big Mac - is a basket of raw
materials, goods, and services. But, unlike the Big Mac -
and the purchasing power index it spawned - houses are
also investment vehicles and stores of value. They yield
often tax exempt capital gains, rental income, or benefits
from occupying them (rent payments saved). Real estate is
used to hedge against inflation, save for old age, and
speculate. Prices of residential and commercial property
reflect scarcity, investment fads, and changing moods.
Homeowners in both the UK and the USA - spurred on by
aggressive marketing and the lowest interest rates in 30
years - have been refinancing old, more expensive,
mortgages and heavily borrowing against their "equity" -
i.e., against the meteoric rise in the market prices of their
abodes.
According to the Milken Institute in Los Angeles, asset
bubbles tend to both enhance and cannibalize each other.
Profits from surging tradable securities are used to buy
property and drive up its values. Borrowing against
residential equity fuels overvaluations in fervid stock
exchanges. When one bubble bursts - the other initially
benefits from an influx of funds withdrawn in panic from
the shriveling alternative.
Quantitatively, a considerably larger share of the nation's
wealth is tied in real estate than in the capital markets.
Yet, the infamous wealth effect - an alleged fluctuation in
the will to consume as a result of changing fortunes in the
stock exchange - is equally inconspicuous in the realty
markets. It seems that consumption is correlated with
lifelong projected earnings rather than with the state of
one's savings and investments.
This is not the only counter-intuitive finding. Asset
inflation - no matter how vertiginous - rarely spills into
consumer prices. The recent bubbles in Japan and the
USA, for instance, coincided with a protracted period of
disinflation. The bursting of bubbles does have a
deflationary effect, though.
In a late 2002 survey of global house price movements,
"The Economist" concluded that real estate inflation is a
global phenomenon. Though Britain far outpaces the
United States and Italy (65% rise since 1997), it falls
behind Ireland (179%) and South Africa (195%). It is in
league with Australia (with 113%) and Spain (132%).
The paper notes wryly:
"Just as with equities in the late 1990s, property bulls
are now coming up with bogus arguments for why
rampant house-price inflation is sure to continue.
Demographic change ... Physical restrictions and tough
planning laws ... Similar arguments were heard in
Japan in the late 1980s and Germany in the early 1990s
- and yet in recent years house prices in these two
countries have been falling. British house prices also
tumbled in the late 1980s".
They are bound to do so again. In the long run, the rise in
house prices cannot exceed the increase in disposable
income. The effects of the bursting of a property bubble
are invariably more pernicious and prolonged than the
outcomes of a bear market in stocks. Real estate is much
more leveraged. Debt levels can well exceed home equity
("negative equity") in a downturn. Nowadays, loans are
not eroded by high inflation. Adjustable rate mortgages -
one third of the annual total in the USA - will make sure
that the burden of real indebtedness mushrooms as interest
rates rise.
The Economist (April 2005):
"An IMF study on asset bubbles estimates that 40% of
housing booms are followed by housing busts, which last
for an average of four years and see an average decline
of roughly 30% in home values. But given how many
homebuyers in booming markets seem to be basing their
purchasing decisions on expectations of outsized
returns-a recent survey of buyers in Los Angeles
indicated that they expected their homes to increase in
value by a whopping 22% a year over the next decade-
nasty downturns in at least some markets seem likely".
With both the equity and realty markets in gloom, people
revert to cash and bonds and save more - leading to
deflation or recession or both. Japan is a prime example of
such a shift of investment preferences. When prices
collapse sufficiently to become attractive, investors pile
back into both the capital and real estate markets. This
cycle is as old and as inevitable as human greed and fear.