Why the Wall Street Bubble Must Burst?
In 1938, and in the teeth of the longest and fiercest depression that the United States had ever known, capital spending hit an all time high. That’s right! In 1938 the men who owned America began to pour millions of Dollars into new plant and equipment as if there was no tomorrow. We don’t think much about it today, because it has been a long time since the United States has experienced a real bone jolting economic slowdown. The fact is, however, that the very best time for the industrialist to invest in new technologies is in the middle of a depression. This is because it is at such times that labor, raw materials, and new equipment can be purchased at rock bottom prices. Henry Ford may have jumped the gun a bit. He shut down his River Rouge plant for two years starting in 1932 so that it could be completely rebuilt. Being a bit of a genius, Ford used his time and money to redesign the plant to create one of the most powerful little engines ever built: the Ford V8. This engine was so good that it was modified only slightly to equip certain aircraft for use in World War II. It also powered a series of red hot Ford cars all the way through the 1950s. At the same time that Ford was rebuilding his River Rouge plant, Joseph Alois Schumpeter, an Austrian economist who had migrated to Harvard University, was hard at work on a book that would explain the paradox suggested above, namely the timing of business cycles and technological change. In this all but forgotten work one of our most famous economists spelled out the secrets of the business cycle, that is the same old pattern of boom and bust that may be coming back to haunt us now.
Many, if not most, American college students know Schumpeter’s name because of his work in defense of free enterprise called Capitalism, Socialism, and Democracy. This was not, however, the book that Schumpeter was working on as America slogged through the mean and hungry 1930s. The book published by Schumpeter in 1939 is called ” Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process. ” Not only is Schumpeter’s definitive two volume study of the business cycle not on college reading lists today, but, indeed, it continues to languish in its first edition. The embarrassing truth is that Schumpeter’s real masterpiece remains almost unread. The present writer checked out this forgotten work from one of our leading university research libraries to discover that Schumpeter’s book had been borrowed only a total of fourteen times in the nearly four decades from June 1961 to the present!
There are probably two reasons for this. In the first place, Schumpeter’s magnum opus on the business cycle came out on the eve of the Second World War. As the dark clouds of war began to cast their shadow over Europe, Asia, and eventually the United States, economists (and everyone else) clearly had more pressing concerns. Not only that, but it was also clear to Americans that the US Army would soon take care of the problems of excess supply being experienced in the labor market. It was also quite obvious to everyone that the factories were about to start humming again, this time to produce for war.
After the conflict, of course, and all the way through the 1970s, it was widely believed that the business cycle had been “repealed” by means of the clever economic manipulations suggested by the British Lord John Maynard Keynes. College kids in the halcyon 1960s were taught by their professors that the economy was not one of scarcity, but, rather, of endless abundance. The Great Society had arrived. Keynesian economics was in its glory days. This new body of thought and practice was one of the British Empire’s last and most influential exports. If Keneysianism had, indeed, hung the business cycle by the neck until dead, then the only decent thing to do was to bury the corpse. Schumpeter’s text, unfortunately, was placed alongside the remains of business cycle it its tomb. Some things, however, will not simply and decently die. They come back to haunt you. Do you remember platform shoes? They should have expired peacefully in about 1973, but just take a look at your teen age daughter! Some fifty years later, there are those who, like the present writer, appear to suspect that the business cycle, too, is back.
The highly respected Investors’ Business Daily recently devoted a full-length front page article to the following shocking idea: “Ominous Parallels To Late 1920s? Then As Now: Roaring Stocks, Deflation, Stingy Feds.” If what the IBD is worried about turns out to be true, the American economy could be in for hard times again! If this happens, our somewhat lazy academic economists might find it worthwhile to check Schumpeter’s book out of the library a little more often. What they will find there is briefly explained in the following . If Schumpeter’s historical and economic analysis is correct, we are sliding down the long back side of what is called a “Kondratieff wave” and picking up speed as we head towards the trough. What will be required to start marching up the other side and back into prosperity, according to Schumpeter, is a period of “creative destruction.” During this unpleasant period the fictitious values of the boom (like an overpriced stock market ) are destroyed. It is at such times that capitalists finally go to work and invest in new technologies to power us out of the depression that almost always occurs. In previous economic crises, such as the period of the “late 1920s” that the Investor’s Business Daily has so convincingly evoked for us, the process of “creative destruction” was initiated by bizarre public and official behaviors. This included stock manias, economic panics, bank runs, Fed jawboning, and stock market crashes. Does any of this sound familiar?
Schumpeter inherited the idea that there is a long a-periodic economic cycle governing all of this from an unfortunate Russian called Kondratieff. We’ll call him “K” for short. K’s article on what he called “long waves” came out in 1926. Not much later K perished in one of Stalin’s brutal purges, probably for having above average intelligence. Schumpeter speaks of Kondratieff’s “long wave” very approvingly and discusses it together with two observed business cycles of shorter duration called the “Juglar” and the “Kitchin” cycles after the statisticians who described them. Schumpeter believed that there were “…six Juglars to a Kondratieff and three Kitchins to a Juglar- not as an average but in every individual case” (pp.173-174).
Having lived through nine years of economic crisis by the time his book was published, Schumpeter believed that the Great Depression happened because the end points of all three of these fluctuations occurred at the same time (p. 173). Juglar and Kitchin cycles have been pretty much forgotten today. The Kondratieff long wave, however, still excites interest among cycle buffs, perhaps because it fits in so nicely with what we know about economic history. All three of the patterns pointed out by Schumpeter, on the other hand, have one very important element in common. The Kitchin, the Juglar, and the Kondratieff are all based on the timing of technological change (or what the economic historians call “innovation”) as it occurs within the free market system. The Kondratieff is easier to see because it fits in with the most obvious moments in the development of the industrialism in its dynamic relationship with free enterprise. The first Kondratieff, Schumpeter says, was the Industrial Revolution itself which lasted from about the 1780s through 1842. The era that followed (1842-1897) was, according to Schumpeter, ” the age of steam and steel.” The third Kondratieff was based on “electricity, chemistry, and motors”, and was ongoing when Schumpeter was working on his masterpiece (p.170). These periods of growth and expansion saw ever increasing productive and financial power in the industrializing countries and were punctuated by episodes of economic crisis in every case. If the IBD has called it correctly, we might be entering such an era of economic crisis once again. The key to the picture is the long- term behavior of prices in general and commodity prices in particular. The short form of the argument is as follows: when prices go into long periods of decline, look out!
The logic of the long wave idea is not complex. Long wave theorists believe that innovation in the world of production and management happens not as a series of single events, but as a related set of changes all simultaneously affecting one another. Those of us who have lived through the computer revolution can see the logic of this in our own lives. Take computers (or as the stand up comic guy might say “Please take computers!”). No sooner did you get a simple PC for a little word processing and maybe to balance your checkbook, than it was obsolete. The reason was that, not many months after you bought it, you found out you needed something called a “modem.” Then you noticed that your original software was already archaic, ineffective, and slow: six months after you bought it. A few short years later, everything you see and hear off from an overheated stock market to the problems of the “E-traders” is about “telecommunications.” “Telecommunications”, it turns out includes the computer you now own which is ten thousand times more powerful and about half the price of the first one you bought not so very long ago! The total complex of innovations and interconnections that has taken place in cyberspace in the last two or three years has happened so fast that you may already feel like a dinosaur. This can be especially true when your pre-teen comes up to you and starts whining about something called “bandwidth.” All of the eras of intense technological change mentioned by Schumpeter as the basis of K’s “long wave” were like this. The first of the Kondratieff waves, according to Schumpeter was due to industrialization itself. Schumpeter refers to the waves that followed as based on “railroadization”, electrification, and “motorization”(p.167). To follow out Schumpeter’s logic here we would call the era that we have been living through the era of “computerization.” Of course, our era is not over yet. In fact, some people believe that the era of “computerization” has hardly begun; especially those people who are paying several hundred times earnings for those high flying Internet stocks.
The question you should be asking by now is “Why does there have to be a down segment of the long wave? Why can’t things just keep going up?” Schumpeter’s answer to this question occupies the best part of the five hundred plus pages that make up the second volume of his major work. In a short form of words, however, Schumpeter’s position can be simply explained as follows. Industry produces two kinds of goods: consumer goods and producer goods. The production of consumer goods (in other words what the economist calls “capital goods”) dominates the upswing. This inevitably leads to increases in the amounts of consumer goods being produced as the new capital goods create wealth more efficiently. This is, indeed, where the problem lies, namely, with the new producer goods that created prosperity in the first place! As Schumpeter puts it: “In general, however, new products will be released as prosperity wears on, their impact being part of the mechanism that eventually turns prosperity into recession”(p.502).
This is where we came in! That is, with the clarion call of the Investors’ Business Daily and their concern to the effect that the period we are living through looks an awful lot like the “Roaring ‘Twenties.” The period of the 1920s saw both declining prices in basic commodities and a stock mania on Wall Street . According to the IBD it also saw the endless jawboning of a certain Mr. Young who was at the What seems to happen at the top of the long wave is that the effects of innovation spread out like ripples in a pool and eventually involve almost all firms in the economy. When this takes place the profit picture for each individual firm changes. As more and more companies incorporate the new technology, profit rates are less and less exciting to each of those companies and to the people who own them. Owners of capital who are not making the kind of money that they enjoyed during the upswing decide to sit things out until better times come along. Technically, they withdraw capital from production. Consequently, the demand for raw materials normally used in production (ie, basic commodities) also declines. This demand side weakness ushers in a long period of declining prices, business failures, and, paradoxically, a stock market that becomes overheated as capital is switched from productive to speculative uses.
This was, more or less, what was going on in the late 1920s. A certain Mr. Young was Chairman of The Federal Reserve Bank of the United States at the time. Compared to Mr. Young, who snarled about “stock speculators” and how he was going to hang them from the yardarm, current Fed Chairman Mr. Alan Greenspan looks like a nice guy. Like his unfortunate predecessor, however, Mr. Greenspan is also trying to jawbone the markets out of their madness or what he calls their “irrational exuberance.” As far as prices are concerned, as in the 1920s, international prices in basic commodities have been down, down, down especially in agriculture. Soybeans are currently at a 27 year low and it is unlikely that silver could be produced at prices recorded for this precious metal in the futures market. The only significant commodity that has recovered its’ price level recently is petroleum and we probably have OPEC and its occasional effectiveness as a cartel to thank for this.
The IBD is right. The period we are living through is very much like the late 1920s. We have declining prices in basic commodities. We have non-stop merger activity, some of it in clear contravention of the laws on the books (has anyone here ever heard of the Sherman Anti-Trust Act?). We also have a stock market which seems to have gone wacko. This is because declining commodities prices and poor business conditions elsewhere in the world has caused foreign capital to flow into Wall Street for a speculative holiday. This is probably the real reason that stock prices have been on a rampage for the last few years. Meanwhile, the United States has shouldered a trade deficit that is, quite simply, off the charts. It used to be that when a country imported several hundred Billion Dollars worth of goods more than it exported in the course of a year that country’s currency would suffer. Now it doesn’t seem to matter, but some people are suspicious anyway. What will happen if old habits in the currency markets re-assert themselves and somebody mounts a speculative attack against the Dollar next Monday morning?
In addition to a runaway trade deficit, Americans have the largest negative savings rate in the world. It makes us look prosperous, since many households are having a lovely time living on credit, but the reality is that the Dollar is increasingly backed by negative capital, in this case by consumer debt. Thus, if it weren’t for these massive inflows of capital from abroad, the Dollar might look pretty shaky. When Mr. Greenspan, looks at this situation he gets scared and its hard to blame him. Like Young before him, Alan Greenspan has been attempting to deflate the Wall Street bubble, not because he doesn’t want us all to become rich, but because he is alarmed by the potential instability of the situation. Hence, the “jawboning.”
“Jawboning” is a nanny-like lecturing of markets that never works, as Charles P.Kindleberger points out in his masterful Manias, Panics, and Crashes: A History of Financial Crises. The market has been shrugging off Greenspan’s lectures for years now. Not only has no one listened to the jawboning, but also until recently ever larger quantities of cash have been flowing into mutual funds via pension plans despite the worst things that Alan Greenspan could say or imply. Thus, the little guy, too, can enjoy prosperity; on the proceeds of his life savings! Forty percent of American households now participate in the stock market through their retirement plans. A lot of people have been making a lot of money the easy way. It is unlikely, therefore, that Greenspan will talk this market down. It is much more likely that some sort of destabilizing force will affect things from the outside. The underlying cause of depressions , as Schumpeter explains in Business Cycles, is the long term movement of prices generated by long waves of technological change. What goes up has to come back down.
There are those who believe that Greenspan would bring down this bull market gently if he could. Certainly he has tried. It is unlikely that Greenspan’s gentle jawboning will do this, however, since, as Kindleberger points out, when investors are going hog wild in an inflationary stock market they are simply not willing to listen to reason from the lips of central bankers and their like. From Schumpeter’s point of view, the underlying cause of the next market crash, would simply be that the long wave of prosperity that began in 1938 is now over. According to Kindleberger’s careful history mentioned above the speculative bubble in many past economic crises has often burst as the result of some purely exogenous event. If an army somewhere loses a battle, for example, markets crash as investors run for the exits. The IBD closes its’ provocative article mentioned above by suggesting that the infamous Y2K bug might just play the role of the required exogenous force here. Let’s hope that they are wrong for once!