From KALLISTE@delphi.comMon Sep 16 10:52:33 1996
Date: Sun, 15 Sep 1996 22:32:02 -0500 (EST)
From: KALLISTE@delphi.com
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Subject: Sell Stocks Now

		    Sell Stocks Now

		   by J. Orlin Grabbe

	Stock market crashes are often related to spurious 
"causes".  It might be the Federal Reserve's hiking of 
interest rates.  It might be the indictment of Hillary 
Rodham Clinton.  But the real cause will be something 
else:  the puncture of a popular delusion, an awakening 
from mass hypnosis,  the end of a collective dream.

	What is believed to be obviously true now (steady or 
increasing real growth rates of GNP, record corporate 
earnings, low inflation, steady commodity prices, stable 
and sound financial institutions, and widespread peace 
under a "new world order") will a year from now be 
viewed as obviously false in light of the "facts" (declining 
real GNP, falling corporate earnings, inflation in some 
sectors accompanied by deflation in others, wildly 
gyrating commodity prices, extended problems in the 
banking and insurance sectors, a renewed crisis in the 
savings and loan industry, and "old world chaos" in the 
Middle East and in the area of the former Soviet Union). 

	Not because the world will have really changed 
that much in a year.  But perceptions of what is happening 
will be radically different.  Some might say, more 
realistic.  According to the Swiss economist Eugene 
Boehler, the "modern economy is as much a dream 
factory as Hollywood."  It is based only a small part on 
real needs, and for the greatest part on fantasy and myth.  
The stock exchange, far from ruling economic life, is at 
the mercy of tides of collective fantasies.  Depressions 
come about when there is a loss of economic myth 
(Eugene Boehler, "Der Mythus in der Wirtschaft," 
*Industrielle Organization*, XXXI, 1962.)

	An example of the Hollywood dream factory at 
work was this year's Democratic Convention in Chicago. 
We were lead from the sideshow entertainment of an actor 
in a wheelchair, then cast down into the tear-jerking 
death-throes of Al Gore's drug-addicted sister, but finally 
swept upward in the euphoric crossing of the 21st century 
bridge behind Pied Piper Bill Clinton. Or that was the 
intention, anyway.  The grand climax was instead 
punctured by the reality of politics as usual. Dick Morris--
Clinton's closest advisor, whom *Time* magazine had 
originally intended to depict as Clinton's brain on its 
cover--was found shacked up with a hooker, confiding to 
her that Bill  was a "monster" and Hillary a "twister", and 
that he had handled the details of secret Saudi Arabian 
side-payments to the President.

	The dream view of the stock market is, of course, 
at variance with the prevailing doctrine of "rational 
expectations."  Rational expectations began as an 
extremely useful view of price equilibrium created by 
John Muth ("Rational Expectations and the Theory of 
Price Movements," *Econometrica*, July 1961).  But it 
grew into a cult view that all economic and financial 
decisions were "rational" in a quite different sense than 
originally proposed by Muth.  

	The essence of rational expectations can be 
grasped by imagining a long line of cars waiting for a 
traffic signal to turn green.  When the light turns green, 
the entire line begins moving at once, uniformly 
accelerating through the intersection. And why not? After 
all, each person waiting in the line knows the light is 
about to change from red to green.  Each person knows 
that each other person in the line knows this also. And 
they all know they will get through the intersection faster 
if they all move together.  So each expects the other to 
rationally act as he himself does, and they all make it 
through the light before it turns red again.

	People with these expectations are called 
"rational" in economics.  In real life, they are known as 
"fender-benders".  Because in real life,  traffic doesn't 
behave this way, and neither do people.  There will 
always be the curmudgeon who has just broken up with 
his girlfriend and is staring out the side window at the 
marquee of a topless bar, oblivious to the horns blowing 
behind him.  The Russian novelist Fyodor Dostoyevsky 
explained it best more than a hundred years ago.  One of 
his characters describes the new (rational) economic 
world order:

	'Then,' (this is all of you speaking), 'a 
	new political economy will come into 
	existence, all complete, and also 
	calculated with mathematical accuracy, 
	so that all problems will vanish in the 
	twinkling of an eye, simply because all 
	possible answers to them will have been 
	supplied.  Then the Palace of Crystal 
	will arise.  Then [blah, blah, blah] . . . '   

	Well . . . why shouldn't we get rid of all 
	this calm reasonableness with one kick, 
	just so as to send all these logarithms to 
	the devil and be able to live our own 
	lives at our own sweet will? . . . One's 
	own free and unfettered volition, one's 
	own caprice, however wild, one's own 
	fancy, inflamed sometimes to the point 
	of madness-that is the one best and 
	greatest good, which is never taken into 
	consideration because it will not fit into 
	any classification, and the omission of 
	which always sends all systems and 
	theories to the devil.  (*Notes from 
	Underground*, 1864.)
	
	Current stock prices, which (except for a severe 
downturn in the first half of 1994) have been rising ever 
since the Gulf War, have ridden a vision of new-found 
American strength, our return as the world's policeman, 
putting down the evil Saddam Hussein, and bringing 
lasting peace to Bosnia.  With the demise of the Soviet 
Union, the vision saw the U.S. leading a resurgent United 
Nations to a political solution of all the world's ills.  But 
this was only an idea, a voluntary con.  The U.S. 
intercession in Bosnia quietly overlooked the Russian 
intrusion into Chechnya.  The U.S. reaction to Iraq's 
intrusion into the Kurdish zone equally overlooked the 
Turkish intrusion into the same area. The U.S. cannot 
dictate either Japanese trade policy or Chinese missile 
sales. And so on. A false illusion that began with Saddam 
Hussein is likely to end with Saddam Hussein.  After all, 
for all its saber-rattling, the U.S. needs Saddam to avoid 
an Iranian takeover of the Middle East.

	It is inevitable that such punctured illusions will 
puncture the inflated balloon of asset prices.  Starry-eyed 
investors who see the owning of mutual funds as the sure 
way to new-found wealth, would prefer to quietly 
overlook what has happened in Japan since 1989.  In 1989 
the Nikkei 225 reached 39,0000. From that peak, it fell 64 
percent by mid-1992.  Each dollar invested had turned 
into thirty-six cents.  An equivalent fall in today's Dow 
Jones Industrial Average (say from 5850) would leave it 
at about 2100.  The carnage on Wall Street would be 
something to behold.

	As is probable in the U.S., the Japanese inflation 
in asset prices was followed by a restriction in the money 
supply.  The rate of growth of the Japanese real money 
supply, which had come to exceed 10 percent in 1989, fell 
to minus 2 percent by 1992, a year in which industrial 
output fell by 8 percent, the worst since the oil-shocks of 
the mid-1970s.  At  its peak in 1989, the Tokyo stock 
market was valued at more than Yen 500 trillion ($3.6 
trillion), or about 30 percent higher than the listed value 
of all U.S. companies.  Japanese stock PE ratios stock 
were 70 to 1 in 1989, then fell to 38 to 1 in 1992, but by 
end of 1993 were back above 70 to 1 because of  falling 
corporate earnings.   

	The drop in land and stock values put the Japanese 
banking system into jeopardy.  No one any longer thought 
the land around the Imperial Palace was worth more than 
all of California.  Corporate stock, which was held as part 
of bank capital, and fluctuates with the market, became 
one of the reasons the Ministry of Finance in early 1993 
used money from the postal savings system to purchase 
stock in an attempt to bolster stock prices.  (The 
difference between Japan and the U.S. is that the U.S. 
Federal Reserve has recently intervened to purchase stock 
at a market *peak*.  This in itself will exacerbate the 
ensuing crash in the U.S.)

	But things seemed different in the late 1980s in 
Japan. There was an image, supported by continued credit 
creation, that land and stock prices would always rise.  
Equity-linked corporate finance, such as convertible 
bonds, seemed destined to drive the cost of capital to 
almost zero.  Equity and equity-related sources of funds 
for manufacturing companies rose from 25 percent in the 
first part of the 1980s to 70 percent by 1989.  Forty 
percent of the funds raised by manufacturing companies 
were then invested in other financial assets.  And as 
banks' lending base to manufacturing fell (from 50 to 16 
percent), the banks began lending to households, property 
companies, and service firms to make up the slack. The 
latter in turn invested in land and stocks, because their 
prices, it was thought, would continue to go up.  In 1989 
the Bank of Japan helped bring the party to an end.

	In the U.S., the recent rise in stock prices has been 
fueling by a shifting of household assets into stocks and 
stock mutual funds.  The average household exposure to 
stocks is the largest it has been in U.S. history--larger than 
before the 1929 crash.

	"Speculative excess, referred to concisely as a 
mania, and revulsion from such excess in the form of a 
crisis, crash, or panic can be shown to be, if not 
inevitable, at least historically common" (Charles P. 
Kindleberger, *Manias, Panics, and Crashes: a History of 
Financial Crises*, 1989).  Financial crises are often 
associated with the peaks of a business cycle.  Booms in 
asset markets (stocks and bonds) are generally aided by an 
excess increase in the supply of money, which is then 
inevitably restricted because of rising inflation. 

	The slow decline of the French bank Credit 
Lyonnais is a foretaste of  similar things to come in the 
U.S.  The S&L bailout of the 1980s  may turn into an 
attempted massive government/FDIC bailout of the U.S. 
banking system by the turn of the century.  Distortions 
equivalent to those seen in the S&Ls have been created in 
the banking system by the presence of federal deposit 
insurance.  The existence of deposit insurance has isolated 
banks from market discipline in lending.  It has allowed 
banks as well as thrifts to engage "with impunity in all 
manner of excessive risks--foreign exchange speculation 
(Franklin National), speculative energy loans (Penn 
Square), inadequately investigated loans (Continental 
Illinois), insider loans (the Butcher banks), uncollectable 
Third World loans (almost every top ten bank) and so 
forth" (J. Huston McCulloch, "Bank Regulation and 
Deposit Insurance," *Journal of Business*, January 1986).  

	The U.S. government has written enormous 
amounts of unhedged put options on bank assets, and will 
be faced with a massive increase in insurance obligations 
at the same time tax receipts are drastically reduced by a 
declining economy. Thus federal government quasi-
defaults (mandatory roll-overs of debt) are likely.  Interest 
paid on the debt is already one of the largest categories of 
the U.S. federal budget. 

	Currently, government debt is largely in the hands 
of professional portfolio managers.  So the usual 
temptation of a central bank, such as the Federal Reserve, 
to reduce the real value of federal debt by inflation is 
restricted.  Any hint of a move toward an inflationary 
policy will lead to massive dumping of government 
securities, which will drive up long-term nominal and real 
interest rates.  Marginal borrowing rates of both 
government and industry will rise.  The U.S. may attempt 
to maintain revenue through tax hikes.  (In 1929 the top 
income tax rate was 25 percent, but had increased to 63 
percent by 1935, and by the end of  World War II was at 
93 percent.)  But such efforts may not succeed, during a 
time when the abolition of the IRS has become 
increasingly popular.

	The ensuing credit crunch will hit industry hard, as 
the banking system becomes a circular conduit for 
government funds*receiving payments of deposit 
insurance, and (perhaps forcibly) purchasing government 
securities as assets.  Basle capital requirements currently 
give a zero-risk weighting to OECD government 
obligations.  One of the consequences of this requirement 
has been an increased incentive for U.S. banks to 
purchase U.S. government bonds or similar obligations to 
conserve on capital usage, to the exclusion of corporate 
lending. 

	As securities are dumped, the mark-to-market 
value of banks' remaining assets will fall.  A similar 
process occurred at the beginning of the 1930s:  "Banks 
had to dump their assets on the market which inevitably 
forced a decline in the market value of those assets and 
hence of the remaining assets they held.  The impairment 
in the market value of assets held by banks was the most 
important source of impairment of capital leading to bank 
suspensions, rather than the default of specific loans or of 
specific bond issues" (Milton Friedman and A. J. 
Schwartz, *A Monetary History of the United States, 
1867-1960*, 1963).

	There will be bank failures.  Having the Federal 
Reserve as a lender of last resort will not prevent this.  
Canada, without a lender of last resort between 1930 and 
1931, did not suffer any bank failures.  The U.S. suffered 
thousands.  This was partly because Canada allowed 
branch banking nationwide.  In the U.S., a legacy of 
prohibitions against branch banking have impacted both 
the asset and the liabilities side of banks balance sheets.  
Because banks do not branch nationwide, they are more 
vulnerable to banking runs in a particular section of the 
country.  Because banks are local, they have 
overspecialized in local loans--to oil and real estate in 
Texas and Oklahoma, to timber in the Northwest, to 
farmers in the Midwest.  The money center banks, 
meanwhile, may have overextended themselves in 
international directions. 
	
	What are some of the other likely consequences? 
Consider the declines of 1929-1932 and 1973-1974.  On 
September 3, 1929 the closing high on the Dow Jones 
Industrial average was 381.17.  Three years later, on July 
8, 1932, it reached a low of 41.22, or 10.81 percent of its 
previous level.  In January 1973, the Dow Industrials 
reached a closing high of 1061.14.  Less than two years 
later it closed at 572.20, or 53.92 percent of its previous 
level.  Using a hypothetical figure of 5850 for the Dow 
Jones Industrials, these same percentage drops imply Dow 
Industrial levels of  632.39 by analogy with 1929, or 
3154.32 by analogy with 1973.  The first would imply a 
drop of over 5200 Dow points, while the second would 
only imply a drop of  2695 points.  Either would be 
serious.

	 Stock investments take place under the influence 
of an over-riding image of the future.  The economist 
Kenneth Boulding wrote:  "A decision is essentially a 
choice among competing images of the future, . . . and 
with the development of complex images of the future, 
decisions become an increasingly important element in 
the dynamics of the individual human being and his 
society. . . . The human race is not merely pushed by past 
events or present circumstances, but it is also pulled by its 
own images of the future into a future, which may not be 
the same-and in fact is not likely to be the same-as its 
images of it, but which is nevertheless powerfully affected 
by those images" (*Ecodynamics:  A New Theory of 
Societal Evolution*, 1978).

	The changed image of the future that brings about 
a stock market crash will bring about a concomitant fall in 
business investment, this decline to be reinforced by 
government deficits and a banking crisis. Decreased 
employment and a declining industrial output will follow. 
At the beginning of the Depression of the 1930s, Keynes 
wrote that in "the fall of investment . . . I find-and I find 
without any doubt or reserves whatsoever-the whole of 
the explanation of the present state of affairs" (John 
Maynard Keynes, "An Economic Analysis of Unemployment," 1931).  

	International political consequences may be the 
most tragic of the coming U.S. asset price deflation.  
Following World War I (the Great War), disruptions 
caused by the war itself, followed by the collapse of the 
Austro-Hungarian empire, lead to hyperinflation and 
social revolution in Germany and Eastern Europe.  When 
the U.S. went into depression following the 1929 crash, 
and the depression spread internationally, the German 
Weimar Republic (1919-1933) gave away to National 
Socialism.  Today a similar process is evidently taking 
place in the remnants of the Soviet Union.  The rise of a 
new dictator in Russia of the order of Stalin seems 
assured.  

	Carl Jung noted that times of major change are 
accompanied by symbols of transformation (Carl Jung, 
*Symbols of Transformation*, 1976).  Among other 
things, these include socially-observed "signs in the 
heavens" (Carl Jung, *A Modern Myth of Things Seen in 
the Skies*, 1969). Through the influence of archetypal 
processes, the attention paid by the popular media to the 
unexpected or the unexplained greatly increases. The fin-
de-siecle timing of the economic downturn will 
undoubtedly generate an excess of eschatological fervor.  
At the last major economic downturn, toward the end of 
1973, the public eagerly awaited the arrival of the comet 
Kohoutek and leading newspapers carried reports of space 
creatures seen in Pascagoula, Mississippi.  Today we 
observed the popularity of the "X-Files,"  the movie 
*Independence Day*, and speculation about cosmic 
debris causing catastrophe on earth (e.g. Arthur Clarke's 
*The Hammer of God*).  
	
	Given that the technological myth of space visitors 
is already ensconced in the popular imagination, the 
arrival of extraterrestrials either to save us or to destroy us 
will also be widely anticipated. 

	But one thing is for sure:  Bill Clinton will not be 
around to lead us out of Egypt, and across the 21st 
century bridge into the Promised Land.

September 15, 1996
Web Page:  http://www.aci.net/kalliste/
