Prepared by Friedberg Mercantile Group

Trained economists rarely pay attention to excesses in financial markets. These episodes (economists call them bubbles) blow over most of the time without much of an effect on real economic activity. Two such extreme examples were the 1962 and 1987 crashes. In those rare instances when crashes precede economic depressions they are not viewed as having caused the depression. Rather, they are viewed as being as inscrutable as the Sphinxes, at best as testimonies to the markets' clairvoyance or collective wisdom. And yet, as the euphoria of a boom gives way to the pessimism of a bust, one ought to wonder what really happens to buying plans and business projects of overextended consumers and businessmen.

In what follows, Hernan Cortes Douglas, an economist of international repute, examines past periods of financial excesses and concludes that contrary to professional opinion, crashes and depressions are intimately connected.

Some years, like some poets and politicians and some lovely ladies, are singled out for fame. So economist John Kenneth Galbraith told us. The year 1929 was clearly such a year. Will 1997 be another? A collapse of Wall Street, anticipating a contraction as virulent as the Great Depression, is a highly likely scenario. This article aims not at convincing but at warning. History teaches, however, that words of warning in a climate of euphoria fall largely on deaf ears. This is how it has been and how it shall be. The majority find a number of reasons to discard arguments based on the lessons of the past. History is, however, implacable with those who ignore its lessons.

All stock market crashes are unforeseen for most people, especially economists. This is the first lesson of history.

In a few months I expect to see the stock market much higher than today. Those words were pronounced by Irving Fisher, America's distinguished and famous economist, Professor of Economics at Yale University, 14 days before Wall Street crashed on Black Tuesday, October 29, 1929.

A severe depression such as 1920-21 is outside the range of probability. We are not facing a protracted liquidation. This was the analysis offered days after the crash by the Harvard Economic Society to its subscribers. After continuous and erroneous optimistic forecasts, the Society closed its doors in 1932. Thus, the two most renowned economic forecasting institutes in America at the time failed to predict a crash and depression were forthcoming, and continued with their optimistic views, even as the Great Depression took hold of America.

Irving Fisher lost $140 million (in today's dollars) in the stock market crash, according to his biographer son, Irving Norton Fisher. Fisher was a man of many talents, a great economist, an excellent theoretician, one of the founders of econometrics, and a pioneer in index number analysis. He was also the inventor of the kardex index file system, which he sold to Remington Rand for millions, and subsequently lost in the crash.

John Maynard Keynes, the most famous British economist, who made fortunes in the financial markets for himself and Cambridge University, lost œ1 million (in today's pounds) in the crash, according to biographer Professor Skidelski.

With two exceptions, no academic economist forecast the crash of 1929 and the following depression. Even more dramatic is the fact that in 1988, six decades after the crash and depression, Kathryn Dominguez, Ray Fair, and Matthew Shapiro concluded in the American Economic Review that employing sophisticated econometric techniques of the late 1980s and even using data unavailable in 1929, the Great Depression could not have been forecasted.

Rudy Dornbusch, Professor of Economics at M.I.T., has said that the Great Depression is, to macroeconomics, a mysterious and unexplained phenomenon.

A financial collapse has never happened when things look bad. This is another lesson of history. On the contrary, macroeconomic flows look good before crashes. Before every collapse, economists say the economy is in the best of all worlds. Everything looks rosy, stock markets go up and up, and macroeconomic flows (output, employment, etc.) appear to be improving further and further. This explains why a crash catches most people, especially economists, totally by surprise. The good times are invariably extrapolated linearly into the future. Is it not perceived as senseless by most people in today's euphoria to talk about crash and depression?

The political mood is also optimistic. In November 1928, Herbert Hoover was elected President of the United States in a landslide, and his election set off the greatest increase in stock buying to that date. Less than a year after the election, Wall Street crashed.

Similarly today, with a Democrat in the White House and Republicans in control of Congress, the perception is that they ensure the continuation of the best of times. As a result, the November 1996 election set off the greatest increase in Wall Street to date. All stock market collapses occur with a heavily indebted private sector, history also shows. Indebtedness is a sign of confidence. The lender trusts that the debtor will be able to pay the principal and interest on time. The debtor"if not a crook"believes the same. He does not have the money now, but he will have it later. Accelerated overindebtedness is, correspondingly, a sign of overconfidence, and in the latter stages, of euphoria. It is too easy, after the fact, to label as irrational many actions undertaken in a stage of overconfidence. These actions appeared perfectly sound to the decisionmakers at the time of the decision. For example, according to The Wall Street Journal last November, an American regional bank lent 100% of the price of a house to a person without stable income, recently divorced, and whose previous house had been foreclosed. In this stage, you and I may call it overconfidence. The Wall Street Journal used it as an example of the emerging brave New World of mortgage financing. Historians will call it something else. Irrational exuberance perhaps? Experience also shows euphoria is rampant before the crash. This time is different is euphoria's motto, even though signs of disequilibrium appear, warning of danger ahead. In 1989, for example, price-earnings ratios of Japanese stocks climbed to ridiculous levels as the Nikkei index soared to 39,000. Despite numerous warning signals, many pundits and analysts continued to favor Japanese investments, arguing that Japanese accounting systems were different and that central banks now know how to keep an economy depression-proof. This time is different, was the rallying cry. But, as we now know, the Japanese stock market subsequently collapsed by 60%, and a virulent and protracted recession ensued.

Psychologists refer to this phenomenon as cognitive dissonance, which pertains to the denial of the warning signs, the rationalization of risky decisions, and inaction. We do not want to see, we do not want to know; we rationalize and justify the unjustifiable.

Euphoria leads to carelessness. In America, at present, the ratio of dividends to price is lower than the interest rate on bank deposits. Today it is less than 2%, indicating that stocks are more than 45% more overvalued than in 1929 (when the ratio was 2.89%). This means a bank deposit is providing a higher return at a sizably lower risk than stocks. Why buy stocks then? Buyers of stocks confidently expect to sell to someone else at an even higher price. If they cannot, they lose. In financial circles, this is called the Greater Fool Theory. And again history teaches us that this theory makes its grand entrance, time and time again, before a crash.

It is said that Henry Ford was taking the elevator to his penthouse one day in 1929, and the operator said, Mr. Ford, a friend of mine who knows a lot about stocks recommended that I buy shares in X, Y, and Z. You are a person with a lot of money. You should seize this opportunity. Ford thanked him, and as soon as he got into his penthouse, he called his broker, and told him to sell everything. He explained afterwards: If the elevator operator recommends buying, you should have sold long ago.

Euphoria leads to those unacquainted with financial markets to enter in the last leg of the boom. And that's where they lose everything. About 88% of all the money now in mutual funds has arrived there in the past 6 years. These new investors have never been through a correction of even 10%. Most new entrants into the stock market are totally inexperienced. More money went into mutual funds in the first half of 1996 than in the whole year of 1993, the previous record year. At the same time, 1996 shows record highs in personal bankruptcies and in credit card delinquency rates. Are consumers going into debt simply not to miss out on the stock market boom?

The capitalized value of U.S. stock markets is now equal to America's GDP for the first time in history. Ominously, history teaches us that every time Wall Street's capitalized value exceeds not 100%, but 70%, of GDP, a crash soon follows.

The collapse of the stock market is the warning, the signal, that the loose-reined optimism, the euphoria, is reverting with a vengeance. All projects deemed excellent under euphoria turn into mistakes when the new pessimism prevails.

All great crashes were followed by economic depressions. In the three centuries of stock market data available, there have been three major collapses: the crash of the London stock market in 1720, followed by an economic contraction lasting several decades, and the collapses of 1835-40 and 1929-32, also followed by economic depressions.

The first recorded major bear market took place before the United States was born. It started in 1720 with the crash of the London stock market, and is better known as the South Seas Bubble. In only 2 years, 91% of the stock issues went off the board. The issues not only collapsed in price"they also disappeared.

The crash anticipated a bear market that lasted 64 years, until 1784, and also anticipated a protracted economic contraction. In the 2 decades after 1720, UK industrial production increased less than 0.5% per year, and less than 1% per year in the following 4 decades.

Since 1784, stock prices have been in a secular bull market. It has lasted over 210 years, coinciding with the existence of the United States as a nation. In this period, two corrections took place: in 1835-40 and 1929-32. Both anticipated two important economic contractions.

Overconfidence, excessive optimism, and euphoria lead to overindebtedness, unwise investments, carelessness, fragility, and a final collapse. This is another lesson of history. Are not these disequilibria leading to financial crashes and depressions the same ones economic theory has warned are the ultimate causes of crises"the economic theory we learned from Wicksell and von Mises, from Pigou, from Fisher, and from Hayek?

Ludwig von Mises, another Austrian, also anticipated a worldwide depression in the 1930s, as reported by Fritz Machlup, Mises' assistant at the time. Mark Skousen also tells us Mises' wife, Margit, wrote in her husband's biography that he rejected in the summer of 1929 a high position in Credit Anstalt, one of the largest banks in Europe at the time. His explanation was simple: A great crash is coming, and I do not want my name in any way connected with it. Less than two years later, Credit Anstalt was bankrupt.

Excessive optimism in the last leg of the boom leads to unwise investments being made, both real and financial. This is another lesson of history. These investments appeared justified in a context in which everything is going up and every mistake can be corrected and any indebtedness can be subsequently handled with higher incomes and wealth. Often these expected increases are paper-wealth increases and are not realized before the crash"especially for the latecomers to the stock market who join when all prudence advises staying away.

The increasing indebtedness of corporations, households, and the government, as in America today, generates an increasingly fragile financial sector and a highly vulnerable economy. Debt in the U.S., in its traditional definition, has reached 220% of GDP, exceeding the previous maximum of 190% of GDP in 1929. The balance sheets of banks, corporations, and families reflect this fragility, and show the consequences of cumulative mistakes concerning financial decisions. Some of these mistakes were disguised by rescue operations by the government, as in the case of the bankruptcies of the American savings and loans corporations. Some of their effects have been postponed, as in the successive mistakes by American banks in extending loans to agriculture, the petroleum sector, the debt crisis governments, and real estate.

Last year was also a record year for personal bankruptcies and credit card delinquencies, as already mentioned.

Last but not least, there is the government. In the 1920s, America had a fiscal surplus and a current account surplus. Now it has twin deficits. In the 1920s, the U.S. was the world's largest international creditor. Now it is the world's largest international debtor. In the 1920s, the high private sector debt was unaccompanied by a similar government debt. Today the American government debt is the highest in peacetime history.

Total debt in America approximates the value of all private real estate plus the value of American equities, when including unfunded public sector obligations. In other words, total debt is now equivalent to the value of the two most important components of wealth in America, excluding human capital"with an important difference. In a crash, the prices of both equities and real estate collapse (in the 1930s equities dropped 90% in value), while debt requires painful liquidation.

When euphoria changes into pessimism and fear, this indebtedness, previously justified by optimism and confidence, will be perceived as dangerous. Creditors, initially apprehensive, later in panic, will try to recover their funds, eliminating credit renewals, thus forcing foreclosures and bankruptcies, and deepening the crisis. This is how it has been, and how it shall be.

When euphoria ends, debt liquidation begins. In 1933, Irving Fisher published his Debt-Deflation Theory of Depression in Econometrica. He explained how asset liquidation reduces the initial overindebtedness with massive bankruptcies, deepening the depression. At the end of the process, the country is in a shambles. But it's ready for recovery"a recovery without the burden of debt.

The liquidation of debt is the first step to recovery. This explains why the policy packages aimed at reactivating the Japanese economy after the crash of 1989 have failed. The total debt of corporations, households, and government in Japan still exceeds 300% of GDP today. Unless this debt is drastically reduced, no lasting recovery can take place.

By the way, did we not learn that central banks now know how to avoid major contractions? Is the Bank of Japan different? After growing 4.9% per year in 1989-90, real GDP per capita in Japan fell to 0.4% in 1991-94, with 1993 showing an actual reduction. The Bank of Japan lowered the interest rate under its control to implement what it defines as an expansionary monetary policy. The short-term real interest rate plummeted to 0% in 1997 from 5% in 1990. There is free credit in Japan, but Japan does not recover. Do central banks really know how to avoid or come out of depressions? Fiscal policy has been expansionary. The surplus of 2.8% of GDP in 1989-91 turned into a 3.9% deficit in 1996. Government debt shot up 33% from 1990 to 1996 (from 69.1% to 92.4% of GDP). And Japn does not recover. Did not Keynes teach us that fiscal policy is the solution, the way out of a severe contraction?

Money growth (M2) in Japan has dropped from 12% per year in 1989 to negative in 1992 to less than 3% since. Are Japanese banks not lending? Maybe the figure of 300% of debt/GDP holds the answer. Wall Street is today ending the last leg of the great bull market. The coming collapse will be worldwide, because most stock markets are synchronized with Wall Street. Even those markets in a different phase, such as the Japanese stock market, will experience a dramatic fall.

On the other hand, many stock markets are situated, as Wall Street is, at the end of the last phase of the bull market. This is true for stock markets in Germany, the UK, France, Switzerland, the Netherlands, Spain, Canada, Mexico, Brazil, South Korea, Philippines, Australia, India, and many others.

As these markets are synchronized in the same phase as New York's, they will soon begin to fall in a worldwide collapse of stock markets.

This collapse will anticipate, as the 1929 crash did, a severe contraction and depression in the world economy.

March 16, 1997
Friedberg Mercantile Group

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