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The Rankin File: #29

Does it matter what happens to sharemarkets? Do sharemarket crashes cause depressions? Or are the wobbles an early warning of economic disaster that might be avoided if governments could read the warnings correctly? Can we learn from history? Can we learn the wrong things from history?

The diagram below was in the Sunday Star­Times a couple of weeks ago:

For people who draw simplistic lessons from history, a global equity crash on or near October 1997 seemed a foregone conclusion.

The above diagram neglects to show the Dow Jones Index of the American stockmarket in the years after the 1929 and 1987 "crashes". The collapse continued for 4 years in after 1929, whereas the "bull market" soon returned after 1987. The whole experience in the 1980s was rather different from that before and after 1929.

The bottom 1994­97 line of the above graph is really a continuation of the middle 1984­87 line. If American share prices were overvalued in 1987, then they were much more overvalued in 1997.

There are three circumstances that lead to a rapid appreciation of share prices. Two of those circumstances can lead to dangerous situations that are almost certain to end in crashes.

The first circumstance - falling interest rates - is benign. Falling interest rates represent falling profit rates, but not falling profit amounts. Thus falling interest rates create rising capital values. For example, a cut in interest rates from 10% to 5% means that both interest and profits, as liabilities, halve. But the income of the company doesn't fall. Rather, the residual profit increases (ref. Profit, the Profit Motive and Social Profit). With people buying shares only expecting to get a dividend return of 5% on their shares instead of 10%, they are willing to pay twice as much for those shares if the total profit is in fact 10% of capital.

Thus low interest rates are associated with low profit rates and high capital values. Falling interest rates are associated with rising share prices, creating capital gain and the expectation of capital gain. Rising interest rates, on the other hand, are associated with falling share prices and capital losses.

Falling interest rates have been the main factor driving the Dow Index in the mid­1990s. The fear of precipitating a crash locks the US Federal Reserve Bank into keeping interest rates low. The present American environment is both counter­inflationary and counter­deflationary; the exact opposite of the stagflationary environment of the 1970s.

If one believes in Kondratieff Cycles - as I do to some extent - then this low and falling inflation environment will be sustained for another 15 years or so, and will bring an end to the instability of the 1970s and 1980s. It is an economic environment approaching the "stationary state" feared by the classical economists of the early 19th century, but looked forward to by the later classical economists (such as John Stuart Mill) who took more of a post industrial view of the evolving world economy.

Kondratieff cycles were discovered by the Soviet economist Nikolai Kondratieff in 1927. They are "long wave" cycles two generations long (40 to 60 years). Thus the international economy would experience deflationary phases for up to 25 years (downswings), and expansionary phases of similar duration (upswings). The Kondratieff analysis suggests that the world economy entered an upswing around 1994; an upswing that should last until about 2020. (Kondratieff, who had forecast the Great Depression, was killed by Stalin in the 1930s for having the temerity to suggest that the capitalist world economy would recover!)

Each Kondratieff upswing or downswing is different to its predecessor. So the lessons of history cannot be read in too literal a fashion. For example, the 1973 to 1993 downswing would be better described as "disinflationary" rather than "deflationary" (ie falling inflation rather than falling prices). The next upswing might be characterised by lower inflation than the post­war upswing, productivity dividends arising from our getting to grips with the productive potential of computers, and more environmentally sustainable forms of economic growth. Certainly, such an interpretation of Kondratieff gives me grounds for optimism. It suggests that, so long as the worlds sharemarkets are driven only by low and falling interest rates, then the bull run may simply taper off without any need for a crash. The 1994­97 line in the above graph need not follow the path of the other two.

The two dangerous circumstances which lead to a rapid and destabilising growth of share values are (i) sudden switches in the direction of international capital flows between various countries and groups of countries, and (ii) speculation for capital gain funded by borrowed money.

In a stable world economy, the "playing field" in each nation is tilted in favour of the residents of that nation. International capital can be thought of as analogous to ocean tides. The kind of limited protection that I imply, if adopted in every country, would ensure that the world's economic tides are neap tides, rather than spring tides. The international economy can flourish when all countries protect themselves from destabilising influences.

The 1920s and 1970s were both decades of unusually high spring tides. In the early­mid­1920s, massive amounts of especially American capital flowed into Latin America, and Central/Eastern Europe. In addition there were short term inflows into Britain from France, and long­term outflows from Britain into its Empire, including significant flows into Australasia. In 1927 these flow patterns started to reverse. The German sharemarket took a dive in the process, much as South East Asian markets have done this year. American investment in Germany reduced to a trickle. And, as world prices of agricultural commodities fell in the late 1920s American money sought alternative investments to those in Latin America. Americans chose to keep their savings at home rather than invest it abroad.

Money flowed into Wall Street in 1928. As the price/dividend ratios increased, it was capital gains that investors sought, and not profits. As capital gains increased, then banks, wanting to share in the action, preferred to lend money to share buyers than to struggling farmers. Banks could get much higher interest rates on this kind of investment, because the immediate returns were so great that the interest rates on such loans hardly seemed to matter. The traditional relationship between profits and interest rates was broken. While profit rates continued to fall, interest rates rose.

In the 1927­29 period, all three factors were in place. Falling profit rates; a spring tide of international capital flowing into New York; banks lending at usurious interest rates to share buyers. The sharemarket may not have been significantly overvalued before the crash of 1929. A sharemarket driven by capital gain cannot stand still, however, whereas a sharemarket driven upwards by low interest rates can. Once the selling began, the speculators who had borrowed had no choice but to sell. That's the classic recipe for a crash.

In New Zealand in 1987 both of the dangerous elements were present. It was just like New York in 1929. Furthermore, subsequent monetary policy turned the crash into a depression. In America in 1987, there was also a lot of speculation using borrowed money, and a lot of unethical trading. But America in 1987 was not sucking in international hot money in the way New Zealand was.

The American market in 1997 is overvalued because of the perception that the American economy is locked into low and falling interest rates. It is much more overvalued that it was in 1987. But it is also less likely to suffer a crash of 1929 proportions because all the dangerous circumstances were not present in 1995­97 to the extent they were in 1927­29. But there are signs that they will be present in America in 1998.

If the capital flight from SE Asia and Latin America continues, and is exacerbated by flight from Eastern Europe, then the Dow Index might accelerate to even greater heights next year. Furthermore, there may be temptations for banks to lend to share buyers. While memory of 1987 should constrain this kind of moneylending, if too many people in the finance sector have become converts to the paradigm that Brian Gaynor recently described in the NZ Herald, then that shared enthusiasm might override commonsense.

International capital flows can easily reverse or accelerate. A reversal happened in SE Asia this year. In America in 1997, the bull market was aggravated by capital flight from SE Asia and from capital that would otherwise have gone to Asia staying at home.

The present danger in the USA is that the switch in sentiment away from SE Asia will be aggravated by switch away from Latin America and away from Eastern Europe. Indeed, in late October 1997, it appears to have been markets such at that in Brazil that feared worst. An NZ Herald article (1 November) titled "Spotlight on Brazil as turmoil spreads" stated that the Brazilian market plunged 10% in less than an hour, nearly two days after the big recovery in Wall Street. Brazil continues to be seen as very shaky.

With Japan set to liberalise its financial system in 1999, Japanese capital could further boost a bull run in America in 1998 and 1999. The big international crash would then come late in 1999 or 2000, and would trigger collapses worldwide, as international capital flows reorient themselves, responding to distress rather than to greed. A massive depression could follow, as there would be little scope for central banks to cut already low interest rates. The whole thing would of course be aggravated if the looming 2000 computer bug strikes.

I favour the Kondratieff perspective, however, and not the Doomsday 2000 scenario. I believe that we will soon see global money flowing back into SE Asia. Currency values there have fallen significantly. These countries are exporters of manufactures rather than the agricultural commodities that Latin America in the 1920s specialised in. SE Asian countries are now well placed to resume their growing shares of the world's exports, leaving the pan­European world to develop along post­industrial lines.

Thus, I believe that the wobbles in the world's capital markets will settle down for a decade or so; not quite forever as implied by the naive new American paradigm but long enough to reinforce the perceptions of the uncritical optimists. In that time, hopefully, there will be growing moves towards an assertion of national and international economic sovereignty, leading to, among other things, regulation of international capital markets. I prefer to believe in this optimistic scenario, while being fully aware of the dangers associated with the alternatives.

The most dangerous thing that can happen during a sustained period of economic optimism is the neglect of economic history. Without economic history, we have no social memory. Instead we adopt either the naive view that "history repeats itself" in the context where history itself has become little more than mythology, or the crass view that history just doesn't matter. The Wall St. crash of 1929 has certainly entered the realm of mythology.

{ This document is:              http://www.oocities.org/Athens/Delphi/3142/krf29-shar_wobbl.html
{ the above reference is to: http://www.oocities.org/Athens/Delphi/3142/krf22-profit_m.html
                                   

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