When Will the Bubble Burst?

by

George Reisman

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 which 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.

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.

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. 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.

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.

Of course, 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. 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.

-- (@ .), January 18, 2000

Answers

Maybe we could ask Alan Greenspan to wear a tulip on his lapel?

-- Mad Monk (madmonk@hawaiian.net), January 18, 2000.

So, in short, the answer to the question is "When King Klintoon and his Kronies can no longer , through gross market intervention, keep an object levitating that must yield eventually to the pull of gravity, as all things must in this Universe."

We may be surprised yet by the number of months left in this Mania-of-The-Millennium, as since Greedspin was "re-appointed by Klintoon"(read the book "The Creature From Jekyll Island" to see what a FARCE that public misconception is), I saw that that was the FIRST step to ensure TPTB that the Democraps are kept in power, so that could mean almost another year of UNBELIEVABLE events yet to occur.

Not saying that we won't yet have a crash, it's just that they may be able to forestall it a while longer. Note now how the air is being let out of the I-net stocks slowly SO FAR.

-- profit of doom (doom@helltopay.ca), January 18, 2000.

What has occurred to me FWIW, is that there are two different demographic types who invest (yes I know that is oversimplification, but hang in there for a moment); the people worried about the the fed rate increase, and bonds buy stocks on the NYSE. People who day trade or are convinced that .com stocks and related industries are part of the new paradigm and immune from the mundane stuff on the NYSE buy on the NASDQ. Look at the difference between the performance of the DOW and the NASDQ today despite some good earnings reports. That has been going on for awhile.

I am guessing that this marketplace disparity will keep going a while longer. I am taking Bob Brinker's advice (re my posting on Saturday), but I still own some tech that I hope I don't ride down. Go figure.

-- Nancy (wellsnl@hotmail.com), January 18, 2000.

Look at the overseas markets right now. There's a whole lotta red across the board...

Look at the price of oil right now.

If cold water won't wake up the average American Ponzi-victim...then the SHOCK of a loss of 30% of their "security" in a week soon will, IMHO.

What takes years to build can be destroyed in a tiny fraction of the time.

Panic in the Market is always (potentially) but a week away. Short the Indexes. Grab profits (small, frequent)

Terror makes panic seem mild.

-- Joseph Almond (sa2000@webtv.net), January 18, 2000.

When Will The Bubble Burst?

NEVER!!!

-- K. Stevens (kstevens@ It ALL went away 18+ days ago .com), January 18, 2000.

Hi, @,

Are you a follower of the Austrian School? Reisman (a former student of Von Mises) has put out some fantastic stuff. Have you seen his book, "Capitalism"? It's a must read.

-- eve (123@4567.com), January 19, 2000.