History points to another crash landing

By Larry Elliott

LONDON: In the spring of 1720, when all of London was clamoring for shares in the South Sea company, Sir Isaac Newton was asked what he thought about the market. "I can calculate the motions of the heavenly bodies, but not the madness of the market," the scientist and master of the mint is supposed to have replied.

Newton should have heeded his own wise words. Having sold his (pounds sterling) 7,000 of stock in the company, he later bought back in at the top of the boom and went down for (pounds sterling) 20,000. Like all the other mug punters in every bout of speculative fever, Newton was cleaned out when the crash came.

Little has changed in the intervening 280 years. Common to every bubble is the ingrained belief that this time it will be different, that the rise in the price of an asset is rooted in sound common sense rather than recklessness, stupidity and greed.

Take the crash of 1929, for example. In Devil Take the Hindmost, his excellent book charting the sad history of bubbles, Edward Chancellor records how Wall Street's elite convinced themselves that the rules of economics had been rewritten and that the market could support ever-higher share prices. John Moody, the founder of the credit agency, intoned in 1927 that "no one can examine the panorama of business and finance in America during the past half-dozen years without realizing that we are living in a new era".

Yale economist Irving Fisher declared a few weeks before the October crash that stock prices had reached a "permanently high plateau". Why was this? Simple. The creation of the Federal Reserve in 1913 had abolished the business cycle, while technological breakthroughs had created a "new economy" that was much more profitable than the old.

As share prices continued their heady rise, traditional methods of stock market valuations were abandoned. It did not matter that many of the start-up companies of the late 1920s were not making any money; what counted was that some day they surely would. So share prices were justified by discounted future earnings.

Investors mortgaged themselves up to the hilt to buy stocks in exotic companies from broking houses, the number of which proliferated in the 1920s. One analyst warned that "factories will shut ... men will be thrown out of work ... the vicious circle will get into full swing and the result will be a serious business depression". He was ridiculed, naturally.

Sound familiar? It should, because the gravity-defying performance of stocks in London and New York is eerily redolent of 1929. Those of us who have been warning for some time that the whole stock market edifice is built on sand have so far been proved wrong.

It is possible that we will continue to be wrong and that this time the rules really have been rewritten. It may be that Alan Greenspan has abolished the business cycle, that Goldman Sachs' contented equity guru Abby Joseph Cohen is wiser than Irving Fisher, that Amazon.com is in a different league from RCA (the go-go stock of the 1920s). Maybe.

However, there are plenty of warnings there for those prepared to heed them. One is what is happening in the markets themselves. More and more money is being concentrated in a handful of stocks in the technology sector, while shares in "old industry" fall.

An analysis by Peter Oppenheimer, of HSBC, showed that the price-earnings gap in London between the new economy stocks and the old economy stocks is the largest for any market ever.

An analysis of the balance sheet of Amazon.com by Tim Congdon of Lombard Street showed that liabilities were covered more than four times by holdings of cash and securities in early 1999.

However, by the end of the year high investment and trading losses meant that liabilities were higher than cash and securities. He believes that the rise in the Nasdaq index is being underpinned by firms borrowing money to buy each other's shares -- the equivalent of taking in each other's washing.

Amazon.com's results, he says, give "a fascinating and alarming insight into the cost of building an Internet brand. Arguably, they also demonstrate that the hi-tech element in the American stock market is now gripped by a speculative madness of a kind never before seen in the organized financial markets of a significant industrial country".

The economist Robert Gordon has started to unpick the American productivity data in an attempt to put the "new paradigm" into historical perspective. "I believe that the inventions of the late 19th century and early 20th century were more fundamental creators of productivity than the electronic-Internet era of today," he said.

Oppenheimer, at HSBC, estimates that share prices in the new economy imply growth rates that are unlikely to be achieved and that collectively shares are overvalued by 40 percent.

Sushil Wadhwani, a member of the Bank of England's monetary policy committee, quoted a survey last week showing that 133 internet companies that have gone public since 1995 would need on average to expand their revenues by 80 percent a year for the next five years. Microsoft, which has had a virtual monopoly, has managed 53 percent a year; Dell 66 percent.

It is no wonder that Greenspan is doing his level best to massage share prices down. He knows that the alternative could be a full-scale panic. But even on the assumption that there is no repeat of 1929, there are certain conclusions to be drawn.

First, the euro looks considerably undervalued against the U.S. dollar. European exchanges have performed strongly in recent months. Equity investors seem to have cottoned on to the recovery in the European economy, but foreign exchange dealers -- perhaps recalling how they were too long on euros around its launch -- have not.

Second, the real medium-term danger for the global economy will be deflation rather than inflation. A stroll down any high street shows that downward pressure on prices is strong; it would not take much to tip western economies from disinflation into deflation. Even though policymakers believe they have scope to ease monetary and fiscal policy, the experience of Japan in the 1990s suggests that such action may be more difficult than they think.

A crash would have more profound implications, not least the rediscovery of the virtues of social democracy and the need for some curbs on the global money machine. A meltdown on Wall Street would be seen, rightly, as the crescendo of a period of financial turbulence that started a decade ago.

Those who today are insistent that we are all Americans now would say that the United States was just another Thailand waiting to happen. After all, the United States has all the ingredients -- a rising trade deficit, a consumer credit binge and wasteful investment in non-performing assets.

At this point, it is traditional to say that a crash is to be avoided at all costs. Actually, it would be no bad thing. A shake-out would not mean that the benefits associated with the new technologies would be lost, any more than the end of the railway boom in the 19th century put an end to railways.

But crashes do have the effect of cleansing the stables, and boy, do these stables need cleansing! In the aftermath of the 1929 crash the policies of laissez-faire were cast aside in favor of controls on speculation and the financial system in general. Sadly, those lessons have been forgotten, with the result that we live in a state of perpetual financial instability and allow money idolatry to hollow out societies from the inside.

-- Guardian News Service