FREE ESSAY ON WHY THE WALL STREET BUBBLE MUST BURST?

WHY THE WALL STREET BUBBLE MUST BURST?

Why the Wall Street Bubble Must Burst?
In 1938, and in the teeth of the longest and fiercest depression that the United States
had ever known, capital spending hit an all time high. That's right! In 1938 the men who
owned America began to pour millions of Dollars into new plant and equipment as if there
was no tomorrow. We don't think much about it today, because it has been a long time
since the United States has experienced a real bone jolting economic slowdown. The fact
is, however, that the very best time for the industrialist to invest in new technologies
is in the middle of a depression. This is because it is at such times that labor, raw
materials, and new equipment can be purchased at rock bottom prices. Henry Ford may have
jumped the gun a bit. He shut down his River Rouge plant for two years starting in 1932
so that it could be completely rebuilt. Being a bit of a genius, Ford used his time and
money to redesign the plant to create one of the most powerful little engines ever built:
the Ford V8. This engine was so good that it was modified only slightly to equip certain
aircraft for use in World War II. It also powered a series of red hot Ford cars all the
way through the 1950s. At the same time that Ford was rebuilding his River Rouge plant,
Joseph Alois Schumpeter, an Austrian economist who had migrated to Harvard University,
was hard at work on a book that would explain the paradox suggested above, namely the
timing of business cycles and technological change. In this all but forgotten work one of
our most famous economists spelled out the secrets of the business cycle, that is the
same old pattern of boom and bust that may be coming back to haunt us now.
Many, if not most, American college students know Schumpeter's name because of his work
in defense of free enterprise called Capitalism, Socialism, and Democracy. This was not,
however, the book that Schumpeter was working on as America slogged through the mean and
hungry 1930s. The book published by Schumpeter in 1939 is called  Business Cycles: A
Theoretical, Historical, and Statistical Analysis of the Capitalist Process.  Not only is
Schumpeter's definitive two volume study of the business cycle not on college reading
lists today, but, indeed, it continues to languish in its first edition. The embarrassing
truth is that Schumpeter's real masterpiece remains almost unread. The present writer
checked out this forgotten work from one of our leading university research libraries to
discover that Schumpeter's book had been borrowed only a total of fourteen times in the
nearly four decades from June 1961 to the present!
There are probably two reasons for this. In the first place, Schumpeter's magnum opus on
the business cycle came out on the eve of the Second World War. As the dark clouds of war
began to cast their shadow over Europe, Asia, and eventually the United States,
economists (and everyone else) clearly had more pressing concerns. Not only that, but it
was also clear to Americans that the US Army would soon take care of the problems of
excess supply being experienced in the labor market. It was also quite obvious to
everyone that the factories were about to start humming again, this time to produce for
war.
After the conflict, of course, and all the way through the 1970s, it was widely believed
that the business cycle had been repealed by means of the clever economic manipulations
suggested by the British Lord John Maynard Keynes. College kids in the halcyon 1960s were
taught by their professors that the economy was not one of scarcity, but, rather, of
endless abundance. The Great Society had arrived. Keynesian economics was in its glory
days. This new body of thought and practice was one of the British Empire's last and most
influential exports. If Keneysianism had, indeed, hung the business cycle by the neck
until dead, then the only decent thing to do was to bury the corpse. Schumpeter's text,
unfortunately, was placed alongside the remains of business cycle it its tomb. Some
things, however, will not simply and decently die. They come back to haunt you. Do you
remember platform shoes? They should have expired peacefully in about 1973, but just take
a look at your teen age daughter! Some fifty years later, there are those who, like the
present writer, appear to suspect that the business cycle, too, is back.
The highly respected Investors' Business Daily recently devoted a full-length front page
article to the following shocking idea: Ominous Parallels To Late 1920s? Then As Now:
Roaring Stocks, Deflation, Stingy Feds. If what the IBD is worried about turns out to be
true, the American economy could be in for hard times again! If this happens, our
somewhat lazy academic economists might find it worthwhile to check Schumpeter's book out
of the library a little more often. What they will find there is briefly explained in the
following . If Schumpeter's historical and economic analysis is correct, we are sliding
down the long back side of what is called a Kondratieff wave and picking up speed as we
head towards the trough. What will be required to start marching up the other side and
back into prosperity, according to Schumpeter, is a period of creative destruction.
During this unpleasant period the fictitious values of the boom (like an overpriced stock
market ) are destroyed. It is at such times that capitalists finally go to work and
invest in new technologies to power us out of the depression that almost always occurs.
In previous economic crises, such as the period of the late 1920s that the Investor's
Business Daily has so convincingly evoked for us, the process of creative destruction was
initiated by bizarre public and official behaviors. This included stock manias, economic
panics, bank runs, Fed jawboning, and stock market crashes. Does any of this sound
familiar?
Schumpeter inherited the idea that there is a long a-periodic economic cycle governing
all of this from an unfortunate Russian called Kondratieff. We'll call him K for short.
K's article on what he called long waves came out in 1926. Not much later K perished in
one of Stalin's brutal purges, probably for having above average intelligence. Schumpeter
speaks of Kondratieff's long wave very approvingly and discusses it together with two
observed business cycles of shorter duration called the Juglar and the Kitchin cycles
after the statisticians who described them. Schumpeter believed that there were
…six Juglars to a Kondratieff and three Kitchins to a Juglar- not as an average but
in every individual case (pp.173-174).
Having lived through nine years of economic crisis by the time his book was published,
Schumpeter believed that the Great Depression happened because the end points of all
three of these fluctuations occurred at the same time (p. 173). Juglar and Kitchin cycles
have been pretty much forgotten today. The Kondratieff long wave, however, still excites
interest among cycle buffs, perhaps because it fits in so nicely with what we know about
economic history. All three of the patterns pointed out by Schumpeter, on the other hand,
have one very important element in common. The Kitchin, the Juglar, and the Kondratieff
are all based on the timing of technological change (or what the economic historians call
innovation) as it occurs within the free market system. The Kondratieff is easier to see
because it fits in with the most obvious moments in the development of the industrialism
in its dynamic relationship with free enterprise. The first Kondratieff, Schumpeter says,
was the Industrial Revolution itself which lasted from about the 1780s through 1842. The
era that followed (1842-1897) was, according to Schumpeter,  the age of steam and steel.
The third Kondratieff was based on electricity, chemistry, and motors, and was ongoing
when Schumpeter was working on his masterpiece (p.170). These periods of growth and
expansion saw ever increasing productive and financial power in the industrializing
countries and were punctuated by episodes of economic crisis in every case. If the IBD
has called it correctly, we might be entering such an era of economic crisis once again.
The key to the picture is the long- term behavior of prices in general and commodity
prices in particular. The short form of the argument is as follows: when prices go into
long periods of decline, look out!
The logic of the long wave idea is not complex. Long wave theorists believe that
innovation in the world of production and management happens not as a series of single
events, but as a related set of changes all simultaneously affecting one another. Those
of us who have lived through the computer revolution can see the logic of this in our own
lives. Take computers (or as the stand up comic guy might say Please take computers!). No
sooner did you get a simple PC for a little word processing and maybe to balance your
checkbook, than it was obsolete. The reason was that, not many months after you bought
it, you found out you needed something called a modem. Then you noticed that your
original software was already archaic, ineffective, and slow: six months after you bought
it. A few short years later, everything you see and hear off from an overheated stock
market to the problems of the E-traders is about telecommunications. Telecommunications,
it turns out includes the computer you now own which is ten thousand times more powerful
and about half the price of the first one you bought not so very long ago! The total
complex of innovations and interconnections that has taken place in cyberspace in the
last two or three years has happened so fast that you may already feel like a dinosaur.
This can be especially true when your pre-teen comes up to you and starts whining about
something called bandwidth. All of the eras of intense technological change mentioned by
Schumpeter as the basis of K's long wave were like this. The first of the Kondratieff
waves, according to Schumpeter was due to industrialization itself. Schumpeter refers to
the waves that followed as based on railroadization, electrification, and
motorization(p.167). To follow out Schumpeter's logic here we would call the era that we
have been living through the era of computerization. Of course, our era is not over yet.
In fact, some people believe that the era of computerization has hardly begun; especially
those people who are paying several hundred times earnings for those high flying Internet
stocks.
The question you should be asking by now is Why does there have to be a down segment of
the long wave? Why can't things just keep going up? Schumpeter's answer to this question
occupies the best part of the five hundred plus pages that make up the second volume of
his major work. In a short form of words, however, Schumpeter's position can be simply
explained as follows. Industry produces two kinds of goods: consumer goods and producer
goods. The production of consumer goods (in other words what the economist calls capital
goods) dominates the upswing. This inevitably leads to increases in the amounts of
consumer goods being produced as the new capital goods create wealth more efficiently.
This is, indeed, where the problem lies, namely, with the new producer goods that created
prosperity in the first place! As Schumpeter puts it: In general, however, new products
will be released as prosperity wears on, their impact being part of the mechanism that
eventually turns prosperity into recession(p.502).
This is where we came in! That is, with the clarion call of the Investors' Business Daily
and their concern to the effect that the period we are living through looks an awful lot
like the Roaring 'Twenties. The period of the 1920s saw both declining prices in basic
commodities and a stock mania on Wall Street . According to the IBD it also saw the
endless jawboning of a certain Mr. Young who was at the What seems to happen at the top
of the long wave is that the effects of innovation spread out like ripples in a pool and
eventually involve almost all firms in the economy. When this takes place the profit
picture for each individual firm changes. As more and more companies incorporate the new
technology, profit rates are less and less exciting to each of those companies and to the
people who own them. Owners of capital who are not making the kind of money that they
enjoyed during the upswing decide to sit things out until better times come along.
Technically, they withdraw capital from production. Consequently, the demand for raw
materials normally used in production (ie, basic commodities) also declines. This demand
side weakness ushers in a long period of declining prices, business failures, and,
paradoxically, a stock market that becomes overheated as capital is switched from
productive to speculative uses.
This was, more or less, what was going on in the late 1920s. A certain Mr. Young was
Chairman of The Federal Reserve Bank of the United States at the time. Compared to Mr.
Young, who snarled about stock speculators and how he was going to hang them from the
yardarm, current Fed Chairman Mr. Alan Greenspan looks like a nice guy. Like his
unfortunate predecessor, however, Mr. Greenspan is also trying to jawbone the markets out
of their madness or what he calls their irrational exuberance. As far as prices are
concerned, as in the 1920s, international prices in basic commodities have been down,
down, down especially in agriculture. Soybeans are currently at a 27 year low and it is
unlikely that silver could be produced at prices recorded for this precious metal in the
futures market. The only significant commodity that has recovered its' price level
recently is petroleum and we probably have OPEC and its occasional effectiveness as a
cartel to thank for this.
The IBD is right. The period we are living through is very much like the late 1920s. We
have declining prices in basic commodities. We have non-stop merger activity, some of it
in clear contravention of the laws on the books (has anyone here ever heard of the
Sherman Anti-Trust Act?). We also have a stock market which seems to have gone wacko.
This is because declining commodities prices and poor business conditions elsewhere in
the world has caused foreign capital to flow into Wall Street for a speculative holiday.
This is probably the real reason that stock prices have been on a rampage for the last
few years. Meanwhile, the United States has shouldered a trade deficit that is, quite
simply, off the charts. It used to be that when a country imported several hundred
Billion Dollars worth of goods more than it exported in the course of a year that
country's currency would suffer. Now it doesn't seem to matter, but some people are
suspicious anyway. What will happen if old habits in the currency markets re-assert
themselves and somebody mounts a speculative attack against the Dollar next Monday
morning?
In addition to a runaway trade deficit, Americans have the largest negative savings rate
in the world. It makes us look prosperous, since many households are having a lovely time
living on credit, but the reality is that the Dollar is increasingly backed by negative
capital, in this case by consumer debt. Thus, if it weren't for these massive inflows of
capital from abroad, the Dollar might look pretty shaky. When Mr. Greenspan, looks at
this situation he gets scared and its hard to blame him. Like Young before him, Alan
Greenspan has been attempting to deflate the Wall Street bubble, not because he doesn't
want us all to become rich, but because he is alarmed by the potential instability of the
situation. Hence, the jawboning.
Jawboning is a nanny-like lecturing of markets that never works, as Charles
P.Kindleberger points out in his masterful Manias, Panics, and Crashes: A History of
Financial Crises. The market has been shrugging off Greenspan's lectures for years now.
Not only has no one listened to the jawboning, but also until recently ever larger
quantities of cash have been flowing into mutual funds via pension plans despite the
worst things that Alan Greenspan could say or imply. Thus, the little guy, too, can enjoy
prosperity; on the proceeds of his life savings! Forty percent of American households now
participate in the stock market through their retirement plans. A lot of people have been
making a lot of money the easy way. It is unlikely, therefore, that Greenspan will talk
this market down. It is much more likely that some sort of destabilizing force will
affect things from the outside. The underlying cause of depressions , as Schumpeter
explains in Business Cycles, is the long term movement of prices generated by long waves
of technological change. What goes up has to come back down.
There are those who believe that Greenspan would bring down this bull market gently if he
could. Certainly he has tried. It is unlikely that Greenspan's gentle jawboning will do
this, however, since, as Kindleberger points out, when investors are going hog wild in an
inflationary stock market they are simply not willing to listen to reason from the lips
of central bankers and their like. From Schumpeter's point of view, the underlying cause
of the next market crash, would simply be that the long wave of prosperity that began in
1938 is now over. According to Kindleberger's careful history mentioned above the
speculative bubble in many past economic crises has often burst as the result of some
purely exogenous event. If an army somewhere loses a battle, for example, markets crash
as investors run for the exits. The IBD closes its' provocative article mentioned above
by suggesting that the infamous Y2K bug might just play the role of the required
exogenous force here. Let's hope that they are wrong for once!