From KALLISTE@delphi.comMon Sep 16 10:52:33 1996 Date: Sun, 15 Sep 1996 22:32:02 -0500 (EST) From: KALLISTE@delphi.com To: jya@pipeline.com, jqp@globaldialog.com, tenega@aol.com, jw-rh@ix.netcom.com, bigred@duracef.shout.net, jlavis@communique.net, liberty@gate.net, vikbob@halcyon.com, rwb@daka.com, cato@cato.org, akimery@citizen.infi.net, pwatson@utdallas.edu, garb@ix.netcom.com, maddog6@flex.net, edb@interport.com, wdmann@ix.netcom.com, germanic@netcom.com, eric@remailer.net, sandfort@crl.com, loboazul@icsi.net, bdolan@use.usit.net, fathom9@aol.com, defraud@tpi.net, L.L.Grabbe@theol.hull.ac.uk, JMcCorm215@aol.com, jdtabor.uncc@uncc.campus.mci.net, zns@interserv.com, tbyfield@panix.com, drdean@bio.win.net, rpedraza@sierra.net, kalliste@aci.net Subject: Sell Stocks Now Sell Stocks Now by J. Orlin Grabbe Stock market crashes are often related to spurious "causes". It might be the Federal Reserve's hiking of interest rates. It might be the indictment of Hillary Rodham Clinton. But the real cause will be something else: the puncture of a popular delusion, an awakening from mass hypnosis, the end of a collective dream. What is believed to be obviously true now (steady or increasing real growth rates of GNP, record corporate earnings, low inflation, steady commodity prices, stable and sound financial institutions, and widespread peace under a "new world order") will a year from now be viewed as obviously false in light of the "facts" (declining real GNP, falling corporate earnings, inflation in some sectors accompanied by deflation in others, wildly gyrating commodity prices, extended problems in the banking and insurance sectors, a renewed crisis in the savings and loan industry, and "old world chaos" in the Middle East and in the area of the former Soviet Union). Not because the world will have really changed that much in a year. But perceptions of what is happening will be radically different. Some might say, more realistic. According to the Swiss economist Eugene Boehler, the "modern economy is as much a dream factory as Hollywood." It is based only a small part on real needs, and for the greatest part on fantasy and myth. The stock exchange, far from ruling economic life, is at the mercy of tides of collective fantasies. Depressions come about when there is a loss of economic myth (Eugene Boehler, "Der Mythus in der Wirtschaft," *Industrielle Organization*, XXXI, 1962.) An example of the Hollywood dream factory at work was this year's Democratic Convention in Chicago. We were lead from the sideshow entertainment of an actor in a wheelchair, then cast down into the tear-jerking death-throes of Al Gore's drug-addicted sister, but finally swept upward in the euphoric crossing of the 21st century bridge behind Pied Piper Bill Clinton. Or that was the intention, anyway. The grand climax was instead punctured by the reality of politics as usual. Dick Morris-- Clinton's closest advisor, whom *Time* magazine had originally intended to depict as Clinton's brain on its cover--was found shacked up with a hooker, confiding to her that Bill was a "monster" and Hillary a "twister", and that he had handled the details of secret Saudi Arabian side-payments to the President. The dream view of the stock market is, of course, at variance with the prevailing doctrine of "rational expectations." Rational expectations began as an extremely useful view of price equilibrium created by John Muth ("Rational Expectations and the Theory of Price Movements," *Econometrica*, July 1961). But it grew into a cult view that all economic and financial decisions were "rational" in a quite different sense than originally proposed by Muth. The essence of rational expectations can be grasped by imagining a long line of cars waiting for a traffic signal to turn green. When the light turns green, the entire line begins moving at once, uniformly accelerating through the intersection. And why not? After all, each person waiting in the line knows the light is about to change from red to green. Each person knows that each other person in the line knows this also. And they all know they will get through the intersection faster if they all move together. So each expects the other to rationally act as he himself does, and they all make it through the light before it turns red again. People with these expectations are called "rational" in economics. In real life, they are known as "fender-benders". Because in real life, traffic doesn't behave this way, and neither do people. There will always be the curmudgeon who has just broken up with his girlfriend and is staring out the side window at the marquee of a topless bar, oblivious to the horns blowing behind him. The Russian novelist Fyodor Dostoyevsky explained it best more than a hundred years ago. One of his characters describes the new (rational) economic world order: 'Then,' (this is all of you speaking), 'a new political economy will come into existence, all complete, and also calculated with mathematical accuracy, so that all problems will vanish in the twinkling of an eye, simply because all possible answers to them will have been supplied. Then the Palace of Crystal will arise. Then [blah, blah, blah] . . . ' Well . . . why shouldn't we get rid of all this calm reasonableness with one kick, just so as to send all these logarithms to the devil and be able to live our own lives at our own sweet will? . . . One's own free and unfettered volition, one's own caprice, however wild, one's own fancy, inflamed sometimes to the point of madness-that is the one best and greatest good, which is never taken into consideration because it will not fit into any classification, and the omission of which always sends all systems and theories to the devil. (*Notes from Underground*, 1864.) Current stock prices, which (except for a severe downturn in the first half of 1994) have been rising ever since the Gulf War, have ridden a vision of new-found American strength, our return as the world's policeman, putting down the evil Saddam Hussein, and bringing lasting peace to Bosnia. With the demise of the Soviet Union, the vision saw the U.S. leading a resurgent United Nations to a political solution of all the world's ills. But this was only an idea, a voluntary con. The U.S. intercession in Bosnia quietly overlooked the Russian intrusion into Chechnya. The U.S. reaction to Iraq's intrusion into the Kurdish zone equally overlooked the Turkish intrusion into the same area. The U.S. cannot dictate either Japanese trade policy or Chinese missile sales. And so on. A false illusion that began with Saddam Hussein is likely to end with Saddam Hussein. After all, for all its saber-rattling, the U.S. needs Saddam to avoid an Iranian takeover of the Middle East. It is inevitable that such punctured illusions will puncture the inflated balloon of asset prices. Starry-eyed investors who see the owning of mutual funds as the sure way to new-found wealth, would prefer to quietly overlook what has happened in Japan since 1989. In 1989 the Nikkei 225 reached 39,0000. From that peak, it fell 64 percent by mid-1992. Each dollar invested had turned into thirty-six cents. An equivalent fall in today's Dow Jones Industrial Average (say from 5850) would leave it at about 2100. The carnage on Wall Street would be something to behold. As is probable in the U.S., the Japanese inflation in asset prices was followed by a restriction in the money supply. The rate of growth of the Japanese real money supply, which had come to exceed 10 percent in 1989, fell to minus 2 percent by 1992, a year in which industrial output fell by 8 percent, the worst since the oil-shocks of the mid-1970s. At its peak in 1989, the Tokyo stock market was valued at more than Yen 500 trillion ($3.6 trillion), or about 30 percent higher than the listed value of all U.S. companies. Japanese stock PE ratios stock were 70 to 1 in 1989, then fell to 38 to 1 in 1992, but by end of 1993 were back above 70 to 1 because of falling corporate earnings. The drop in land and stock values put the Japanese banking system into jeopardy. No one any longer thought the land around the Imperial Palace was worth more than all of California. Corporate stock, which was held as part of bank capital, and fluctuates with the market, became one of the reasons the Ministry of Finance in early 1993 used money from the postal savings system to purchase stock in an attempt to bolster stock prices. (The difference between Japan and the U.S. is that the U.S. Federal Reserve has recently intervened to purchase stock at a market *peak*. This in itself will exacerbate the ensuing crash in the U.S.) But things seemed different in the late 1980s in Japan. There was an image, supported by continued credit creation, that land and stock prices would always rise. Equity-linked corporate finance, such as convertible bonds, seemed destined to drive the cost of capital to almost zero. Equity and equity-related sources of funds for manufacturing companies rose from 25 percent in the first part of the 1980s to 70 percent by 1989. Forty percent of the funds raised by manufacturing companies were then invested in other financial assets. And as banks' lending base to manufacturing fell (from 50 to 16 percent), the banks began lending to households, property companies, and service firms to make up the slack. The latter in turn invested in land and stocks, because their prices, it was thought, would continue to go up. In 1989 the Bank of Japan helped bring the party to an end. In the U.S., the recent rise in stock prices has been fueling by a shifting of household assets into stocks and stock mutual funds. The average household exposure to stocks is the largest it has been in U.S. history--larger than before the 1929 crash. "Speculative excess, referred to concisely as a mania, and revulsion from such excess in the form of a crisis, crash, or panic can be shown to be, if not inevitable, at least historically common" (Charles P. Kindleberger, *Manias, Panics, and Crashes: a History of Financial Crises*, 1989). Financial crises are often associated with the peaks of a business cycle. Booms in asset markets (stocks and bonds) are generally aided by an excess increase in the supply of money, which is then inevitably restricted because of rising inflation. The slow decline of the French bank Credit Lyonnais is a foretaste of similar things to come in the U.S. The S&L bailout of the 1980s may turn into an attempted massive government/FDIC bailout of the U.S. banking system by the turn of the century. Distortions equivalent to those seen in the S&Ls have been created in the banking system by the presence of federal deposit insurance. The existence of deposit insurance has isolated banks from market discipline in lending. It has allowed banks as well as thrifts to engage "with impunity in all manner of excessive risks--foreign exchange speculation (Franklin National), speculative energy loans (Penn Square), inadequately investigated loans (Continental Illinois), insider loans (the Butcher banks), uncollectable Third World loans (almost every top ten bank) and so forth" (J. Huston McCulloch, "Bank Regulation and Deposit Insurance," *Journal of Business*, January 1986). The U.S. government has written enormous amounts of unhedged put options on bank assets, and will be faced with a massive increase in insurance obligations at the same time tax receipts are drastically reduced by a declining economy. Thus federal government quasi- defaults (mandatory roll-overs of debt) are likely. Interest paid on the debt is already one of the largest categories of the U.S. federal budget. Currently, government debt is largely in the hands of professional portfolio managers. So the usual temptation of a central bank, such as the Federal Reserve, to reduce the real value of federal debt by inflation is restricted. Any hint of a move toward an inflationary policy will lead to massive dumping of government securities, which will drive up long-term nominal and real interest rates. Marginal borrowing rates of both government and industry will rise. The U.S. may attempt to maintain revenue through tax hikes. (In 1929 the top income tax rate was 25 percent, but had increased to 63 percent by 1935, and by the end of World War II was at 93 percent.) But such efforts may not succeed, during a time when the abolition of the IRS has become increasingly popular. The ensuing credit crunch will hit industry hard, as the banking system becomes a circular conduit for government funds*receiving payments of deposit insurance, and (perhaps forcibly) purchasing government securities as assets. Basle capital requirements currently give a zero-risk weighting to OECD government obligations. One of the consequences of this requirement has been an increased incentive for U.S. banks to purchase U.S. government bonds or similar obligations to conserve on capital usage, to the exclusion of corporate lending. As securities are dumped, the mark-to-market value of banks' remaining assets will fall. A similar process occurred at the beginning of the 1930s: "Banks had to dump their assets on the market which inevitably forced a decline in the market value of those assets and hence of the remaining assets they held. The impairment in the market value of assets held by banks was the most important source of impairment of capital leading to bank suspensions, rather than the default of specific loans or of specific bond issues" (Milton Friedman and A. J. Schwartz, *A Monetary History of the United States, 1867-1960*, 1963). There will be bank failures. Having the Federal Reserve as a lender of last resort will not prevent this. Canada, without a lender of last resort between 1930 and 1931, did not suffer any bank failures. The U.S. suffered thousands. This was partly because Canada allowed branch banking nationwide. In the U.S., a legacy of prohibitions against branch banking have impacted both the asset and the liabilities side of banks balance sheets. Because banks do not branch nationwide, they are more vulnerable to banking runs in a particular section of the country. Because banks are local, they have overspecialized in local loans--to oil and real estate in Texas and Oklahoma, to timber in the Northwest, to farmers in the Midwest. The money center banks, meanwhile, may have overextended themselves in international directions. What are some of the other likely consequences? Consider the declines of 1929-1932 and 1973-1974. On September 3, 1929 the closing high on the Dow Jones Industrial average was 381.17. Three years later, on July 8, 1932, it reached a low of 41.22, or 10.81 percent of its previous level. In January 1973, the Dow Industrials reached a closing high of 1061.14. Less than two years later it closed at 572.20, or 53.92 percent of its previous level. Using a hypothetical figure of 5850 for the Dow Jones Industrials, these same percentage drops imply Dow Industrial levels of 632.39 by analogy with 1929, or 3154.32 by analogy with 1973. The first would imply a drop of over 5200 Dow points, while the second would only imply a drop of 2695 points. Either would be serious. Stock investments take place under the influence of an over-riding image of the future. The economist Kenneth Boulding wrote: "A decision is essentially a choice among competing images of the future, . . . and with the development of complex images of the future, decisions become an increasingly important element in the dynamics of the individual human being and his society. . . . The human race is not merely pushed by past events or present circumstances, but it is also pulled by its own images of the future into a future, which may not be the same-and in fact is not likely to be the same-as its images of it, but which is nevertheless powerfully affected by those images" (*Ecodynamics: A New Theory of Societal Evolution*, 1978). The changed image of the future that brings about a stock market crash will bring about a concomitant fall in business investment, this decline to be reinforced by government deficits and a banking crisis. Decreased employment and a declining industrial output will follow. At the beginning of the Depression of the 1930s, Keynes wrote that in "the fall of investment . . . I find-and I find without any doubt or reserves whatsoever-the whole of the explanation of the present state of affairs" (John Maynard Keynes, "An Economic Analysis of Unemployment," 1931). International political consequences may be the most tragic of the coming U.S. asset price deflation. Following World War I (the Great War), disruptions caused by the war itself, followed by the collapse of the Austro-Hungarian empire, lead to hyperinflation and social revolution in Germany and Eastern Europe. When the U.S. went into depression following the 1929 crash, and the depression spread internationally, the German Weimar Republic (1919-1933) gave away to National Socialism. Today a similar process is evidently taking place in the remnants of the Soviet Union. The rise of a new dictator in Russia of the order of Stalin seems assured. Carl Jung noted that times of major change are accompanied by symbols of transformation (Carl Jung, *Symbols of Transformation*, 1976). Among other things, these include socially-observed "signs in the heavens" (Carl Jung, *A Modern Myth of Things Seen in the Skies*, 1969). Through the influence of archetypal processes, the attention paid by the popular media to the unexpected or the unexplained greatly increases. The fin- de-siecle timing of the economic downturn will undoubtedly generate an excess of eschatological fervor. At the last major economic downturn, toward the end of 1973, the public eagerly awaited the arrival of the comet Kohoutek and leading newspapers carried reports of space creatures seen in Pascagoula, Mississippi. Today we observed the popularity of the "X-Files," the movie *Independence Day*, and speculation about cosmic debris causing catastrophe on earth (e.g. Arthur Clarke's *The Hammer of God*). Given that the technological myth of space visitors is already ensconced in the popular imagination, the arrival of extraterrestrials either to save us or to destroy us will also be widely anticipated. But one thing is for sure: Bill Clinton will not be around to lead us out of Egypt, and across the 21st century bridge into the Promised Land. September 15, 1996 Web Page: http://www.aci.net/kalliste/