WASHINGTON, Aug. 9 (UPI) -- Anthony Trollope's 1875 masterpiece "The way we live now" is an astonishingly accurate early portrayal of the peak of a speculative bubble "the Melmotte era." It missed in only one respect: the Melmotte Era lasted only nine weeks. Our own generation's speculative "Melmotte Era" has lasted almost a decade, but it is in the process of ending.
August Melmotte, the villain of "The way we live now" was intended by Trollope to portray the new cosmopolitan financiers that were taking over European finance in the boom of 1866-73; he "rises above honesty as a general rises above humanity when he sacrifices an army to conquer a nation." Melmotte was an early proponent of globalization; much of his business rhetoric could have come straight from an International Monetary Fund mission statement of about 1998. In the hugely speculative climate of 1873 (it was the biggest stock market bubble before 1929, and led to a decade of severe depression) he creates a bubble railway company, to finance a line between Salt Lake City and Vera Cruz, Mexico, an objective positively dot-comesque in its silliness even now, let alone then. The bubble succeeds superbly in attracting investors, but lasts only nine weeks, after which the Great South Central Pacific and Mexican Railway Company suspends operations, Melmotte commits suicide, and order is restored.
As I said, the only unrealistic thing about Melmotte's bubble and subsequent scandal is that it lasts only nine weeks. Our own bubble, which may now be close to bursting, has lasted very much longer than that -- from the Netscape Initial Public Offering to the Google IPO will have been almost nine years.
The mechanism by which bubbles occur and then collapse into a decade of economic angst is a well established one, but seems to have been missed by many commentators. First the stock market, which has been strong but within established price parameters (in terms of such old fashioned measures as price-earnings ratio and dividend yield) begins to exhibit extraordinary strength, rising for month after month with no apparent reason other than optimism itself. This stage was reached early in 1995, when the dividend yield on the Standard and Poor's 500 index dropped below 3 percent, a feat it had only ever managed ephemerally in the past (the yield as of Friday morning was a mere 1.73 percent.)
After a while, commentators and indeed in this case Alan Greenspan, the Chairman of the Federal Reserve Board, produce new rationales (such as the "productivity miracle" that appeared in 1997) to explain the stock market's strength, and Wall Street seizes on these new rationales to justify propelling the market ever higher, since its denizens are all making unprecedented amounts of money from the rise. More and more money rushes into the market, traditional ethical standards are thrown to the wind, and taxi drivers start offering you stock tips or give up their taxis to enter the magic world of "day trading" for their own account. The major issuing houses bring out IPO after IPO, each one on a slenderer basis of real operations, and with a more exquisite distillation of this particular boom's hot new idea.
Eventually, the timing determined by a subtle interplay between the gradual exhaustion of money available for investment and the never-ending supply of silly new ideas that can be designed to attract the investing public, the bubble peaks.
However, it does not generally then "burst" with a loud bang, after which all is once again well; it has sucked in too much of the world's savings, and caused too much investment to be misdirected into hopeless projects for any such benign fate. In 1929, the bubble famously burst, with the Wall Street crash. However, the crash of 1987, bigger than that of 1929, occurred at a point when the U.S. economy was expanding in a healthy fashion, there had as yet been little misdirected investment, and stock prices were by historical standards only modestly overvalued (the dividend yield on the S&P 500 Index made it below 3 percent, but only just.) 1873 in New York and London, and 1990 in Tokyo, had offered no comparable crash, and nor in the event did 2000 in New York.
Once the bubble bursts or begins to deflate there is for several years an "undertow" in the economy, which prevents satisfactory and sustained growth from being achieved. Maynard Keynes, getting it right for once in his life, wrote in his 1936 "General Theory" and elsewhere of the "overinvestment" that had occurred before 1929, causing the economy of the 1930s to settle into a sub-optimal equilibrium with little investment and continuing high unemployment.
There is no doubt that in the 1930s, policy mistakes were made in the United States, notably the protectionism of the 1930 Smoot-Hawley Tariff, the rapid increase in government spending, which sucked resources out of the private sector, the inadvertent tightening of money supply by the Federal Reserve, and the income tax increase in 1932, imposed in the worst of the depression. However, even without equivalent mistakes, Japan in the 1990s demonstrated that after a bubble, the economy generally fails to perform as it should for a decade or more. A moderately severe and very prolonged recession, with the stock market dropping back to historically normal valuation levels, was what I and many others expected in the fall of 2000, after the bubble had clearly burst.
This time around, that didn't happen. The George W. Bush administration, taking office just as the downturn hit, pumped out not one but two sets of tax cuts, plus a substantial and apparently uncontrolled increase in federal spending, part but by no means all of it due to the war on terror. It also encouraged Greenspan to engage in a huge money printing spree, holding real interest rates negative for three years and counting.
The result was that the bubble never really deflated. Valuations never got back to their normal historic levels. Even though dividends, which had been suppressed during the height of the frenzy, have increased in the last year owing to the 2003 dividend tax cut, the S&P 500 Index would have to trade at 623 compared with Friday morning's 1080 to yield as much as 3 percent -- historically the top of the normal valuation level, not its middle.
On earnings, the S&P 500 Index is currently trading at 25 times earnings, which brokers are claiming is only a little above the mid-point of its average over the last 10 years. But guys, 10 years ago is only August 1994; for 9½ of those 10 years we've been in a historically unprecedented bubble, with price-earnings ratios consistently above the normal range and dividend yields consistently below it.
To get back to its long term historical average price-earnings ratio of about 14, the S&P 500 Index would have to trade at about 608. That's without taking account of the fact that reported earnings on the S&P 500 Index are currently inflated by two factors: (i) the historically unprecedented level of "extraordinary items" charged directly against capital, in the 1980s about 5 percent of earnings, now in the 30-40 percent range and (ii) the continuing high level of un-expensed stock options, themselves responsible for more than 10 percent of current S&P 500 earnings.
In 2003-04, this has resulted in the economy being in a thoroughly false position. The valuation bubble in the stock market hasn't deflated, so bubble projects are still getting financed. If anyone doubts that statement, pause one moment to consider the Google IPO, priced at over 100 times earnings (themselves very inflated, as I pointed out in April) with a proposed market capitalization of $36 billion, with ten times the number of shares to be issued in the IPO available for dumping into the market by insiders over the 6 months following the IPO, and with a distribution system that deliberately cocks a snoot at the conventional methods of Wall Street.
The arrogance of Google's management is breathtaking; the financial carnage caused by the issue will be spectacular. What is sad is that, if Google had pushed the issue out quickly three months ago, had used conventional distribution methods, and had capitalized itself at $10 billion instead of $36 billion, it might have been successful; the underlying business is a sound one, it's just intrinsically of a fairly modest size.
Going forward, every scrap of ammunition in the fiscal and monetary policy armory has been fired off at the economy, so the post-bubble economic undertow that prevents economic growth from occurring is now taking hold. Judging by the post 1929 experience and that in Japan in the 1990s, in both of which the prior bubble was smaller in terms of gross domestic product than that in the United States in 2000 (not to speak of the U.S. housing bubble of 2001-04) the deflationary undertow will be very severe, and will persist not merely for the reminder of this decade but into the next one. The $423 billion per annum U.S. budget deficit (shortly to rise sharply as renewed recession takes hold) and the $600 billion per annum U.S. trade deficit will make matters worse, producing a healthy dose of inflation to go with the recession, and lowering U.S. living standards even further than is otherwise inevitable.
It is likely that 10 years from now, when the long recession/stagflation period is at last beginning to lift, real U.S. living standards, on average, will be as much as 20 percent below where they are today, once the higher savings rates and higher tax levels of 2014 are taken into account. If Bush loses in November, it will be interesting to see who gets blamed for this -- John Kerry, in whose presidency the worst of the downturn will hit, George W. Bush, who postponed the downturn by tax cuts but worsened it by public spending rises, or Bill Clinton, on whose watch the preceding bubble inflated (it must be remembered that liberals blamed the Great Depression on the entirely innocent boom-era president Calvin Coolidge for half a century after 1929.)
The real culprit, of course will be Alan Greenspan, who saw "irrational exuberance" in the market on December 4, 1996 but did nothing about it, then prolonged the period of financial madness from 2001 to 2004 by throwing money at the economy. But by 2014, he will be forgotten by the general public, as are his predecessors today; it will be no fun blaming him.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press) -- details can be found on the Web site greatconservatives.com.
