Every now and then the world is visited by one of these delusive seasons, when 'the credit system,' as it is called, expands to full luxuriance: everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open; and men are tempted to dash forward boldly, from the facility of borrowing.
Promissory notes, interchanged between scheming individuals, are liberally discounted at the banks, which become so many mints to coin words into cash; and as the supply of words is inexhaustible, it may readily be supposed what a vast amount of promissory capital is soon in circulation. Every one now talks in thousands; nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital, and falls back in amazement at the amount of public wealth, the 'unexampled state of public prosperity!'" Washington Irving (1783-1859), 'A Time of Unexampled Prosperity'
The Louvre Agreement of February 22, 1987 mandated a tightening of monetary policy in the United States and an easing of monetary policy in Japan to stabilize the dollar after a nearly fifty percent plunge against the yen in the previous two years. The Bank of Japan did its job to excess. Under its governor, Satoshi Sumita, the Bank of Japan lowered the discount rate from 6 percent to 2 1/2 percent. The Japanese money supply soared to double digit rates. Under normal conditions, the monetary expansion would have been inflationary, but the appreciation of the yen following the Plaza Accord of 1985 made it nearly impossible for Japanese producers to raise prices. Consumer prices inched up only slightly, from 100 in 1985 to 101.4 in 1988. Wholesale prices actually fell from 100 to 91.8 thanks to the strong yen and falling oil prices. Instead of raising the prices of goods and services, the excess liquidity pushed up the prices of land and equity instead.
Interest rates became so low that in real terms they were nearly zero. Credit was virtually free - sparking a liquidity boom to beat all others. The Nikkei average rose at an annual rate of 45 percent per year from 1987 to 1989. By the end of 1989 the Nikkei had risen to almost 40,000 from a little over 10,000 in 1985. Land prices in Tokyo had more than tripled. The Imperial Palace in Tokyo was, in theory, worth more on paper than the entire state of California.
Satoshi Sumita finally recognized the "monster" his easy money policies had created and raised the discount rate from 2 1/2 percent to 3 1/4 percent during 1989. But the Tokyo market continued to soar. In December, just as the Nikkei peaked, Sumita was succeeded by Yasushi Mieno as governor of the Bank of Japan. Unlike Sumita, who had come to the Bank of Japan as a star prodigy from the powerful Ministry of Finance, Mieno had spent his entire career rising slowly through the ranks at the Bank of Japan. Although he was born to a well-to-do family, his father's wealth was wiped out during World War II, and Yasushi was forced to live an extremely Spartan existence. To support himself as a student at Tokyo University, he had peddled soap and lived with a stable of sumo wrestlers run by a father of a friend. His austere youth had convinced Mieno that Japan's success resulted from its people's frugality and hard work, virtues that the asset boom threatened to subvert.
Like the "grinch that stole Christmas," Mieno struck on Christmas day, only eight days after he became governor, raising the discount rate one full percentage point to 4 1/4 percent. By August, 1990, he had raised the discount rate to 6 percent. The stock and property markets went into a tailspin. Seemingly overnight the boom of the late 1980s was over for Japan. The boom - based as it was on easy money and inflated asset prices - was replaced by a spectacular bust. From its peak of 39,915, reached on the last day of trading for the year 1989, the Nikkei average plunged to almost 14,000 by the summer of 1992. By that time Tokyo property prices had fallen by half. Mieno gained the dubious distinction of destroying more financial wealth than any other central banker in history. (Businesses and households in Japan suffered a combined loss of over $ 7 trillion.) Even though the Tokyo Nikkei average had fallen forty percent from its peak, Mieno did not cut the discount rate until July, 1991, by which time the Japanese economy was in a recession from which it still has not recovered.
Today, a decade later, economists are experiencing deja-vu. The United States' economy is now exhibiting the same characteristics as those of the Japanese "bubble economy." The Asian crisis has forced the American economy to adjust to a dramatic appreciation of the dollar against those of East Asia - a process that depresses the dollar price of traded-goods. The collapse of the Asian economies has also caused a collapse in oil prices, adding to deflationary pressures. But despite the complaints of steel workers in Pittsburgh and Boeing workers in Seattle or farmers everywhere, the American economy is steaming ahead thanks to explosive growth in the money supply. From an average annual growth rate of a little over five percent during 1995 and 1996, the M2 money supply accelerated to nearly double digit rates when the Asian turmoil began in the summer of 1997.
Much of the liquidity pumped out by the Federal Reserve to keep the economic expansion going has found its way into the stock market, pushing the greatest bull market in history to extraordinary heights. Alan Greenspan publicly questioned the stock market's "irrational exuberance" as early as December, 1996, when the Dow Jones average was at 6,400. He warned then that "history tells us there will be a correction; what it doesn't help you on very much is when." Less than two years later, the Dow Jones average almost touched 9,400.
America's liquidity bubble started to show some signs of cracking this summer. For a while, beginning in April, M2 money growth slowed from its torrid pace of 9 percent per year to a more moderate 5 percent. Economic growth slowed from an annual rate of 5.9 percent in the first quarter to only 1.6 percent in the second. The Dow Jones industrial average reached an all time record high of 9,337 on July 17, and then retreated, falling 512 points in a single day on August 31, before bottoming out almost two thousand points below the July peak. It was the worst stock market sell off in eight years. Alan Greenspan suddenly became apprehensive. Instead of warning about the market's "irrational exuberance," he suddenly became worried about the market's "irrational fears." Greenspan was now convinced that the fallout from Asia crisis was about to threaten the American economic expansion. "It is just not credible that the United States can remain an oasis of prosperity," he asserted, and the Federal Reserve sprang into action to launch a pre-emptive strike against a perceived economic slowdown. On September 30 the FOMC reduced the federal funds rate target from 5.5 percent to 5.25. The stock market was unimpressed by that cut, so Alan Greenspan surprised the market with another quarter point cut two weeks later, and another to 4.75 percent at the scheduled FOMC meeting on November 17. In less than two months, the federal funds rate fell 75 basis points, and the Dow Jones industrial average made an impressive recovery. By early December it was threatening to hit new all time highs.
But the economic slowdown the Federal Reserve had feared so much was just a mirage. Up until the eve of the release of the third-quarter GDP figures on October 30, economists were convinced the slowdown was real - the consensus estimate of the growth rate of third-quarter real GDP ranged from 1.8 to 2.2 percent. The preliminary estimate turned out to be 3.3, and that was subsequently revised upward still further to 3.9 percent. The economy was not slowing to a grinding halt; growth was accelerating, and the liquidity bubble was back with a vengeance. The money supply started increasing at an astonishing rate of 14 percent per year. In retrospect, the Federal Reserve's aggressive easing turned out to be a policy blunder.
As we enter the last year of the millennium, the outlook for the immediate future looks too good to be true - continued rapid economic growth and low inflation. But there are internal contradictions in this economic boom. It is propelled by an unsustainable bubble in asset prices caused by excessive monetary liquidity. Demand for the nation's final output has dramatically shifted from exports to domestic consumption by households, encouraged to go on a spending spree by phenomenal, as yet unrealized, stock market gains. More families than ever have investments in the stock market - about double the percentage from as recently as 1990. And as stock prices climb, stock holders feel wealthier and consume more of their disposable income. In recent months the personal savings rate in the United States turned negative, i.e., American households are now spending more than they earn - something that has not happened since the 1930s. 2 But the bull market will not last forever, and when the bubble is finally pricked, consumer spending will dry up in an instant.
Bubbles always burst in the end, usually with painful consequences. Those that buy into the bubble, those who are mesmerized by the rapid increases in the prices of equity and property, encourage firms to overinvest and investors to over-borrow. When the correction finally arrives, we are left with an uneconomic capital stock and impoverished households. And the longer the bubble lasts, the bigger the bang when it bursts. No one knows how, or when, the current bubble will end. The Fed can continue to flood the economy with money for some time. After all, demon inflation has not yet raised its pointed head. The public rightly regards a rise in consumer prices to be a bad, but an irrational rise in equity or housing prices is still regarded as an unqualified good. But sooner or later, the Federal Reserve will have to rein in economic growth by raising interest rates. The economy is overheating. Economic growth cannot continue to exceed its potential rate of 2 1/2 percent for much longer without igniting an acceleration in labor costs. No one knows where "full employment" (that magic NAIRU rate) is, but if we're not there, we're very close. The 4.4 percent national unemployment rate is the lowest in practically three decades. Whatever the critical number is, when we finally hit it, the bubble will burst; labor costs will start to accelerate, and either inflation or a sharp drop in corporate profits will follow. Neither are good for equity markets.
One thing's for certain. The next move by the Federal Reserve will be to raise short-term interest rates, not lower them. Boosting monetary growth will not save the economy in the long run. Greenspan was right when he questioned the "irrational exuberance" of the stock market back in Christmas of 1996. Since then he has increasingly become a shill for Wall Street capitalism. But even he would admit his aggressive monetary easing this fall was a mistake.
Mac Williams
Cosmos Mariner
Destination Unknown
© December 20, 1998