there has been a fundamental change in criteria for judging security
values. Widespread education of the public in the worth of equity
securities has created a new demand.
The Outlook & Independent Magazine (May 15, 1929)
One of the
most consistent phenomena in the world of investing is the presence
of faith in the transformation of economic law after a stock market
boom has been in progress for several years. Experts proclaim
an advent of a new era, an era in which the old numbers and old
patterns of investing have been superseded, usually by a combination
of technological improvements and central bank wisdom. Investors
are assured that "this time, it’s different." This time,
stocks will go up despite low dividends, interest rates will stay
low despite rising government deficits, and consumers will continue
to buy despite poor job prospects.
who have seen their stocks rise want dearly to believe this story
of a new era. Even more optimistic are employees who have seen
their portfolios increase in their retirement funds. They look
at the numbers, and they know that without unprecedented economic
returns, they will not have sufficient capital to live comfortably
on when they retire, given the low level of dividends, especially
after their funds’ management expenses are deducted. They have
to believe in above-average returns if they are to maintain their
dreams of golden years on the golf course. Otherwise, they would
have to revise their plans. They have made these plans on the
assumptions that the Social Security System’s chain letter, created
in 1936, is not coming to an end.
what they want to believe. They resist the intrusion of evidence
that points to a different, less pleasant scenario. This is always
true. It will always be true.
always a few pessimists who look at the numbers and conclude:
"This dream isn’t going to end painlessly, but it is going
to end." They are like John the Baptist, crying in the wilderness.
economic crisis in American history began in October, 1929. It
did not end for a decade. This is why it’s worth looking at what
the experts were telling the public in 1929.
a committee of economists turned in a report. The committee had
been assembled in 1927. As things turned out, the title of the
committee was more indicative of things to come than the actual
report: the Committee on Recent Economic Changes of the President’s
Conference on Unemployment. The report was submitted to the President’s
Conference on Unemployment in February, a few weeks before the
inauguration of the newly elected President who was officially
the chairman of the committee, Herbert Hoover, or as he was unofficially
referred to by outgoing President Coolidge, "the wonder boy."
members were associated with the National Bureau of Economic Research,
which had been founded in 1920 to survey the economy, gather statistics,
and produce reports. The NBER over the years has become the number-one
expert organization of economic boom and recession. Even today,
its assessment of when a recession begins and ends is considered
the final word.
the director of the NBER’s research staff was Edwin F. Gay, professor
of economic history at Harvard University. In his introduction
to the two-volume report, Professor Gay hinted that the American
economy had entered into a new era.
of psychological attitude, here indicated, seem to suggest that
something distinctly different from our former experience is
taking place. The chief characteristics of the present economic
phase, agreed upon by our numerous visitors from abroad, are,
it is true, evolved logically from what has preceded, and we
are still finding answers along similar lines to a similarly
constructed problem. But there seem now to be differences of
degree which approach differences in kind.
This no doubt
sounded like great news to the newly elected President, who was
about to take over from President Coolidge. But what was the basis
of this new era? Technology, for one. Business ethics, for another.
And this combination was creating millionaires by the score.
sense we may say that the unprecedented utilization of power
and its wide dispersion by automobile and tractor, in which
this country leads the way, is a new addition of enormous potentiality
to our resources. With the general increase of wealth, the growth
in the number of millionaires has been accompanied by a remarkable
rise in the real wages of industrial workers, and a wide range
of investments. The profession of management is clearly emerging,
and there is visible an increasing professional spirit in business,
which springs from and entails recognized social responsibilities.
all good news, especially when added to "The strength and
stability of our financial structure, both governmental and commercial.
. . ." (Recent Economic Changes in the United States,
1929, vol. I, p. 11)
of the NBER, Wesley Mitchell, concluded the two-volume study.
He warned against becoming complacent. The economy was good, but
significant exception of stock-market dealings and closely related
processes, the latest statistics indicate that the expansion
which began in January, 1928, was proceeding at a temperate
pace when this report went to press in March, 1929. Of course,
that is no proof that moderation will characterize the later
stages of the current cycle or its successors. For we can ascribe
the mildness of recent fluctuations only in part to intelligent
management. Every factor which has restrained prosperity has
had its share in preventing the development of an unhealthy
boom, and so in guarding against a violent relapse.
There might possibly be "a violent relapse" in "the
later stages of the current cycle," but at present, any suggestion
that the economy was experiencing "an unhealthy boom"
was not justified by the detailed research of the committee. What
would be the sign of looming problems? "If and when Europe
regains its prewar level of prosperity, world prices rise, and
American agriculture works out of its troubles, then our skill
in controlling business cycles will be put to a severer test"
(vol. 2, p. 909). That seemed a long way off. When economists
gather, such unpleasant economic events are always a long way
October 24, the stock market crashed. This became known as Black
Thursday. The following Tuesday, October 29, the events of the
previous Thursday were dwarfed.
as a surprise to Professor Irving Fisher of Yale, the millionaire
inventor of the Rolodex. On September 5, he had issued the following
statement to the press:
be a recession in stock prices, but not anything in the nature
of a crash. Dividend returns on stocks are moving higher. This
is not due to receding prices for stocks, and will not be hastened
by any anticipated crash, the possibility of which I fail to
professor understood that lots of Americans did not believe him.
There was an irrational fear of stocks. These fears were unwarranted.
A few years
ago people were as much afraid of common stocks as they were
of a red-hot poker. In the popular mind there was a tremendous
risk in common stocks. Why? Mainly because the average investor
could afford to invest in only one common stock. Today he obtains
wide and well managed diversification of stock holdings by purchasing
shares in good investment trusts.
trusts in his day were the equivalent of mutual funds today. The
investor got diversification. Did he ever!
British & Continental
went lower in 1932.
Fisher lost his fortune. He did not lose his job. His theory of
the quantity theory of money (MV=PT) was picked up and developed
by Milton Friedman to create what today is known as monetarism.
to that stock market crash, the experts rushed into print. Their
assessments were later assembled into a little book, Oh, Yeah?
(Viking Press, 1931).
Rockefeller, Sr.: "Believing that fundamental conditions
of the country are sound and there is nothing in the business
situation to warrant the destruction of values that has taken
place on the exchanges during the past week, my son and I have
for some days been purchasing sound common stocks. We are continuing
and will continue our purchases in substantial amounts at levels
which we believe represent sound investment values." (Oct.
"Things are better than they were yesterday." (New
York Evening Post, Nov. 4, 1929). "The crash was a
good thing. . . . You watch" (New York Times, Oct.
3, 1930) "These really are good times but only a few know
it." (New York Times, March 15, 1931).
"Sooner or later a crash is coming that will take in the
leading stocks and cause a decline of from 60 to 80 points on
the Dow Jones barometer." (Sept. 5, 1929) [It dropped from
381 on Sept. 3, 1929 to 41 on July 8, 1932.] "In a big
way, 1931 can be described as a year of opportunity." (Dec.
M. Schwab, Chairman, Bethlehem Steel. "Never before has
American business been as firmly entrenched for prosperity as
it is today" (Dec. 10, 1929). [He died bankrupt in 1939.]
P. Lamont, Secretary of Commerce. "As weather conditions
moderate we are likely to find the country as a whole enjoying
its wonted state of prosperity. Business will be back to normal
in two months." (March 3, 1930) "We have weathered
the worst of the storm and signs of stability and recovery are
already appearing." (Dec. 6, 1930).
Secretary of Labor. "The worst is over without a doubt."
(June 30, 1930). "We have hit bottom and are on the upswing."
(Sept. 12, 1930).
Hoover to the American Bankers Convention. "During the
past year you have carried the credit system of the nation safely
through a most difficult crisis. In this success you have demonstrated
not alone the soundness of the credit system, but also the capacity
of the bankers in an emergency." (Oct. 2, 1930) [About
6,000 banks went bankrupt over the next 30 months.]
of Oh, Yeah? ends appropriately with a quotation from former
President Calvin Coolidge:
country is not in good condition."
On Feb 25,
Gramlich, a member of the Board of Governors of the Federal Reserve
System, gave a speech at the Euromoney Bond Investors Congress
in London. It received little publicity in the United States.
Among FED Board governors, Gramlich is the grinch.
was the twin deficits: Federal and trade. He argued that they
can go together, but they are not twins.
He made a
major point early: a balance of payments surplus is the product
of a high rate of thrift domestically.
the nation does finances either private domestic investment
directly or the accumulation of claims on foreigners. This means
that national saving — the sum of private and government saving — equals
private domestic investment plus that period’s accumulation
of claims on foreigners, or the trade surplus. The trade surplus
can also be thought of as net foreign lending.
is also true: any imbalance of payments is based on high rates
of saving on the part of one’s trade partners.
saving is the only way a country can have its capital and own
it too. Models of the economic growth process identify national
saving as one of the key policy variables in influencing a nation’s
living standards in the long run.
of thrift is America’s problem, as Gramlich admitted later in
his presentation. But before he got there, he raised this supposedly
hypothetical issue. The problem is, it describes the United States
suppose that expansionary fiscal policy resulted in a rise in
budget deficits. If this expansion were totally financed by
borrowing from foreigners, domestic interest rates would not
change much, and domestic investment and private saving might
not either. In this scenario, there could be a simultaneous
dollar-per-dollar change in budget and trade deficits — the classic
twin-deficit scenario. Such a situation is most likely to occur
in small economies fully open to international trade and capital
flows, economies in which domestic interest rates are determined
by world capital markets and are independent of domestic economic
What we are
seeing today is the world’s largest economy, which is performing
exactly as he describes here. The reason is, the dollar is the
world’s reserve currency and Americans are the world’s most voracious
consumers. Asian central banks are cranking out fiat money by
the digital carloads in order to keep the dollar from falling.
They are afraid that a falling dollar will mean reduced imports
by Americans — a safe bet.
We are now
coming into uncharted waters. The debt/GDP ratio is soaring in
there have not been significant instabilities in U.S. federal
budget deficits. Overall deficits have averaged about 2 percent
of GDP over the past four decades, but figure 1 shows that when
interest is deducted, primary budget deficits have averaged
close to zero, the approximate level that stabilizes the debt-to-GDP
ratio. Hence, the outstanding debt, while fluctuating in the
range of 25 percent to 50 percent of GDP, has actually declined
slightly as a share of GDP. It was 38 percent of GDP in the
mid-1960s and is now only 37 percent of GDP. The ratio did rise
as high as 50 percent in the high-deficit years of the early
1990s, but it dropped sharply thereafter with the primary budget
surpluses of the late 1990s.
Federal deficit for fiscal 2004 of $520 billion is in the range
of 5% of GDP — over twice what he says is normal. Gramlich did hold
back. He did not cite the $520 billion deficit for this fiscal
year, which would reveal a large upward move in the debt/GDP ratio.
As a result
of recent fiscal changes, the budget has lately fallen into
primary deficit again; this primary deficit is now more than
2 percent of GDP (1.5 percent after cyclical adjustment). The
deterioration reflects the much-discussed recent rapid growth
in expenditures, along with significant tax cuts. Perhaps more
significant, in a few years the United States will face huge
looming costs for retirement and health programs. It will take
extraordinary fiscal discipline just to keep the present primary
deficit near its current level of 1 to 2 percent of GDP over
the short, medium, and long run. And even at that level, the
stability condition is violated by at least 1 percent of GDP,
suggesting that the debt-to-GDP ratio is likely to climb steadily
trade side, figure 2 shows that the trend is definitely more
worrisome. While the budget debt has fluctuated between 25 percent
and 50 percent of GDP over the past several decades, the net
external debt has grown steadily. Until 1985, this external
debt was not even positive; that is, until that time the United
States had net claims on foreigners. But because the United
States has run persistent and sizable primary trade deficits
since 1990, the net external debt is now 25 percent of GDP and
rising sharply. The primary trade deficit is now 5 percent of
GDP, violating the stability condition by nearly this same amount.
At this rate, the external debt ratio will climb very quickly.
at figure 2; it’s a chiller. Ever since 1988, net external
debt has moved relentlessly upward, from 0% to 25% of GDP.
points to the looming day of reckoning, when "the economy
gets outside of the credibility range."
deficit there is probably a credibility range. By that, I mean
a limited range within which a country may be able to violate
its stability condition and have its debt-to-GDP ratio trend
upward without further economic consequences. . . .
economy gets outside of the credibility range, more significant
relative price adjustments become likely. On the trade side,
for example, the continued accumulation of foreign claims on
the U.S. economy will raise the issue of whether foreign investors
will want to hold an ever-increasing share of their wealth in
the form of U.S. assets. Or, as is the focus of the stability
condition above, whether the U.S. economy can indefinitely pay
out ever-higher shares of GDP in the form of interest and dividend
payments. The conventional view is that at some point there
should be a relative price adjustment — some combination of rising
U.S. interest rates (to make U.S. assets more attractive), rising
foreign prices (to make imports more expensive), moderating
U.S. prices (to make U.S. exports more competitive), or a change
in exchange rates. Each of these reactions is likely to occur
naturally, and each moves in the direction of lowering the external
imbalance. That is why foreign trade deficits are typically
thought of as self-correcting. The main risk here is that the
natural adjustments may not occur gradually, but so rapidly
as to threaten various types of dislocations.
the ways out, he says: (1) productivity growth (which requires
more saving); (2) fiscal austerity on the part of politicians.
above, such a fiscal austerity policy is the only known way
to correct persistent budget deficits. The reduction in deficits
should lower domestic interest rates and trigger changes in
exchange rates that lower imports and raise exports. Hence,
well-designed fiscal austerity measures could solve all the
problems simultaneously. They correct budget deficits directly,
they reduce trade deficits indirectly, and the implied higher
level of national saving also permits more funds to flow into
capital formation and long-term productivity enhancements. Fiscal
austerity is the one tried and true approach to dealing with
budget and trade deficits simultaneously.
What is the
likelihood of belt-tightening by Congress? The odds are surely
against it. So, here is how Gramlich ended his speech. Note the
phrase, "dislocating changes." This is true grinchism.
forces tending to increase both deficits: political
and demographic for budget deficits, income elasticities for
trade deficits. At some point, continued large-scale trade deficits
could trigger equilibrating, and possibly dislocating, changes
in prices, interest rates, and exchange rates. Continued budget
deficits will steadily detract from the growth of the U.S. capital
stock and may also trigger dislocating changes.
that you pay attention to Gramlich’s speech. It’s a bit technical,
even in my extracted version. He was sounding the alarm in the
international investment community. He was saying, as loud as
any senior official has said it, that the twin deficits cannot
Herb Stein, Nixon’s chairman of the Council of Economic Advisors,
things that cannot go on have a tendency to stop.
main risk here is that the natural adjustments may not occur gradually,
but so rapidly as to threaten various types of dislocations."