The Bear's Lair: Three years from the peak

By MARTIN HUTCHINSON, UPI Business and Economics Editor  |  March 3, 2003 at 5:37 PM
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WASHINGTON, March 3 (UPI) -- Next Monday, March 10, is three years from the peak in the U.S. stock market, March 10, 2000, when the Nasdaq composite index closed at 5,048.62. In bear market terms, this is a very long time. Three years from the September 1929 peak, the stock market had already touched its nadir, in June 1932 (at which point the Dow Jones industrial average had dropped 88 percent) and had begun to move off the bottom, although a nightmarish banking crisis lay ahead. Are we at the same stage now?

Since 1929 holds the U.S. record in terms of a stock market slump followed by economic depression, the 1929 precedent is at first glance encouraging -- if even such a horrendous depression took less than three years to emerge, then surely, three years after the peak, things must have got about as bad as they are going to get. In which case, as Federal Reserve Chairman Alan Greenspan notoriously claimed to Sen. Phil Gramm in August 2001, it was worth it.

Of course, it's not as simple as that. President Herbert Hoover, while making encouraging noises about the economy very similar to those emitted from the Bush administration, made a number of policy errors that exacerbated the economic decline. He increased tariffs sharply, by signing the notorious Smoot-Hawley Tariff Act of 1930, which in an era when the United States was running a balance of payments surplus, produced huge economic dislocation. He destabilized the European financial system, by demanding repayment of U.S. war debts without any regard as to the economic or balance of payments condition of those who owed the money, or the payment of corresponding obligations within Europe. Most important, the Fed, worried about inflation, "sterilized" the inflow of gold from U.S. exports by selling government debt, thus sharply tightening the money supply. The Great Depression has frequently been blamed on the gold standard; in reality it was largely caused by this inept meddling with the gold standard from a Fed that was still relatively new and largely driven by political considerations.

The effect of these moves was not only to worsen the Great Depression, but also to bring it on more quickly. The hard line on European loans dried up imports from the United States, causing trade to contract sharply -- U.S. merchandise imports dropped by no less than 70 percent in 3 years, from $4.4 billion in 1929 to $1.3 billion in 1932, far more than the corresponding drop in U.S. gross domestic product, and a major contributor to the feedback of malaise internationally. Of course, with international trade collapsing, there were few chances for uplift in the U.S. economy or in markets generally.

It must at this stage be clear that the stock market peak in March 2000 was more extreme than that in September 1929 -- whether you measure it by market capitalization as a percentage of GDP, by average price/earnings ratio on common stocks, by percentage of households owning shares or by the length and size of the preceding bull market. All the moral obloquy that was poured on the Coolidge 1920s by liberal commentators after the Great Depression had hit applies with redoubled force to the Clinton 1990s. Redoubled, for two reasons: First, it had happened before, more or less within living memory (the legendary Albert Gordon, investment banker since 1925 and rescuer of Kidder Peabody in 1931, was still active during the 1990s, for example). Second, unlike the ascetic Coolidge, a man of deep moral and financial conservatism, Clinton by his morally and ethically uninhibited presidency validated the corner-cutters who are an inevitable accompaniment of bubbles.

It can fairly argued that the 88 percent drop in the market after 1929 was an overstated response to a depression exacerbated by policy mistakes. However a drop of, logarithmically, half as much -- not 44 percent, but 65.4 percent -- would send the Dow Jones index (closing at 7,837 Monday) to 4,061 and the Standard and Poor's 500 Index (834 at Monday's close) to 529. As we are still far above those levels the question re-emerges: Are we going to reach them, or have we touched the bottom?

My difficulty with the thesis that, having been in a stock market downturn for as long as the 1929-32 episode, we must have touched the bottom, is that the economic path followed since 2000 has been very different from that followed after September 1929.

As with the Coolidge/Clinton comparison, the contrast in personnel between the dour Hoover and the indulgent George W. Bush is striking. More striking still is the contrast between Bush's two undistinguished ex-businessmen Treasury secretaries, Paul O'Neill and John Snow, and Hoover's holdover from the Coolidge administration (until he forced him out in February 1932), Andrew Mellon, one of the legendary American capitalists, the founder of Alcoa, Mellon Bank and Gulf Oil, and regarded at the time as the greatest Treasury secretary since Alexander Hamilton. It is certainly not obvious that economic policy is in safer hands today.

In terms of actions, the contrast is even more striking. Hoover raised both public spending and then taxes, in order to reduce an exploding federal deficit -- the effect was to increase rapidly the share of resources being eaten by the government, not a pro-growth measure. Bush has increased spending, like Hoover albeit for different reasons, but remains determined to cut taxes -- if he persists in this determination, growth will be quicker to return. Hoover increased tariffs sharply, destroying world trade. Bush has been about neutral on tariffs, imposing punitive tariffs on steel imports, while talking a good game on free trade and globalization.

Most important is the contrast in monetary policy. In 1929, the Fed tightened money, and kept it tight, in spite of declining interest rates, while the economy spiraled down. This time, Greenspan, who like the 1920s Fed had pursued an accommodating monetary policy during the bubble (M3 money supply grew at 8 percent to 10 percent in 1995-2000), became even more accommodative after January 2001, and is now presiding over short- and long-term interest rates at 40-year record low levels, which may not have done much for the stock market but has resulted in a gigantic surge in housing.

The contrast in policies and personalities between 1929-32 and 2000-03 is clear; what is not clear is the continuing effect of that contrast. In that context, it is useful to look at the Japanese example. There, January 1990 saw the peak of a stock market and real estate bubble that was the equal of the United States in 2000, and greater than the United States in 1929, but certainly comparable in magnitude to both (though the commercial real estate sector in 1990 Japan was inflated to a degree not present in the U.S. bubbles.)

The Bank of Japan initially pursued an accommodative monetary policy, but once interest rates had reached zero, it did not until recently carry out the extensive purchases of government debt that would be needed to create more money. The government increased spending, as did both Hoover and Bush, and ran government deficits larger than either U.S. leader has yet managed, thus following closely the Hoover example of an expanding government share in the economy. In terms of foreign trade, Japan ran a surplus throughout (like the U.S. in 1929-32, but unlike the U.S. today) but became if anything slightly less protectionist than its previous extraordinary stance.

As is well-known, the effect of Japanese policy was a rolling recession that was nothing like as deep as the U.S. Great Depression, but on the other hand has now lasted 13 years and counting. Interestingly, the stock market lost about half its value almost immediately, and then continued to trend down over the next decade, so that today the index is down about 78 percent from its high, in logarithmic terms about halfway between the Great Depression's 88 percent drop and the milder 65 percent drop I postulated above. However, in 1993, three years after the peak, the Japanese stock market was still around half its peak level, and more than double the level to which it has sunk today.

The Japanese example indicates the choice facing the incoming Bush administration in 2001. In order to avoid the exceptionally severe stock market and economic contraction of 1929-32, the administration and the Fed opted (probably unknowingly) for the milder, but horribly prolonged Japanese experience of 1990-2003. It is a choice you can argue about. The social and political effect of the Great Depression scarred a generation. On the other hand even a mild recession that lasts a decade and a half will blight a very high proportion of our working lives -- 2013 is a long way off yet.

What you cannot on this analysis deny is that we are nowhere near the bottom yet, either in terms of the stock market (even if the administration continues to avoid Hoover's economic errors) or in terms of time. If as seems likely the Fed and the administration continue to fight the necessary deflation in stocks and housing, then we will see a continuing downturn in markets for another 2-3 years, with the stock market bottom coming only about 2005-6 and the housing market bottom later, maybe 2007-8.

What is more, when the bottom finally arrives, short-term interest rates will be around zero and the federal budget deficit will be huge, maybe around $600 billion to $700 billion, the level beyond which spiraling interest rates and default loom. Hence, at that stage, there will be no weapons left to help the economy recover, and we will have to wait for nature unaided to take its course -- which as Japan has shown, can be a long wait indeed.

What a pity, what a very great pity, that Alan Greenspan did not raise interest rates when he perceived "irrational exuberance" -- on Dec. 4, 1996, with the Dow Jones index at 6,437.

(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.)

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