Download Research Reports - 1987, No. 21 - American Institute for Economic

AMERICAN INSTITUTE
for ECONOMIC RESEARCH
RESEARCH
REPORTS
Great Barrington, Massachusetts
Vol. LIV No. 21
Published by
01230
November 2, 1987
Fear and Greed
point drop in the Dow Jones on that day — the first of the
extraordinarily large decreases of the past 2 weeks. But this
undiminished current-dollar trade deficit mainly reflected
higher import prices resulting from the dollar's slide in the
foreign exchange markets. The volume of U.S. exports has,
in fact, been growing faster than the volume of imports during recent months, which has led to an expansion of output
and employment in some industries that had lagged behind
the rest of the economy. When the dollar stabilizes against
other currencies, this trend should become evident in the
current-dollar reports. In short, there is little reason to believe that the concerns of those who are troubled by the
"twin deficits" intensified this fall. These concerns should
have, if anything, abated recently.
On the other hand, Republicans and supporters of President Reagan have been quick to blame the Democrats.
Some of these pronouncements attack the budget question
from the other side. They assert that the deficit is the fault
of the Democrat controlled Congress that refuses to cut
spending. As noted above, it is hard to believe that it was
concern over the budget that suddenly brought the stock
market "to its knees."
Other arguments in this vein are more subtle. For example, the failure of Judge Bork to be seated on the Supreme Court has been cited as evidence that the President is
no longer in control of events, i.e., that the Democrats will
now be able to wreak havoc on the business and investment
climate with new taxes, regulations, and protectionism. For
example, the start of the stock market's steepest decline coincided with the completion of a $12 billion "tax package"
by House Democrats. Although this remains a proposal, and
it does not involve large sums, it does contain provisions designed to make "takeovers" more expensive. As such, the
proposal may have served to depress not only stocks currently "in play" (i.e., subject to a takeover bid) but also
stocks whose holders believed might be subject to such a
bid one day.
The astonishing volatility shown by the prices of not
only U.S. common stocks, but also foreign stocks and financial instruments of all types during the past few weeks,
make most generalizations hazardous. Popular explanations
of the sudden decrease in equity prices this fall are, more
often than not, simply restatements of various complex political agendas. For the moment a simple recognition that a
speculative "bubble" was broken will have to suffice. The
significance of recent changes /'e.g., for the future course of
the business cycle) is unlikely to emerge until market quotations settle down, and additional business-cycle indicators
become available.
The 1,000-point decrease in the Dow-Jones Industrial
Average since August, and the fact that the average decreased more than 500 points during a single trading day
(October 19) has dominated the economic and financial
news. There is no shortage of purported villains in these developments or of interpretations of their significance. Most
of these reflect the commentators' predisposed opinions.
The most widely disseminated view, that the markets
have reacted to a lack of official action to reduce the U.S.
budget and trade deficits, is mainly advanced by Congressional Democrats and their allies in the media. The notion
seems to be that the fortunes and prospects of U.S. companies, which are what the prices of their equities presumably reflect, have been impaired by the failure of the U.S.
Government to raise taxes or to enact protectionist measures to limit imports. This is ridiculous, if only because the
conditions cited (large and continuing budget and trade deficits) were also present during 1985, 1986, and the first 8
months of 1987, when U.S. common stock prices more
than doubled.
Moreover, the most recent news on the budget deficit
has been favorable. The deficit for fiscal 1987, ended September 30, was about $148 billion, which was $72 billion
less than in fiscal 1986, and $25 billion less than was projected in the President's budget message last winter. Much of
this decrease may be attributable to a "one shot" payment
of taxes on long-term capital gains that taxpayers realized
in calendar 1986 in anticipation of higher rates during later
years.* However, the actual deficit for the July-September
quarter of fiscal 1987 (for which tax receipts relate almost
entirely to taxpayers' 1987 incomes) was $10 billion less
than was estimated by the Office of Management and Budget last July, which suggests that tax receipts under the new
tax law could be larger (perhaps as much as $40 billion on
an annualized basis) than the budgeteers expect.
The trade deficit in current dollars remains large, and the
report of an undiminished current-dollar trade deficit released on October 14 was widely cited as the cause of a 95-
An Accident Waiting to Happen
Many other "catalysts" of the stock market decline have
been identified, such as Treasury Secretary Baker's remarks
suggesting that the West Germans' refusal to inflate would
result in higher interest rates here and/or a renewed slide of
the foreign exchange value of the dollar. Perhaps the most
widely cited "villain," especially with respect to the rapidity of the decrease, has been the use of computers and future options for "program trading" and "portfolio insurance." The evidence of how these activities affected the
market is sketchy at present, but they will be subject to investigations and studies, not only by the exchanges, but
also by Congress. However, it is most unlikely that any of
the various factors cited as the "cause" of the market's decrease could have done so unless the market was vulnerable
in the first place.
* One estimate is that such capital gains taxes added about $38 billion to Federal receipts in fiscal 1987.
85
CAN MONEY "FLOW OUT OF STOCKS"?
desired by investors as a group: a smaller commitment to
common stocks. By the same token, the higher prices of
fixed-dollar claims, such as bonds, probably reflects very
little in the way of new issues (i.e., flows into bonds,
which presumably would serve to depress bond prices in
any event), and very much the increased desire of investors to own them.
Of course, it is entirely possible for common stock
holdings to be re-arranged among various individual investors and among various types of investors. The $3 billion net purchases by market-makers on October 19 are
an example of this process (the holdings of marketmakers are seldom substantial and the $3 billion was no
doubt re-sold as quickly as possible).
The flow of funds data published by the Federal Reserve include estimates of net purchases and sales of corporate equities among categories of investors during the
18 months ended last June (in billions of dollars):
Of all the comment on developments in investment
markets, perhaps the most muddled is that which describes, say, lower common stock prices as reflecting a
movement of funds "out of common stocks" and into
something else (bonds, gold, cash, or whatever).
In stock sales (as with any other transaction), a seller
exchanges stock for cash and a buyer exchanges cash for
the stock (probably with a broker skimming off some of
the cash). In other words, because there must be a buyer
for every seller there can never be a net flow into or out
of stocks or any particular type of asset.
One or both parties may create (as with a new bond
or share offering, newly mined gold, or fresh bank credit)
or extinguish (as when a company buys back its own securities) something by or in anticipation of a deal. But
the "flows" resulting from such activities are generally
quite small in relation to the totals outstanding, and
they are seldom what is described by those who refer to
money flowing into or out of some type of investment
as an explanation of price moves.
Indeed, new share issues, etc., are generally contingent on stability of prices rather than a cause of instability. Such transactions are usually postponed whenever it
is believed that they would disrupt markets. In other
words, while an individual portfolio may be re-deployed
(say, from stocks to bonds), any individual changes perforce will be mirrored in some other portfolio. Stock
sold from one portfolio for cash will turn up in another,
which will then have less cash.
If a majority of investors decide to reduce the importance of an asset such as common stocks in their portfolios, the desired result can only be achieved by lower
prices, which is what happened on October 19, with a
vengeance. Reportedly, market-makers' purchases of
stocks totaled about $3 billion (fortified by assurances
from Alan Greenspan of the Federal Reserve that they
could count on the credit to do so) on that day, but
their major defense against the onslaught of sell orders
was to drastically reduce the prices offered to sellers and
asked of buyers.
Eventually enough buyers appeared to accommodate
the sellers who wished to sell at the lower prices. Overall
there were as many shares purchased as were sold — cash
moved neither in nor out, but rather through, the market. And it was the lower prices that produced the result
Net Buyers (+)
or
Net Sellers (-)
Private U.S. businesses*
State & local pension plans
Foreigner sf
Private pension plans
Households**
1st
Half
1986
+36.6
+11.2
+9.2
-3.4
-53.6
0.0
2nd
1st
Half
Half
1986 1987
+44.5 +39.5
+9.9 +18.4
+7.8 +16.1
-4.9 -16.2
-57.3 -57.8
0.0
0.0
Total
18 Mos.
+120.6
+39.5
+33.1
-24.5
-168.7
0.0
* Net repurchases of equity.
f Foreign purchases of U.S. equities less U.S. purchases of foreign equities.
** Includes trusts and nonprofit organizations.
Estimates of these flows for third and fourth quarter
1987 will not be available for some time, and a detailed
compilation of trading during the hectic weeks of October would only be the result of a special study that may
or may not be undertaken. It will be interesting to see
how and if the pattern of the 18 months ended last
June, when prices were rapidly increasing, changed when
prices decreased.
Given that the total value of U.S. equities was over
$3.5 trillion last August, it is unlikely that a marked
change in net buying or selling by any sector, such as the
foreigners (who have often been identified as villains in
recent market action), will be clearly identified as the
cause of lower stock prices.
tent to which the process is underway or when the speculative buyers are becoming exhausted. Speculative bubbles often carry prices amazingly beyond any standards of value
and many of those who sell out in the early stages are
drawn back into subsequent frenzied trading.
For several years we have published long-term analyses
of common stock prices in relation to the balance sheet net
worth (at book value and at replacement cost value) and in
relation to annual flows of dividends, earnings, and cash
flows. All of these measures revealed that investors' valuation of common stocks approximately doubled between the
late 1940's and the late 1960's, i.e., common stock prices
increased about twice as much as did underlying book
values, earnings, etc.
The data also indicated that such valuations decreased
markedly in the early 1970's and that during the late 1970's
and early 1980's common stock prices were at about the
same level in relation to book values and flows that they
were during the late 1940's. Similar trends were evident in
The characteristics of a speculative "bubble" have been
long understood (perhaps the definitive work on the subject is Charles Mackay's Extraordinary Popular Delusions
and the Madness of Crowds, published in 1841). The common element in such episodes is that people begin to purchase something such as tulip bulbs, Florida swampland,
common stocks, etc., not for the benefits to be derived
from its ownership, such as beautiful flowers, a place to
live, or future income in rents or dividends, but because
they expect that someone else will pay more for it in the
future. As such purchases bid up prices, additional buyers
are drawn into the market in hopes of re-selling at even
higher prices. At some point no more buyers are to be
found, and prices decrease precipitously.
This understanding is easier to apply in theory and with
hindsight than it is when the price of the object of speculation is increasing steadily. In particular, despite intense efforts by students of the market over many decades, no
means has ever been found to concurrently identify the ex86
table, it is appraised as clearly contracting in our next report, assertions that the next recession is imminent will not
be warranted, unless deterioration is evident in the other
leading indicators.
Another question is whether the collapse of stock prices
will do more than simply reflect the outlook (if indeed that
is the situation). The conjecture is that the sudden loss of
paper wealth and confidence will itself actively and significantly affect the economy during the months ahead. This
is what was widely perceived as the situation in 1929 (even
though the economy actually peaked several months before
the market crash), and what is on the lips of many commentators today. As in 1929, the more fundamental issue is
whether Government policy will make the situation better
or worse.
the ratio of corporate equity holdings of households to
total household financial assets, which increased from under 20 percent in the later 1940's to nearly 40 percent at
the end of 1967, and then decreased to less than 20 percent
at the end of 1976.
In our latest analysis of this type ("Another Look at
Common Stocks,"Research Reports, January 19,1987) we
commented:
. . . it is tempting to assert that there is a long
cycle in the valuations of common stocks, and that
we are now well into the upward phase of that
cycle. Our own "best guess" is that equity valuations are likely to expand . . . as long as general
price inflation appears restrained and general business conditions remain favorable.
At that time (year-end 1986 data were used in the report) common stock prices were about where they were,
roughly 1,800 for the Dow-Jones Industrials or 250 for the
S&P 500, after their recent "crash." Between January and
August of this year, common stock prices increased about
25 percent, bringing their relative valuations back to their
peaks of the 1960's in most instances. This in itself was not
a cause for alarm, given the favorable business outlook and
the precedent of nearly a decade of high valuations during
the 1960's. What "warning signs" there were consisted
mainly of a contracting trend of the monetary aggregates
and an inching upward of interest rates so that there was an
exceptionally wide "spread" between the very low dividend
yields of common stocks and those available on bonds. In
Research Reports for last August 17, we observed that "for
the monetary series to continue to contract with no 'correction' in stocks prices would be most unusual and it would
suggest that the inevitable correction in stocks prices associated with the next recession could be a 'beaut.'"
A TALE OF TWO CRASHES
Since Black Monday, media gurus and others with a talent for hyperbole and a readiness to capitalize on a market
for fearmongering have been thrashing themselves over the
similarities between the current Wall Street collapse and the
stock market crash of 1929. Even though most serious
economists point to many differences that distinguish today's financial maelstrom from that of 58 years ago, a
strong undercurrent of foreboding also propels many of
their "instant analyses." A genuine danger posed by the
crash of 1987 is that people will be persuaded that "more
Government" is needed to curb the supposed excesses of
volatile markets.
Throughout the turmoil since October 19, many analysts
have paid lip service to the trends of leading economic series
that indicate the business expansion will continue, and to
other evidence of the "underlying strength of the economy."
Yet the notion lingers that the 1929 crash was inseparably
linked to the Great Depression that followed, and that the
present troubles one way or another may well lead us down
the same path. In this respect, it has been de rigueur to cite
the force of mass psychology in shaping past turns of events
regardless of the actual situation. That is, things might not
be so bad, but if most people think that they are or are apt
to become so, then even grossly unwarranted forecasts of
economic recession or depression tend to become "selffulfilling prophecies."
Among the most-cited resemblances between the situation
preceding the 1930's depression and today are exchangerate instability; illiquidity in the world economy; increasing
sentiment toward protectionism; and a lack of economic
"cooperation" among the world's major trading partners.
Moreover, Professor Ravi Batra's popular book, The Great
Depression of 1990, which asserts that a trend toward
greater concentration of wealth in America has created financial risks that lend inevitability to another Great Depression, draws heavily on the notions of economists who say
that a similar concentration of wealth in the United States
during the 1920's exacerbated the effects of the stock market crash. (The argument is that investment and luxury
spending are discretionary and therefore are more subject
to erratic fluctuations than is spending on necessities. The
more that wealth is concentrated in the hands of a few, the
greater the effect that such discretionary spending — on
such things as "yuppie cars," vacation condos, and Rolex
watches — will have on the overall economy.)*
1929, 1962, 1967, 1973, 1976 or What?
However, it is by no means assured that the recent stock
market debacle is the harbinger of the next recession. It remains a remote possibility that the precipitous price decreases reflected transient trading conditions (such as an exhaustion of speculative buying as noted above, exacerbated
by reliance on computers to send orders to the trading floor
without review by a human being) and that it does not reflect either a deterioration of the business outlook or a
peaking of investor valuations of common stocks.
The large fluctuations, both up and down, since October
19 probably represent the "aftershocks" of that day. Many
subsequent transactions by brokers, mutual funds, and even
individuals, no doubt reflect a scrambling to meet or unwind unwanted commitments rather than any sort of sober
assessment of prospects or values. The outlook will remain
highly unsettled as long as prices are buffeted by the conflicting emotions of fear and greed.
Many commentators have noted parallels between the recent past and 1929, many of these parallels are remarkable.
But so are the divergences, as discussed in the accompanying article. More relevant to the U.S. economy of today are
the stock market decreases of the postwar period. In most
instances these have preceded a contraction of general business activity, but after some (such as 1962, 1967, and
1976) stock prices recovered to new highs only to decrease
again before the economy began its next recession.
As readers should be aware, common stock prices in constant dollars are a leading indicator of business-cycle change.
But it is only one of twelve such indicators that we use. In
our last report on the indicators, the common stocks series
was appraised as clearly expanding. Even if, as seems inevi-
* It would be impossible in this space to discuss all of the weaknesses
in Batra's essay and other similarly disposed works. For an expanded
discussion of the difficulties with measuring the distribution of
wealth in the United States, see "The Shrinking Middle Class and
Other Myths," Research Reports, September 15, 1986.
87
large role in the recent financial collapse (as noted in the
preceding article, the catalyst that finally precipitated the
crash may have been fears generated by comments made by
the Secretary of the Treasury). And a genuinely threatening
parallel to the era of the Great Depression is the danger
that, as then, people today will be persuaded that "more
Government" is needed to curb the excesses of untrammeled markets.
Viewed from the perspective of its propaganda value,
any financial market crash is grist for populist and socialist
anti-wealth agitators. Given the pre-crash behavior of Ivan
Boesky, David Levine, and company, the present situation
seems to offer especially rich possibilities. The "visuals" of
recent events seem made to order for the activists: exhausted and bewildered floor traders slumped amid the detritus of disaster; grey-suited financial pundits issuing hurriedly prepared statements of confidence; anguished "little
guy" investors; etc. Almost invariably, a "flashback" to the
days of the Great Depression has accompanied commentaries on the current situation. Even the editors of The
Economist, who usually favor understatement and avoid
spurious forecasting, gave exception to the Crash of 1987.
An article in their October 24 issue features a depressionera portrait of two "Hooverville" ragamuffins above the
caption "Yesterday's yuppies." President Reagan, of
course, has an obvious counterpart, as suggested by the jest
that quickly followed his cheery reassurances: "at least
Hoover wore a frown."
In short, those who would use the crash as an opportunity to promote a "new economic agenda" (meaning higher
taxes and more Government control over the economy) can
be expected to pull out all stops. At this point, no one can
say whether the public will be persuaded by their propaganda, but if this were to happen, then the notion that people
often act in ways contrary to reason would be tragically
confirmed.
The obvious fact is that, despite the vastly enlarged role
of Government in financial and other economic affairs,
panics and business cycles still occur. The lesson that ought
to be drawn from this latest "crisis" is just how dangerous
Government now has become to the economic well-being of
all of us. It is not the Levines, the Boeskys, or any other individual or group of individuals, but the Government itself
that is today's market mover. As never before, a word or
phrase from the President, the Secretary of the Treasury,
the Chairman of the Federal Reserve Board, Congressional
leaders, or any number of underlings can induce mass reactions and precipitate wild swings in market valuations.
However "irrational" it may be, as during the 1930's,
the lure of finding a "solution" to the human condition in
the wake of this latest debacle may induce people to give
the politicians even more power. If they do, they will be
trading even more of their dwindling freedom not for economic security, but for even greater uncertainty.
Based on these and other superficial similarities and on
the media blitz that has focused on them, one might reasonably argue that the public will be persuaded that we are
headed for the abyss.
Does What People Think Matter?
The question that never is asked, but one that seems crucial, is whether it any longer makes much difference how
people react to the economic crises that regularly punctuate
their lives. An obvious, but often overlooked, aspect of the
current situation is that individuals today have far less control over "their" resources than they did in 1929.
Governments now expropriate a far larger share of personal wealth than they did 50 years ago, and Government
spending accounts for a vastly greater portion of total domestic expenditures. In 1929, personal outlays (which include total personal consumption expenditures plus interest
paid by consumers to business and personal net transfer
payments to foreigners) amounted to about $79.2 billion,
and personal income included only $1.5 billion, or 1.8 percent, in transfer payments. Total expenditures of local,
state, and Federal governments were $10.3 billion, or about
13 percent of personal outlays. By contrast, in 1986, personal outlays were $2.89 trillion, which included $518 billion, or 18 percent, in government transfer payments, and
total expenditures of local, state, and Federal governments
reached $1.5 trillion, or 51.4 percent of personal outlays.
Moreover, by far the largest portion of most workers'
"savings" today are held in the form of Social Security or
other Government social insurance. In 1929, the Social Security System did not exist. The principal social insurance
programs then were the Federal Employees Retirement
Fund and Veterans' life Insurance. Total contributions to
all social insurance accounts in 1929 amounted to $0.3 billion. By contrast, total social insurance receipts for 1986
were $375 billion — in current-dollar terms a more than
thousandfold increase over 1929, and nearly three times the
reported $131 billion 1986 total of personal savings (which
includes cash and deposits, securities, and the net equity of
individuals in life insurance and in private noninsured pension funds, as well as physical assets). In short, the magnitude of "flows" of Government funds through the economy today tends to dwarf the effects of individual (and
corporate) patterns of spending and saving.
Compared with Government levies on personal and corporate wealth, the recent equity losses pale in significance.
Much has been made of the fact that equity losses in the
"historic" 1987 stock market crash probably will reach $1
trillion. But the fact is that Government now routinely expropriates more than this amount every year (total Government receipts in 1986 were $1,339 trillion). It would be virtually impossible to calculate the magnitude of genuine
losses that accrue from the billions of tax dollars "thrown
away" on the politicians' pet schemes, but it almost surely
is vastly greater than the publicized losses from the financial market collapse. This simply was not the situation in
1929, when the overwhelming majority of economic decisions were made by private individuals who were not subject to constant economic pressures imposed by a whimsical
Government. In brief, so far as future prospects are concerned, the most important "player" in today's economy is
Government itself.
PRICE OF GOLD
Final fixing in London
1986
Oct. 30
$406.50
1987
Oct. 22 Oct. 29
$471.65 $472.45
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A Genuinely Threatening Parallel
This is not to argue that psychological factors play no
part in economic affairs, or that popular fears generated by
social propagandists are inconsequential. If numerous reports are to be believed, "market psychology" played a
88