(This is Part 8 of a continuing series. Go back to Part 7.)
There's seems to be a perception in many quarters that the economy is wobbly because of this and that—businesses being cautious with investments or the unemployment rate rising or the consumer seeming fatigued.
Or we could bring up federal and state budget deficits, the huge current account deficits in foreign trade, the falling index of manufacturing activity and many other things. All of these developments happen to be taking place, but they aren't the cause of the "sluggish economy."
I love that phrase: a "sluggish economy." The laxatives being taken for this condition, of course, are super-low interest rates, a series of huge federal tax cuts and "EZ" credit for all. But none of these measures will work long-term in putting the economy on a solid footing. Why not?
The thing is, the economic trends mentioned above and others are not causes, but rather effects. Something is driving these effects. And we might ask: What is that something?
In recent decades there have been four huge financial bubbles that have formed—the stock market bubble, the dollar bubble, the housing bubble and the credit bubble.
What does a bubble represent? It represents a mania, a phenomenon where prices rise in an exponential curve—and then just as surely fall down on the other side.
Examples of bubbles from history include Dutch tulip bulbs in the 17th century, the South Sea Company in the early 18th century, U.S. and world stock markets in the 1920s and so on.
If you look at charts of these bubbles, or financial manias, they look roughly symmetrical. There's the rise up to the peak, and then the equally dramatic fall-away. They look a bit like a steep mountain peak. Now here's the thing:
The mania always falls lower than where it began.
That is, whatever the starting price level of a mania, it always eventually declines to a point lower than that starting point. I know of no exceptions to this among manias or bubbles for which data is available.
A contributing reason for this is that bubbles are about mass emotions—hope and greed on the upside, fear and despair on the downside. And such mass emotions almost always go too far; they strongly tend to overshoot at both the up and down extremes.
Now let's go back to our four current manias—the stock market bubble, the dollar bubble, the housing bubble and the credit bubble. One of them has already peaked and begun the down journey, and the other three will most likely peak within a few years. No matter. In the long sweep of history they will appear to have peaked at about the same time.
The U.S. stock markets peaked in early 2000 after a spectacular run-up—the amazing bull market of the 80's and 90's, the largest stock market bubble in history.
As part of this mania, the Nasdaq stock index soared to heights of giddiness where companies could command price/earnings ratios in the hundreds. In other words, hundreds of years of earnings were being discounted at those prices. Is that a great bubble or what?
But there's a downside to all this hilarity. Sooner or later such a bubble must form the right side of the mountain peak—the fall from the peak and the descent again down to the plains from where it began.
The Nasdaq, for instance, rose from 300 in 1991 to 5,000 in early 2000—an astronomical ascent of 1700% in only 9 years. On the left side, it's an huge exponential curve that looks like a needle at the top.
Then there was the inevitable downside where the Nasdaq fell about 70% in the first stage of its bear market. There will be sharp rallies along the way, but the Nasdaq still has a long way to travel in order to go below 300, where it started.
On the way up the stock market generated $8 trillion. People spent freely because they felt the impact of all that extra "wealth." Meanwhile, businesses invested freely because they could raise money easily in stock market IPOs. When all is over on the downside that $8 trillion will have simply vanished.
In a sense, that money came from nowhere and goes back to nowhere. When two people trade at a higher price on the exchange it raises the value of everyone's holdings in that stock. Everyone's stock holdings passively increase. Excess "wealth" is created from nowhere. Of course, this mechanism works exactly in reverse on the down side.
(This is the end of Part 8. Go to Part 9.)
—jim sloman, 6.20.03 for Oct 19
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