The American boom: is the end at hand?

By Gerard Jackson
web posted April 1999

What goes up must come down is a saying with which we are all acquainted. Perhaps it is not strictly true in some cases but it certainly applies to the present state of the stock market, even as the Dow reached 10 000. But numbers and trends have nothing to do with it; they are merely signs, symbols, things which tell us nothing in themselves. What we need to know is whether the stock market is booming for the right reasons. There are two kinds of booms: There is the monetary boom. This is caused by governments using credit expansion to stimulate the economy. Its symptoms are pretty straight forward: rising current account deficits, falling saving rates, increasing debt ratios, accumulating malinvestments, rising mergers, a booming stock market marked in its later stages by reckless speculation and grossly overvalued shares.* In reality, this is a phony boom. It is more like drug-taking except in this case the drug is not cocaine, for example, but credit expansion.

The second kind of boom is the real McCoy. No economic steroids here. No 'drug' dealing banks issuing addictive doses of artificial credit. So what fuels and drives this kind of boom? The answer is savings and entrepreneurship. America, fortunately, has no lack of the latter but little if any of the former. In the free market, rising savings (the transfer of purchasing power from consumption to the production of capital goods) extends the capital structure, raises productivity and lowers costs and prices. This is a progressive economy, one in which aggregate profits exceeds aggregate losses. Because the profits are genuine entrepreneurial gains and not the product of inflated credit stock market evaluations will strongly correspond to genuine anticipated earnings streams and thus price earnings ratios will be largely in keeping with market reality. There will be no stock market mania; no speculative frenzy and no stratospheric PEs.

Radio Corporation of America is an excellent example of what I mean. In 1921 its stock stood at $US3. On the eve of the 1929 stock market crash they had rocketed to $US573, a 6 378 per cent increase. Remember, this was considered hi-tech stock, just like net stocks today. For about 20 years after the crash, RCA shares rarely rose above $US10, which means that by 1950 they were still at about the 1921 price of $US3. Needless to say, a lot of people were utterly ruined by this completely predictable collapse. I say predictable because despite the soothing words of Professor Irving Fisher, the likes of Dr Benjamin M. Anderson Jr, who was chief economist at the Chase Manhattan Bank and editor of the Chase Economic Bulletin, thought otherwise. Anderson publicly warned that credit was too loose, that it was fuelling the stock market boom and that a recession and severe market correction was unavoidable. (Anderson's qualitative approach to the economy turned out to be vastly superior to Fisher's mathematical approach). I do not doubt for a moment that the US is in a similar situation today. From early March 1998 to this March M1 rose by about 1.5 per cent but broad money jumped by nearly 11 per cent. This is not my idea of a steady or responsible monetary policy.

Now let us get down to a few contemporary facts. A very important indicator and one that is largely ignored is manufacturing. Despite the recent rise in new jobs manufacturing contracted again, even though credit expansion has continued. I consider this to be a very ominous sign. Moreover, reckless lending by banks has left them dangerously exposed. So with manufacturing contracting where are these jobs coming from? They are mainly at the consumption end of the economy. When manufacturing continues to contract it is not long before those producing at the consumption stages of the economy feel the impact.

I have been asked whether the fall in bond prices which corresponds to a 1 per cent interest rate rise indicates Fed tightening. Financial aggregates certainly do not support the view that monetary tightening is occurring. As I have pointed out before, credit inflation eventually triggers real economic forces that impose a correction on the economy even in the absence of a credit crunch. I suggest that this is happening now. I think there are two reasons why this has not revealed itself in the stock market indexes: 1. There is always a time lag before share prices respond to changes in output. 2. The indexes are not representative of American industry. In other words, a number of shares might already be indicating a slowdown but this is being concealed by the manner in which the indexes are constructed.

As for the title of this article, yes, I do believe the end I near. Some think it will be early next year. However, if manufacturing contraction is as large as I have been led to believe then I think the boom will end this year. But don't ask me for the date until after the crash.

* I should make it clear that because a country runs a current account deficit that in itself does not mean it is pursuing inflationary policies. Furthermore, there is no strict relationship between money supply and stock prices. If profit margins have been eliminated by depression and expectations for future profits are very poor or non-existent I would not expect a monetary expansion to raise share prices.

This piece originally appeared in The New Australian and is reprinted with the kind permission of the author.