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When Will the Bubble Burst?

August 18, 1999

For several years the stock market has made major gains, adding up to what
has probably
been the greatest bull market in all of history. Setbacks that appeared
threatening, such as those
that occurred in April of 1997 and August/September of 1998, have proved
temporary and have
served merely as renewed buying opportunities. With each renewal of the
upward trend, the
conviction has grown that if one buys a diversified list of good stocks
(and even many that are not
so good), one simply cannot lose in the stock market, except temporarily.
Indeed, the persistence
and size of the gains has drawn a growing number of new players into the
market--to the point
where it is now common to hear stories about doctors, lawyers, accountants,
and people in
practically all other walks of life cutting back on their normal activities
in order to devote time to
day trading on the internet.

Clearly, something is wrong. It simply cannot be that we can have a society
in which
everybody lives by day trading in the stock market. While the stock market
does make an
important contribution to capital accumulation and the production of
wealth, it is far from an
unlimited one, and its contribution is not enlarged by hordes of
essentially ignorant people
dabbling in it on the basis of tips and hunches. Yet such an absurd outcome
of practically
everyone being able to live by means of buying stocks cheap and selling
them dear is what is
implied by an indefinite continuation of the bull market. As a result, it
is inescapable that the bull
market must end. Something must occur that will destroy the conviction that
the stock market is
an easy source of gains. That something, of course, will be a major and
prolonged drop in the
market, in which much of the gains that have been made in the last few
years will be wiped out
and in which millions of investors will rue the day that they began playing
the stock market.

To understand precisely how and when this will come about, one needs to
understand
what has been feeding the current bull market. Then one can understand what
will put an end to
it--what will constitute pulling its foundation out from under it.

First of all, stock prices are determined in essentially the same way as
the prices of
anything else that exists in a limited supply at any given time, such as
real estate, skilled and
unskilled labor, paintings by old masters, and rare books and coins. That
is, they are determined
by the combination of their limited supply and the extent and intensity of
the demand for them.
What is directly and immediately responsible for the current bull market is
a sustained and rapid
increase in the demand for stocks. This increase in demand in turn has been
the result of the
repeated pouring into the market of large sums of new and additional money,
created by the
banking system under the umbrella of the Federal Reserve System and related
government
intervention.

What this means is that stock prices have been rising on the foundation of
nothing more than an
increase in the quantity of money. In essence, their rise is no different
in principle than the rise in
the prices of goods and services in San Francisco during the California
gold rush. Then, new and
additional gold money was being dug out of the ground in large quantities
in the surrounding area
and spent largely in San Francisco, with the result that at one point a
single fresh egg sold for a
whole gold dollar. Today, the new and additional money is paper, i.e.,
checkbook money, which is
being rapidly created virtually out of thin air and is being spent mainly
in the stock market, with
the result of comparably high and, almost certainly, comparably fleeting
valuations of many
securities. Since December 1995, the money supply as measured by M2 has
grown by almost
twenty-five percent.[1] More significantly, the increase in checking
deposits specifically of the
kind commonly held with brokerage houses, i.e., so-called
money-market-mutual-fund accounts,
has been at double digit rates: 17.5% in both 1996 and 1997 and 29% in
1998.[2]

Of course, none of this is to say that an increase in the money supply is
the only possible
cause of a rise in the stock market or that it must always cause the stock
market to rise. A higher
degree of saving and provision for the future would also be capable of
raising it. If the average
person wanted to have greater accumulated savings relative to his current
income and
consumption, a substantial portion of the additional savings accumulated
would undoubtedly be in
the form of stocks.

Furthermore, the increase in the quantity of money exerts its favorable
effect on stock prices
only when, as in the last few years, the increase is concentrated in the
stock market and has not yet
sufficiently spread throughout the rest of the economic system. When it
does spread throughout the
economic system and begins substantially to raise commodity prices, the
effect on the stock market
becomes negative. This is because the effect of inflation at that stage is
to undermine capital
formation.

A leading way in which inflation undermines capital formation at that point
is by subjecting
business profits to sharply higher effective rates of taxation. For
example, when a seemingly
substantial rate of profit, say, twenty percent, is accompanied by a rise
in the replacement prices of
assets that is not much less, say, fifteen percent, and businesses must pay
taxes of fifty percent on the
whole of such profits, they end up with an after-tax return of only ten
percent, while what they need
merely in order to be able to replace their assets is an after-tax return
of fifteen percent.

Such considerations help to explain the badly depressed stock market of the
1970s and the early
part of the 1980s. Once inflation begins substantially raising prices, to
quote what I have written
elsewhere, "The customary forms of investment [such as the stock market]
lose because of all of
the ways in which inflation undermines capital formation. The customary
forms of investment can
be compared to the purchase of equipment which inflation will cause to end
up as mere heaps of
scrap iron [because of the lack of ability to replace assets]. At some
point, of course, as the result
of inflation, even the price of scrap iron in the future will be higher
than the price of the equipment
today. But when it is, the prices of everything else will obviously have
increased by much more.
Thus the purchaser of ordinary business assets, or any form of claim to
such assets, ends up, on
average, a major loser. He starts with the price of equipment, and ends
with the price of scrap
iron, while the prices of the things he wants to buy advance more or less
in line with the price of
replacement equipment. The example may be somewhat exaggerated, but it is
correct in
describing the nature of what happens. For such is the result of the
taxation of funds required for
replacement, of the prosperity delusion, of widespread malinvestment, of
the loss of safety of all
the traditional, conservative forms of investment, and of the
withdrawal-of-wealth effect."[3]

It was precisely the substantial overcoming of such conditions since 1980
that helped greatly
to restore the value of the stock market relative to the rest of the
economic system. Starting around
1980, the Federal Reserve began systematically reducing the rate of
increase in the money supply. The
reduction in the rise in prices followed, as did a greatly increased
ability to save and accumulate
capital. This was the foundation of the stock market's recovery.

The rise in the stock market in the last few years, however, is not the
result of any increase
in the ability to save and accumulate capital. On the contrary, personal
saving has been very low and
has been declining even further in recent years--from an insignificant 2.5 percent
of personal income in
1996, to 1.8 percent in 1997, to a barely existing .4 percent in 1998.[4] Most recently,
in the spring of 1999, it
has declined into actual negative territory. Similarly, no sudden vast
burst of foreign investment in
the United States can explain the stock market boom. Indeed, the increase
in foreign private assets
in the United States was substantially less in 1998 than in 1997.[5]

The only thing that explains the current stock market boom is the creation
of new and
additional money. New and additional money, created virtually out of thin
air, has been entering the
stock market in the financing of corporate mergers and acquisitions and of
stock repurchases by
corporations. Its consequent driving up of stock prices and concomitant
creation of a sense of general
enrichment is what is largely responsible for the decline in personal
saving, inasmuch as it encourages
people to consume in the belief that they are now substantially richer than
they were before.

The connection between money creation and the financing of corporate
mergers and
acquisitions and of stock repurchases by corporations is that, under
present conditions, to the extent
that such activities are financed by loans from banks, what the banks lend
out is not only funds
obtained from savings deposits, which the depositors give up the right to
spend so long as they
continue to have their savings deposits, but also the far greater part of
the funds obtained from
checking deposits. In the case of checking deposits, the depositors have
the right to spend the
deposits themselves, which they do when they write checks. When the banks
lend out the funds that
created the checking deposits, the funds lent out represent new and
additional spendable money. This
is because the checking depositors continue to be able to spend their
checking deposits and, in
addition, the banks' borrowers obtain the right to spend the money that the
checking depositors put
into the banks. In other words, there are now two sums of spendable money
where initially there was
only one.

Not only does this new and additional money raise the prices of the stocks
of the companies
being acquired or of the companies engaged in buying back their shares. It
also ultimately raises the
prices of almost all other stocks as well. This is because the recipients
of the new and additional
money, who receive it in exchange for the sale of their shares, turn around
and use all or most of it
in the purchase of other shares, in the process driving up the prices of
those other shares. The sellers
of those other shares in turn use the proceeds to buy still other shares,
driving up their prices. In
effect, the new and additional money passes through the hands of successive
sets of stock buyers, in
the process driving up the prices of all of the stocks it exchanges for.

An important aspect of this process is that while the new and additional
money begins as
conventional checking deposits, it quickly sheds its initial character and
assumes the form specifically
of deposits in money-market-mutual-fund accounts, in which form the sellers
of stocks readily hold
it in preparation for their own subsequent stock purchases. The fact that
money is being created
specifically in the form of money-market-mutual-fund deposits is of further
significance because
unlike the case of conventional checking deposits, the Federal Reserve
imposes no reserve
requirements on such deposits. In the case of conventional checking
deposits, there are legal reserve
requirements, which have the effect of limiting the total volume of
deposits created to roughly ten
times the amount of currency and other reserves in the possession of the
banks. In the case of money-
market-mutual-fund accounts, however, there is no legal limit to the ratio
of deposits to reserves.

The ability of any one injection of new and additional money to raise stock
prices is limited.
Eventually some substantial part of the new and additional money is
absorbed into cash balances
needed in order to finance trading activity at a higher level of stock
prices. Furthermore some
significant part of the new and additional money that originally entered
the stock market is drawn
away from it, in order to finance other areas of buying and selling. These
other areas initially include
such things as the purchase of houses and real estate and various luxuries,
whose purchase takes place
on the foundation of the financial gains achieved in the stock market.
Probably even more
importantly, the rise in stock prices encourages the sale of new stock and
the incurrence of new
business debt for the purpose of building new physical capacity. In effect,
it becomes relatively less
expensive to buy or build new plant and equipment rather than to acquire it
by means of purchasing
a controlling interest in the stock of other companies, which later is
made more and more expensive
as stock prices rise.

In these ways, funds move into the rest of the economic system, ultimately
increasing the level
of spending for virtually everything. Furthermore, it is implicit that the
rise in stock prices resulting
from any single injection of new and additional money must be followed by
some significant reduction
in the market's gains, once any substantial portion of that new and
additional money has completed
its passage through the stock market and moved on into the rest of the
economic system.

What keeps the stock market rising is repeated and progressively
larger injections
of new and additional money of the kind described above. These further
injections not only more than
offset the inevitable movement of funds from the stock market to the rest
of the economic system,
but, by virtue of establishing a pattern of continuing gains in the stock
market and thereby creating
and sustaining the belief in the virtual inevitability of its gains,
succeed in drawing into the market still
more funds.

In its nature, the whole process is one of inflation and must serve to
raise not only stock prices but
prices throughout the economic system.[6]

Several times I have used the word "inflation" and now it is time to
explain how my usage of
the term differs from the one that has become customary.

Most people, and most commentators, use "inflation" as a synonym for
generally rising prices,
especially of consumers' goods. So long as prices on the whole are not
rising, or are rising only
modestly, it is assumed that there is no inflation, or only very little
inflation.

I believe that such a procedure is comparable to saying that so long as
someone shows no
visible signs of illness, he has no illness--that his illness begins only
when its symptoms become
unmistakable.

In contrast, my view, and that of the British classical economists and of
the economists who
have comprised the Austrian school--from Adam Smith to Ludwig von Mises--is
that inflation does
not come into existence when prices start rising noticeably, any more than
heart disease or cancer
come into existence when a person finally has a heart attack or experiences
the acute symptoms of
cancer. On the contrary, these diseases are already well advanced
before their obvious
symptoms appear. Just so with inflation. Inflation is not the rise in
prices. Rather, it is the undue
increase in the quantity of money, which operates ultimately to
cause a rise in prices.

Thus, in my view, the rates of increase in the money supply we have had in
recent years
constitute substantial inflation in and of themselves. And this substantial
inflation has indeed already
caused a substantial rise in prices, namely, the rise in the prices of
stocks and, to a lesser extent, the
rise in real estate prices.

Up to now, much or most of a general rise in prices has been
postponed by a variety
of factors that have served to increase the supply of goods and thus to
hold down their prices. These
have included an increase in the number of workers employed, not only
absolutely but also relatively
to the population as a whole. This has been reflected in rising rates of
participation in the labor force
(particularly on the part of married women) and in a declining rate of
unemployment. At the same
time, there has been an apparent acceleration in the rise in the average
productivity of labor. Both of
these factors--more work being done and done more productively--have served
to more rapidly
increase the supply of goods and services at the same time that a more
rapid increase in the quantity
of money has served to accelerate the increase in the monetary demand for
goods and services.

In addition, the general rise in prices has been slowed as the result of a
virtual depression in
much of Asia, Latin America, and the former Soviet Union in 1997 and 1998.
In sharply reducing
demand from these areas, their depression served substantially to increase
the supply of many
internationally traded commodities that was made available in the United
States and correspondingly
to reduce their prices in the United States. The ability of this factor
further to reduce prices, of
course, must end as soon as those foreign economies stabilize and, indeed,
it will be thrown into
reverse as soon as those economies begin to recover and thus to increase
their demand for
internationally traded commodities. That will serve to reduce the supplies
of internationally traded
commodities in the United States and correspondingly to restore their
prices in the United States. In
fact, it appears that the recovery of important foreign economies is
already underway. Of course,
without increases in foreign supplies, the rise in domestic demand in the
United States will exert
greater upward force on prices. The upward pressure will be compounded by
any decrease in foreign
supplies.

Similarly, once the decline in the unemployment rate comes to an end, which
soon it must do,
given that it is already at little more than four percent, that factor can
no longer serve to increase the
production and supply of goods and services and thus to retard the rise in
prices. Indeed, a more rapid
rise in the demand for labor in the face of a supply of labor that
increases more slowly must serve to
accelerate the rise in wage rates, with corresponding implications for
prices.

Perhaps most important of all, however, is the fact that the rise in the
rate of spending to buy
goods and services has thus far lagged far behind the rise in demand for
stocks and in stock prices
and that this cannot continue indefinitely. Eventually, the two rates of
increase in demand must more
and more tend to coincide. The process can be understood as roughly
analogous to that of filling a
bathtub with water. At first, only the tub fills. But if one leaves the
water running, the tub will soon
overflow and water will start to fill the whole house. If one wants to
avoid flooding the house, one
must turn off the water. But when one does that, the tub stops filling.

The application to the stock market is that the market will stop rising as
soon as the Federal
Reserve becomes sufficiently alarmed about the inflationary flooding of the
economy as a whole that
emanates from the stock market bathtub so to speak. When the Federal
Reserve is finally moved to
turn off the water--the new and additional money--flowing into the stock
market, its rise will be at
an end. Indeed, not only will the stock market stop rising, it will
necessarily suffer a sharp fall.

The fall must result from a combination of money leaving the stock market
for the rest of the
economic system, for the reasons already explained, and from the fact that
a substantial part of the
valuation of the stock market now reflects the anticipation of its
continuing to rise. As soon as it
becomes clear that the rise is over, at least for a very long time to come,
the market will necessarily
fall. It will fall simply because it can no longer be expected to go on
rising.

In order to understand more precisely why the stock market simply cannot go
on rising as it
has without prices exploding in the rest of the economic system, one need
only realize two things.
The first is that in order to keep the stock market rising at any given
rate on the basis of new and
additional money coming into it, the magnitude of that new and additional
money must become
greater and greater. The second is that so long as the stock market rises
not only absolutely but also
relatively to the rest of the economic system, as reflected in such a
measure as the ratio of the
combined value of all outstanding shares to Gross Domestic Product (GDP),
the magnitude of any
given percentage increase in the quantity of money and volume of spending
in the stock market
necessarily looms larger in relation to the economic system as a whole. As
a result, the rate of
increase in the quantity of money and volume of spending in the economic
system as a whole grows
and it becomes progressively more urgent to shut off the inflationary
flow.

The extent to which the rate of increase in the stock market in the last
several years is
unsustainable without the accompaniment of rapidly rising prices can be
inferred by estimating the
long-term sustainable rate of increase in the production and supply of
consumers' goods and services
from year to year. If, for example, the production and supply of consumers'
goods and services could
go on increasing at a rate of, say, three percent per year, then it would
be possible every year to have
a three percent increase in the quantity of money and volume of spending in
the economic system
without prices rising.

(The conclusion of no rise in prices follows because one can think of the
general consumer
price level as obeying a simple arithmetical formula, in which the average
of the prices at which goods
and services are sold is equal to the amount of money spent to buy them,
divided by the quantity of
them sold.

This is a very easy formula to understand in the case of a single good. For
example, the
average price at which a can of soda was sold last week in the supermarket
nearest to one's home is
arithmetically equal to the amount of money spent by the store's customers
in buying cans of soda
from it, divided by the number of cans they bought from it. The formula
obviously applies to the
average price at which any individual good is sold at any given location
over any given period of
time--for example, to the average price at which a given bookstore sold its
books over the course
of a month, and to the average price at which new automobiles were sold by
a given dealership over
the course of a year. At the level of the economy as a whole, i.e., at the
level of aggregate demand
and aggregate supply, the trick is to conceive of the sum of all
consumers' goods and
services together, from aerosol cans to zebra skins, as representing some
definite overall quantity of
consumers' goods and services, i.e., as some definite number of abstract
units of supply, which is
then divided into the overall volume of consumer spending to buy goods and
services. In fact,
everyone already thinks in terms of such abstract units of supply every
time he expresses a thought
such as the supply of goods and services produced in the United States is
larger than the supply of
goods and services produced in Canada or in Great Britain, or that it is
larger in the United States of
today than it was in the United States of a generation ago.

I apologize for the digression. However, many people find it necessary.)

Returning to the present instance of three percent more spending buying
three percent more
goods and services, it would be a case of dividing 1.03 by 1.03. As a
result, the quotient--the general
consumer price level--would remain the same.

At the same time, however, the effect of the same three percent rate of
increase in the quantity
of money and volume of spending operating in the stock market would
be to tend to raise
the combined value of all outstanding shares by three percent (either stock
prices would tend actually
to rise by three percent or there could be three percent more outstanding
shares with the same
average price per share, or any combination of a change in share prices
times number of shares
outstanding resulting in a three percent increase in the aggregate value of
outstanding shares). In this
way, the stock market could rise three percent per year, and there would be
no rise in the general
average of prices of consumers' goods and services.

If the production and supply of goods and services could be made to
increase more rapidly,
say, at four percent or five percent per year, then the increase in the
quantity of money and volume
of spending in the economy that would be compatible with no rise in the
general price level would
be that much greater. At the same time the greater increase in the quantity
of money and volume of
spending operating in the stock market would be to tend to raise the total
value of all outstanding
shares by that higher percentage. Thus, the stock market could rise more
rapidly and the greater gains
would still be real in terms of buying power, for prices of goods and
services would still not rise on
average.

However, it should be obvious that given any reasonable assumptions about
the rate of
increase in the production and supply of goods and services, continuation
of the ten- or twenty-
percent annual increases in the stock market of recent years is absolutely
impossible without prices
rising to the extent to which ten or twenty percent exceeds the rate of
increase in production and
supply. This is because the money needed to go on raising the stock market
must increasingly show
up in a rising demand for goods and services that will far outstrip the
increase in their supply. In the
long run, a three percent annual increase in production and supply is
compatible with stock prices
rising twenty percent a year only if prices in general rise on the order of
the seventeen-percent-a-year
difference. For that will come to be the difference between the rise in the
spending to buy goods and
services and the increase in the quantity of goods and services sold. In
other words, if one divides 1.2
by 1.03, the quotient, which, of course, represents the general consumer
price level, equals
approximately 1.17, which represents a rise in prices of approximately
seventeen percent.

To be sure, in the context of today's situation, as soon as consumer prices
did begin to rise
at any significant rate, the actual effect would almost certainly be a
sharp drop in the stock market.
That is because, if for no other reason, the rise in prices would be
expected to cause the Federal
Reserve to sharply curtail the increase in the quantity of money in general
and the increase entering
the stock market in particular. And even if the Federal Reserve went on
with the inflation, the
negative effects of such sustained substantial inflation on capital
accumulation would be to make the
stock market sharply fall relative to the rest of the economic system and,
for a time no doubt,
absolutely as well, for the reasons previously explained.

The inescapable implication is that sooner or later, the stock-market boom
must end. The
bubble must break. It would almost certainly have ended in the Fall of 1998
with the failure of Long-
Term Capital Management, had the Federal Reserve not arranged for its
rescue and quickly re-accelerated its own policy of money creation.

That event, it must be stressed, shows the extent to which the Federal
Reserve has become
a highly politicized institution. Today, millions, perhaps tens of
millions, of American citizens see their
financial well-being as intimately bound up with the stock market and want
the boom to continue.
They also see the Federal Reserve as having the power to give them what
they want, by means of
continuing an easy money policy. The people's representatives see matters
the same way and are in
a position to impose their will on the Federal Reserve, by means of
changing the laws under which
it operates. In the circumstances, the Federal Reserve has chosen to yield
to the wishes of the mob
and to go on increasing the quantity of money in order to keep the boom
alive. Its recent decision,
at the end of June of 1999, to enact a merely token rise of a quarter of
one percent in the federal
funds rate and then to declare in effect that it sees no need at present to
be further concerned with
inflation, is a confirmation of its policy of continued rapid money
creation--i.e., of continued
inflation.

As a result, the stock market boom can probably not be expected to end
until it becomes clear
that the general level of consumer prices is once again rising at a more
substantial rate and is likely
to further accelerate. Then, hopefully, the Federal Reserve will at last
choke off the inflation of the
money supply. By that time, the stock market will almost certainly fall
whether the Federal Reserve
does so or not, because of the perception of the negative effects of
inflation on capital accumulation.

How far the stock market will fall cannot be scientifically predicted
except to say that in the
nature of things the fall must be great enough to destroy the conviction
that the stock market is an
easy source of gains.

The end of the stock-market boom is something earnestly to be desired. This
is because its
continuation entails a growing state of mania, in which fortunes are
created without any rational
cause, merely by virtue of the pressure of a flood of money seeking outlet
in channels no more real
than empty hopes and dreams, and in which increasing numbers of otherwise
highly intelligent and
perfectly sane people are lured into sacrificing the serious work of their
chosen occupations to the
pursuit of such causeless and ultimately ephemeral wealth.

At the same time, because the mere inflation-induced appearance of wealth
is made to
substitute for the fact of wealth, the boom gives rise to a consumption
that takes place at the expense
of essential saving and capital accumulation and thus serves ultimately to
cause impoverishment.
Indeed, it may well be that the sudden appearance of prospective government
budget surpluses, and
the eagerness to devote them to new and additional government programs,
will turn out to be one
of the leading forms of such destructive consumption, whose actual nature
and real cost will become
apparent once the boom ends. The continuation of the boom means the return
of the kind of problems
experienced in the United States in the 1970s and early 1980s.


Footnotes

1. M2 is by no means a perfect or even a very good measure of the money
supply, but it is better than M1 has been for
the last several years.

2. All the above calculations are based on data appearing in the Federal
Reserve Bulletin
, June 1999, p. A13.

3. George Reisman, Capitalism: A Treatise on Economics, p. 951. See
also ibid., pp. 930-938.

4. Calculations are based on data appearing in Federal Reserve
Bulletin
, ibid., p. A49.

5. See ibid., p. A50.

6. My analysis of inflation and of its uneven effects in raising prices is
essentially that of Ludwig von Mises, who
always stressed that inflation never raises all prices at the same time and
to the same extent, but rather moves through
the economic system unevenly and over time. See, for example, his
discussion in Human Action (Chicago:
Henry Regnery Company, 1966) pp. 416-424.


George Reisman is
Professor of Economics at Pepperdine
University's Graziadio School of Business and Management and is the author
of Capitalism: A Treatise on Economics
(Ottawa, Illinois: Jameson Books, 1996).

This article is copyright 1999 George Reisman and the Jefferson School
and is reprinted here with permission of the author.

See also the business cycle section of the href="http://mises.org/studystory.asp?title=XII%2E+The+Business+Cycle">
Austrian Study Guide.


Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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