Prepared by Friedberg Mercantile Group

The money is talking, the remaining bears are capitulating, and the global stock market is rising unstoppably to an intoxicating climax. So did Barry Riley aptly sign off a recent column in the Financial Times of London. A juggernaut and a foreboding sense of impending tragedy.

It was not much different 70 years ago. The decade of the '20s was "characterized by fairly rapid economic growth without major contractions. [It was] regarded at the time as a `new era'..." With these words, Milton Friedman and Anna Jacobson Schwartz begin the sixth chapter of their monumental work A Monetary History of the United States, 1857-1960. The chapter was entitled "The High Tide of the Reserve System, 1921-1929."

The parallels are eerily reminiscent of our times. "As the decade wore on, the [Federal Reserve] System took-and perhaps, even more, was given-credit for the generally stable conditions that prevailed, and high hopes were placed in the potency of monetary policy as then administered." (Sound familiar?) There was growth and no inflation: In the 6 years from 1923 to 1929, real income grew at a 3.4% rate, wholesale prices fell at an annual rate of 0.9%, the price index implicit in real income grew at an annual rate of 0.1%. The stock of money rose at an annual pace of 4%.

The nirvana of the '90s has been slightly less luxuriant: Real income grew at a bit under 3%, wholesale prices climbed an annualized 1.2%, while the implicit price deflator did so by 2.1%. The broad money stock grew by only 2.25% per annum. The lack of close agreement between price and monetary behavior can be attributed to distortions arising in M2, because of the enormous inflows into mutual funds in the latter period and, possibly, an acceleration in velocity.

A good case can in fact be made that the present decade has witnessed a greater degree of monetary ease than the earlier period. In contrast to the '20s, where the yield curve was constantly negative from 1923 on (except for a few months around the beginning of 1924), the '90s witnessed a positive-and at times historically high-yield curve. Coming out of the 1923 mini-recession, the yield curve went from flat to a peak inversion (in 1929) of 225 basis points (bp). Coming out of the 1990 recession, the yield curve went from being flat to being positive to the tune of 435 bp at its peak at the end of 1992, remaining positive in the subsequent years and never falling below 75 bp.

Friedman and Schwartz contended that "The main features of the financial activity, which culminated in the great stock market boom, were the public floatation on a large scale of foreign securities for the first time in U.S. history, and a widening shift by domestic concerns from bank loans to public issue of bonds and stocks as a means of raising funds. One result of these developments was that they apparently led to a reduction in the average quality of credit outstanding, in the sense that the securities issued and the loans made in the late twenties experienced a larger frequency of default and foreclosure than those issued in the early twenties...the high prosperity of the twenties and the spreading belief in a new era understandably led to an increasingly optimistic evaluation of the prospects of repayment and hence to an increasing readiness to lend on a given project or collateral."

Just a few days ago, officials at Citibank said that the aggregate value of issues from emerging market companies (let alone the much greater totals for emerging sovereign debt) reached $3.42 billion in the first half of 1997, up from $2 billion in the same period of 1996 and out of a total of $6 billion worth of issues for all foreign companies. Meanwhile, the dollar turnover of all ADRs, or foreign listed shares, rose by 20% in the first half to $211.5 billion, reflecting the seemingly insatiable appetite of U.S. investors for foreign securities.

The "widening shift by domestic concerns from bank loans to public issue of bonds and stocks" is a function of this very same public appetite for high nominal returns, causing credit spreads to collapse across a very wide spectrum of low credit quality securities. The "increasing readiness to lend on any given project or collateral" has become an almost permanent feature of today's markets-from Credit Suisse First Boston's high-yield 95% loan to value advances against New York commercial real estate (for subsequent resale, of course, to the public) to multi-billion dollar bridge loans to Russian companies with no financial statements.

Nothing could mar the New Era effervescence of the Roaring Twenties except, of course, euphoria itself. This euphoria had been reflected in soaring securities prices and at least one group of men-the bankers of the Federal Reserve Board and the then-powerful and nearly independent Federal Reserve Bank of New York-expressed deep concern. "The difference," continues Friedman, "was about the desirability of `qualitative' techniques of control designed to induce banks to discriminate against loans for speculative purpose...the view attributed to the Board was that direct pressure was a feasible means of restricting the availability of credit for speculative purposes without unduly restricting its availability for productive purposes, whereas rises in discount rates or open market sales sufficiently severe to curb speculation would be too severe for business in general. The Board's unwillingness to approve a rise in discount rates was partly, no doubt, a reaction to the severe criticism the System had suffered for the 1920-1921 deflation. The Board prevailed until August 1929, when it finally permitted the New York Bank to raise its discount rate. By then the New York Bank believed the time might have passed for such action."

While the Board asserted that "a member bank is not within its reasonable claims for rediscount facilities at its Federal Reserve banks when it borrows either for the purpose of making speculative loans or for the purpose of maintaining speculative loans"-advocating in effect quantitative controls or, at best, moral suasion-the New York Fed argued that credit expansion [i.e., speculative loans-our note] had grown too fast in comparison to business activity. We ought, however, not to be misled to believe that Harrison, the then Governor of the New York Fed, was a hard-money man, for in the same breath he expressed concern that interest rates were too high and represented a menace to the continued expansion! In fact, he really wanted lower rates and he was going to achieve this objective by "sharp, incisive action" involving a rise in the discount rate that would "quickly control the long continued expansion in the total volume of credit so that we might then adopt a System policy of easing rates."

There was no better way to rein in the raging animal spirits of speculation-the manifestations of "irrational exuberance," in the parlance of the mid- '90s-than by a quick and dramatic increase in the discount rate (the archaic predecessor, so to speak, of the Fed Funds rate). So did Harrison believe he could resolve the dilemma. Friedman commented that "it is by no means clear, of course, that this tactic would have worked, but it very likely would have hastened the end of the bull market." It is also no means clear that the Fed was excessively easy during this period.

As we pointed out earlier, from 1923 to 1929 the money stock rose at an annual rate of 4%. More importantly, high-powered money (better known as the monetary base-the only variable over which the Fed could have control) grew by a mere 1.1% rate over the entire period, rising at a 1.8% rate from 1923 to 1927 and then contracting over the subsequent 2 years. While admittedly not offsetting the rise of the deposit-currency and deposit-reserve ratios, the Fed sterilized gold inflows and for the most part behaved in a rather conservative fashion. This is in spite of the fact that the Fed was operating in the spirit of the thesis enunciated in the 1923 Tenth Annual Report: "that there is no simple test such as the reserve ratio, the exchange rate or a price-index number that can serve as an adequate guide for policy"; that policy `is and must be a matter of judgement' based on the fullest possible range of evidence about changes in production, trade employment, prices and commodity stocks."

Seventy years on, the Fed has become a much more aggressive and sophisticated executioner of this very same spirit of indefiniteness; it now not only acts flexibly, but also "opportunistically" and "preemptively." It has allowed the monetary base to expand at a 6.8% annual rate in the face of an indeterminate but nonetheless real fall in the demand for money. Unlike the Fed of the '20s as we saw earlier, the present Fed has fostered-via excessively easy money-a steeply sloped yield curve.

It is worthwhile to note that the dispute between the Board and the New York Fed did not stop the System from tightening: (Upward) changes in the buying rate for bills, over which the New York Fed had more control, caused the System's holdings of bills to fall sufficiently during 1928 and the first half of 1929 to account for the contemporaneous decline in total Federal Reserve credit outstanding. In fact, the monetary base stayed roughly constant or declined slightly during those two years, while the stock of money was lower at the cyclical peak of August 1929 than in April 1928.

The New York Fed's continued insistence on raising the discount rate can be seen in retrospect as being more a matter of form than of substance. For all practical purposes-and in response to the stock market boom-the tightening had already begun in early 1928. This tightening failed to restrain the bull market but "did exert steady deflationary pressure on the economy. Wholesale prices...averaged a trifle lower during the three months centered on the cyclical peak of August 1929 than during the three months centered on the prior trough of November 1927..." In Friedman's opinion, there was "no doubt that the desire to curb the stock market boom was a major if not dominating factor in Reserve actions during 1928 and 1929."

Caught in the midst of a dilemma, the Fed followed "a policy which was too easy to break the speculative boom, yet too tight to promote healthy economic growth." He then continues, "In our view, the Board should not have made itself an "arbiter of security speculation or values"[ed. note: the words used by the Board in its famous February 1929 statement] and should have paid no direct attention to the stock market boom, any more than it did to the earlier Florida land boom...a vigorous restrictive policy in early 1928 might have well broken the stock market boom without its having to be kept in effect long enough to constitute a serious drag on business in general."

Friedman's conclusions are based on his belief that tight money caused and aggravated the Great Depression. This thesis has never been proven. Austrian economists have long argued that easy money stimulated a malinvestment boom that had to be liquidated in the subsequent downturn and that the severity of the depression was directly proportional to the investment excesses of the boom.

One can sympathize with his view that the Fed should have paid no more attention to the stock market boom than to the earlier Florida land boom, since after all, the Fed was only moderately responsible for the boom. Still, one wonders how many more participants would have been caught in the speculative whirlpool had the Fed not tightened as dramatically as it did, and how much worse would the impact on confidence have been (or the number of malinvestments, in the Austrian thesis) as a result of the inevitable crash.

Be that as it may, our own conclusions-based on the few monetary indicators that we reviewed-are that the Fed of the '90s bears more culpability than the Fed of the '20s. Staying the course is no option.

In 1997 the economy is growing at a satisfactory pace, inflation is moderate, yet the stock market is gripped by one of the greatest financial manias in history. By following an excessively easy money policy, Greenspan's Fed has stoked the fires of speculation more than any other group of central bankers in American history.

Although we lack precise numbers, it is a given that the amount of public participation in this Mother of All Bull Markets easily surpasses the one attained in the '20s. In mutual funds alone, the public has invested (including gains) over $3.5 trillion, three quarters of it in only the past 6 years, far more than it owns in bank savings and small and large time deposits.

Consumption levels are being sustained by the steady decline in the savings rate caused by the mindless increase in consumer credit and comforted by the growing level of household "net worth," the much-talked about wealth effect. A serious stock market decline and a tightening of consumer credit could wreak havoc on the economy.

Seventy years on, the Fed faces a frightenigly similar dilemma: to put an end to the boom in the securities markets by sharply raising interest rates, and risk a serious economic contraction, or to follow Milton Friedman's advice (would he proffer the same advice today?) to stay the course with regard to monetary policy and allow speculation to burn itself out, hoping for a miraculous economic soft landing in the face of an horrendous eventual crash. The July 2 Fed meeting may give us the first clue to the likely resolution of this dilemma.

Those who cannot remember the past, it has been said, are condemned to repeat it.

June 29, 1997Friedberg Mecantile Group

181 Bay Street, Toronto, Canada

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