Theory: Asian Contagion of 1997 -> Collapse of Long Term Capital Management hedge fund in 1998 -> Federal Reserve lowers interest rates which increases the money supply and causes mal-investments in stocks.
Beginning with the Mexican crisis and bailout of late 1994 and early 1995, the Federal Reserve was faced with a series of financial collapses. Over the rest of the nineties, we find the Federal Reserve oscillating between halfhearted attempts to restrain the equity boom and responding to crises that it believed called for reversing the previous restraint.
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The Reverse Plaza Accord [of 1995] was, in effect, an agreement that the U.S., German, and Japanese governments would subsidize American consumers’ purchases of Japanese and German manufactured goods. The reversal of the exchange rate trend “was to be accomplished by lowering Japanese interest rates with respect to those in the U.S., but also by substantially enlarging Japanese purchases of dollar-denominated instruments such as Treasury bonds, as well as purchases of dollars by Germany and the U.S. government itself”. Driving the dollar up against foreign currencies would allow the U.S. government to maintain a stance of monetary ease without raising the CPI, since the artificially lowered price of imported goods would tend to counter the price-raising effect of the increased liquidity. But liquidity has to go somewhere. One place it went was into the U.S. stock market.
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The legendary Netscape initial public offering (IPO) occurred in August of 1995. The IPO is significant because every bubble needs a story, which early investors can tell to later ones to justify rising asset prices… Three million copies of Netscape Navigator had been downloaded in three months after its initial release, “making it one of the most popular pieces of software ever launched” (Cassidy 2002, p. 64). As Cassidy relates (pp. 83–86), by the summer of 1995, Netscape was getting ready to go public, even though it had never made a profit and could not project when it might do so. In July, Morgan Stanley prepared a prospectus announcing the intention to take Netscape public at between $12 and $14 a share. However, during the road show to drum up and gauge interest in Netscape’s shares, the promoters found that, at such a low price, the quantity demanded far outstripped the supply of shares. Morgan Stanley raised the initial price to $28, valuing a fledgling, profitless company at more than a billion dollars. The day the stock began trading on the open market, the demand for shares was so high that the Morgan Stanley traders were unable to find a market- clearing price for two hours after the session began. When, at 11:30 that day, Netscape shares finally publicly traded, the stock was priced at $71. It closed the day at 58¼, a first day gain of 108 percent, valuing the company at $2.2 billion.
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Economists sometimes lapse into the misunderstanding that increased labor productivity means that workers have somehow become super-workers. It means no such thing. In general, workers become more productive when they work with more and better capital. At any particular time, in some industries (just which industries depends upon numerous historical contingencies), they will get more and better capital if the Fed reduces borrowing costs. We see, then, that the Fed’s own easy-money policies can give rise to a measurable increase in labor productivity in particular industries and to the impression that productivity in general has dramatically risen. Undeniably, there were some productivity gains in the 1990s—just as there were in the 1920s—but concurrent productivity gains in select industries are more likely to be indicative of an unsustainable boom than of an end to booms and busts.
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A series of economic crises—in East Asia, in Russia, in Brazil, and in the U.S. itself with the Long-Term Capital Management failure and the potential Y2K problem—created a situation in which the Federal Reserve felt obliged to supply repeated influxes of liquidity to the market. As a result, after increasing at a rate of less than 2.5 percent during the first three years of the Clinton administration, MZM (money zero maturity) increased over the next three years (1996–1998) at an annualized rate of over 10 percent, rising during the last half of 1998 at a binge rate of almost 15 percent (FRED 2002).
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By 1999, the liquidity party was in full swing. The rate on 30-year Treasuries had dropped from a high of over 7 percent to a low of 5 percent. The stock markets continued to soar. The NASDAQ Composite rose over 80 percent in 1999 alone.
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Before the second half of the 1990s, it was generally considered mandatory for a business to have had at least several profitable quarters before it went public. But by 1999, companies were going public with little more than a sketchy business plan, an Internet address, and a few twenty-somethings who could speak the right lingo.
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Cassiday (2002, p. 214) says, “[Priceline.com,] in order to boost revenues … had resorted to buying tickets from the airlines at higher prices than customers had offered and making up the difference itself.” Kuo (2001, p. 39) describes how Robertson Stephens, Value America’s investment bank, told its founder, Craig Winn, “Profits weren’t important. The only thing that mattered was driving substantial revenue quickly.” Of course, any business can attain “substantial revenue quickly” if it is willing to lose enough money on each sale.
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The stock market, especially the high technology NASDAQ, seemed to levitate as Y2K liquidity hit the market in late 1999 and early 2000. The NASDAQ Composite index moved from 2746 at the end of September 1999 to 5048 on March 10, 2000, an 83 percent rise in under six months! During this period, the Federal Reserve’s target interest rates, which were rising, obscured the fact that the central bank was easing in anticipation of a possible Y2K liquidity crisis:
During the final quarter of [1999], the Fed pumped sufficient liquidity into the banking system to bring down the Federal Funds Rate from 5.5 per cent to below 4 per cent—the widest deviation from its target rate in over nine years —and thereby paved the way for the last frantic, record-shattering upward lunge in the equity markets, which took place in the first quarter of 2000. Bank loans thus raced ahead at a 19.4 per cent annual pace during the fourth quarter of 1999, the highest in at least fifteen years. … Simultaneously, the growth of the money supply vaulted to 14.3 per cent, even faster than in the wake of the Fed’s moves to calm the crisis of the previous autumn. (Brenner 2002, pp. 180–81)
During what we will roughly designate as “the boom,” from June 1995 to March 2000, MZM grew 52 percent, well ahead of real GDP growth of 22 percent (Rogers 2002) for the same period. The interest rate on 10-year Treasuries declined from 6.91 percent to 4.53 percent in October 1998, before beginning to rise again. Rates peaked in early 2000, roughly corresponding to the end of the boom. Corporate Aaa bond yields declined from 8.46 percent at the beginning of 1995 to 6.22 percent in at the end of 1998. (All data but Rogers from FRED.)
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Even as low interest rates spurred investment in certain capital goods, they led to a collapse in savings. The personal savings rate declined from an already low 2.1 percent (compared to a long-term trend of between 7 percent and 11 percent, as described above) in 1997 to -1.5 percent by 1999 (Bureau of Economic Analysis 1999). Consumers were increasingly leveraged, especially on their homes. “In 1989, about 7 percent of new mortgages had less than a 10 percent down payment, according to Graham Fisher & Co., an investment research firm. By 1999, that was more than 50 percent” (Priest 2001). The divergence of investment demand and savings supply is exactly the phenomenon described by Garrison (2001, pp. 68–71) as characterizing the “policy-induced boom,” where monetary expansion drives a wedge between saving and investment.
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For some economists, the idea that capital reallocation might involve pain is a bit of a puzzle. For example, Paul Krugman (1998) pronounces the ABCT “intellectually incoherent”— largely because it cannot, per Krugman, answer the question: “[How can] bad investments in the past require the unemployment of good workers in the present?” The puzzle is a result of viewing capital as an aggregation of homogeneous “stuff.” Such a perspective overlooks important Austrian insights: capital goods form an intricate, interlocking structure, and the market process that rearranges that structure is a learning process that necessarily takes time. The world assumed by theories that treat capital as a homogeneous “thing” is one in which information and resources flow instantly, and without cost, throughout the entire economy. No capital goods are specific to a particular business. But in such a world, why would there ever be misallocations, bankruptcies, and so forth? The instant that the opportunity cost of owning a resource rose infinitesimally above the marginal revenue expected from employing it, the resource would be sold, at a price equal to that opportunity cost, to another owner better able to employ it. Marginal revenue would always equal marginal cost, and no one would ever make capital gains or losses. As O’Driscoll and Rizzo (1996, pp. 54–55) point out, such a model “must neglect both the learning and the accompanying processes … adjustments must have an infinite velocity and resources must be infinitely mobile for a process to take place at a mere instant.” For instantaneous adjustment to occur, capital goods must consist of a uniform “capital stuff,” any portion of which can be relocated anywhere in an instant. It is only under conditions of general equilibrium that such a notion makes sense. In general equilibrium, all plans are coordinated, all prices are equilibrium prices, all productive resources are deployed where they should be, and all necessary knowledge of changing conditions is instantly transmitted to everyone who needs to know it.
As Mises (1998, pp. 576–77) says:
The piling up of excessive inventories and the catallactic unemployment of workers are speculative. The owner of the stock refuses to sell at the market price because he hopes to obtain a higher price at a later date. The unemployed worker refuses to change his occupation or his residence or to content himself with lower pay because he hopes to obtain at a later date a job with higher pay in the place of his residence and in the branch of business he likes best. Both hesitate to adjust their claims to the present situation of the market because they wait for a change in the data which will alter conditions to their advantage.
As Garrison (1997) points out:
The Austrian theory allows for the possibility that while malinvested capital is being liquidated and reabsorbed elsewhere in the economy’s intertemporal capital structure, unemployment can increase dramatically as reduced incomes and reduced spending feed upon one another. The self-aggravating contraction of economic activity was designated as a “secondary deflation” by the Austrians to distinguish it from the structural maladjustment that, in their view, is the primary problem.
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An alternative class of explanations for booms and busts, which has been applied to the Internet craze by Shiller (2000), Cassidy (2002), and others, might be categorized as mania theories. In a mania, investors become entranced by some particular investment—tulip bulbs, French colonial trading ventures, Florida real estate, the “nifty fifty” stocks, or Internet companies— and begin a self-perpetuating process of bidding more for the asset, seeing its price rise, bidding even more for it, and so on. Like a manic-depressive who can only maintain his manic phase for so long before crashing, eventually investors begin to have doubts about the focus of their mania, at which point the bubble bursts. Commenting on the psychology of such theories is beyond the scope of this paper. Nevertheless, we can say that there is nothing in most mania theories that contradicts an Austrian account of boom and bust. The two theories look at the same phenomenon from the vantage point of two different disciplines: social psychology and economics. They may, in fact, prove to be complementary. The Austrian theory offers a coherent explanation of the onset of the mania—a credit expansion—and the onset of the depression—the cessation of the expansion. After all, the mere fact that people are excited about French-Colonial North America or the Internet cannot create a speculative bubble by itself. The funds to speculate with must come from somewhere, and the Austrian theory identifies where. Mises (1998, p. 583) points out that manias cannot, absent credit expansions, continue for long:
But even if, for the sake of argument, we were ready to admit that capitalists and entrepreneurs behave in the way the disproportionality doctrines describe, it remains inexplicable how they could go on in the absence of credit expansion. The striving after such additional investments raises the prices of the complementary factors of production and the rate of interest on the loan market. These effects would curb the expansionist tendencies very soon if there were no credit expansion. On the other hand, mania theories might help to explain the reason that booms often seem to be channeled into certain faddish investments. We believe that Austrian macroeconomics could benefit from a deeper understanding of such ideas.
