Will the Bubble Burst?*
several years the stock market has made major gains, adding up to what has
probably been the greatest bull market in all of history. Setbacks that
appeared threatening, such as those which occurred in April of 1997 and
August/September of 1998, have proved temporary and have served merely as
renewed buying opportunities. With each renewal of the upward trend, the
conviction has grown that if one buys a diversified list of good stocks
(and even many that are not so good), one simply cannot lose in the stock
market, except temporarily. Indeed, the persistence and size of the gains
has drawn a growing number of new players into the market--to the point
where it is now common to hear stories about doctors, lawyers,
accountants, and people in practically all other walks of life cutting
back on their normal activities in order to devote time to day trading on
Clearly, something is wrong. It simply cannot be that we can have a
society in which everybody lives by day trading in the stock market. While the stock
market does make an important contribution to capital accumulation and the production of
wealth, it is far from an unlimited one, and its contribution is not enlarged by hordes of
essentially ignorant people dabbling in it on the basis of tips and hunches. Yet such an
absurd outcome of practically everyone being able to live by means of buying stocks cheap
and selling them dear is what is implied by an indefinite continuation of the bull market.
As a result, it is inescapable that the bull market must end. Something must occur that
will destroy the conviction that the stock market is an easy source of gains. That
something, of course, will be a major and prolonged drop in the market, in which much of
the gains that have been made in the last few years will be wiped out and in which
millions of investors will rue the day that they began playing the stock market.
To understand precisely how and when this will come about,
one needs to understand what has been feeding the current bull market. Then one can
understand what will put an end to it--what will constitute pulling its foundation out
from under it.
First of all,
stock prices are determined in essentially the same way as the prices of
anything else that exists in a limited supply at any given time, such as
real estate, skilled and unskilled labor, paintings by old masters, and rare
books and coins. That is, they are determined by the combination of their
limited supply and the extent and intensity of the demand for them. What is
directly and immediately responsible for the current bull market is a
sustained and rapid increase in the demand for stocks. This increase in
demand in turn has been the result of the repeated pouring into the market
of large sums of new and additional money, created by the banking system
under the umbrella of the Federal Reserve System and related government
What this means is that stock prices have been
rising on the foundation of nothing more than an increase in the quantity of
money. In essence, their rise is no different in principle than the rise in
the prices of goods and services in San Francisco during the California gold
rush. Then, new and additional gold money was being dug out of the ground in
large quantities in the surrounding area and spent largely in San Francisco,
with the result that at one point a single fresh egg sold for a whole gold
dollar. Today, the new and additional money is paper, i.e., checkbook money,
which is being rapidly created virtually out of thin air and is being spent
mainly in the stock market, with the result of comparably high and, almost
certainly, comparably fleeting valuations of many securities.
Since December 1995, the money supply as measured by M2
has grown by almost twenty-five percent.(1)
Even more significantly, the increase in deposits specifically of the kind
commonly held with brokerage houses, i.e., so-called
money-market-mutual-fund accounts, has been at double digit rates: 17.5% in
both 1996 and 1997 and 29% in 1998.(2)
Of course, this is not to say that an increase in the money supply is the only possible
cause of a rise in the stock market or that it must always cause the stock market to rise.
A higher degree of saving and provision for the future would also be capable of raising
it. If the average person wanted to have greater accumulated savings relative to his
current income and consumption, a substantial portion of the additional savings
accumulated would undoubtedly be in the form of stocks.
Furthermore, the increase in the quantity of money exerts its positive effect on stock
prices only when, as in the last few years, the increase is concentrated in the stock
market and has not yet sufficiently spread throughout the rest of the economic system.
When it does spread throughout the economic system and begins substantially to raise
commodity prices, the effect on the stock market becomes negative. This is because the
effect of inflation at that stage is to undermine capital formation.
A leading way in which inflation undermines capital formation at that point is by
subjecting business profits to sharply higher effective rates of taxation. For example,
when a seemingly substantial rate of profit, say, twenty percent, is accompanied by a rise
in the replacement prices of assets that is not much less, say, fifteen percent, and
businesses must pay taxes of fifty percent on the whole of such profits, they end up with
an after-tax return of only ten percent, while what they need merely in order to be able
to replace their assets is an after-tax return of fifteen percent.
Such considerations help to explain the badly depressed stock market of
the 1970s and the early part of the 1980s. Once inflation begins
substantially raising prices, if I make take the liberty of quoting myself,
"The customary forms of investment [such as the stock market] lose
because of all of the ways in which inflation undermines capital formation.
The customary forms of investment can be compared to the purchase of
equipment which inflation will cause to end up as mere heaps of scrap iron
[because of the lack of ability to replace assets]. At some point, of
course, as the result of inflation, even the price of scrap iron in the
future will be higher than the price of the equipment today. But when it is,
the prices of everything else will obviously have increased by much more.
Thus the purchaser of ordinary business assets, or any form of claim to such
assets, ends up, on average, a major loser. He starts with the price of
equipment, and ends with the price of scrap iron, while the prices of the
things he wants to buy advance more or less in line with the price of
replacement equipment. The example may be somewhat exaggerated, but it is
correct in describing the nature of what happens. For such is the result of
the taxation of funds required for replacement, of the prosperity delusion,
of widespread malinvestment, of the loss of safety of all the traditional,
conservative forms of investment, and of the withdrawal-of-wealth
It was precisely the substantial overcoming of such conditions since 1980 that helped
greatly to restore the value of the stock market relative to the rest of the economic
system. Starting around 1980, the Federal Reserve began systematically reducing the rate
of increase in the money supply. The reduction in the rise in prices followed, as did a
greatly increased ability to save and accumulate capital. This was the foundation of the
stock market's recovery.
The rise in the stock market in the last few years, however, is not the
result of any increase in the ability to save and accumulate capital. On the
contrary, personal saving has been very low and has been declining even
further in recent years--from an insignificant 2.5% of personal income in
1996, to 1.8% in 1997, to a barely existing .4% in 1998.(4)
Most recently, in the Spring of 1999, it has declined into actual negative
territory. Similarly, no sudden vast burst of foreign investment in the
United States can explain the stock market boom. Indeed, the increase in
foreign private assets in the United States was substantially less in
1998 than in 1997.(5)
The only thing that explains the current stock market boom is the creation of new and
additional money. New and additional money, created virtually out of thin air, has been
entering the stock market in the financing of corporate mergers and acquisitions and of
stock repurchases by corporations. Its consequent driving up of stock prices and
concomitant creation of a sense of general enrichment is what is largely responsible for
the decline in personal saving, inasmuch as it encourages people to consume in the belief
that they are now substantially richer than they were before.
The connection between money creation and the financing of corporate mergers and
acquisitions and of stock repurchases by corporations is that, under present conditions,
to the extent that such activities are financed by loans from banks, what the banks lend
out is not only deposits obtained from savings, which the depositors give up the right to
spend so long as they continue to have their savings deposits, but also the far greater
part of the funds obtained from checking deposits. In the case of checking deposits, the
depositors have the right to spend the deposits themselves, which they do when they write
checks. When the banks lend out the funds that created the checking deposits, the funds
lent out represent new and additional spendable money. This is because the checking
depositors continue to be able to spend their checking deposits and, in addition, the
banks' borrowers obtain the right to spend the money that the checking depositors put into
the banks. In other words, there are now two sums of spendable money where initially there
was only one.
Not only does this new and additional money raise the prices of the stocks of the
companies being acquired or of the companies engaged in buying back their shares. It also
ultimately raises the prices of almost all other stocks as well. This is because, the
recipients of the new and additional money, who receive it in exchange for the sale of
their shares, turn around and use all or most of it in the purchase of other shares, in
the process driving up the prices of those other shares. The sellers of those other shares
in turn use the proceeds to buy still other shares, driving up their prices. In effect,
the new and additional money passes through the hands of successive sets of stock buyers,
in the process driving up the prices of all of the stocks it exchanges for.
An important aspect of this process is that while the new and additional
money begins as conventional checking deposits, it quickly sheds its
initial character and assumes the form specifically of deposits in
money-market-mutual-fund accounts, in which form the sellers of stocks
readily hold it in preparation for their own subsequent stock purchases.
The fact that money is being created specifically in the form of
money-market-mutual-fund deposits is of further significance because
unlike the case of conventional checking deposits, the Federal Reserve
imposes no reserve requirements on such deposits. In the case of
conventional checking deposits, there are reserve requirements, which have
the effect of limiting the total volume of deposits created to roughly ten
times the amount of currency and other reserves in the possession of the
banks. In the case of money-market-mutual-fund accounts, however, there is
no legal limit to the ratio of deposits to reserves.
The ability of any one injection of new and additional money to
raise stock prices is limited. Eventually some substantial part of the new and additional
money is absorbed into cash balances needed in order to finance trading activity at a
higher level of stock prices. Furthermore some significant part of the new and additional
money that originally entered the stock market is drawn away from it, in order to finance
other areas of buying and selling. These other areas initially include such things as the
purchase of houses and real estate and various luxuries, whose purchase takes place on the
foundation of the financial gains achieved in the stock market. Probably even more
importantly, the rise in stock prices encourages the sale of new stock and the incurrence
of new business debt for the purpose of building new physical capacity. In effect, it
becomes relatively less expensive to buy or build new plant and equipment rather than to
acquire it by means of purchasing a controlling interest in the stock of other companies,
which latter is made more and more expensive as stock prices rise.
In these ways, funds move into the rest of the economic system, ultimately increasing
the level of spending for virtually everything. Furthermore, it is implicit that the rise
in stock prices resulting from any single injection of new and additional money must be
followed by some significant reduction in the market's gains, once any substantial portion
of that new and additional money has completed its passage through the stock market and
moved on into the rest of the economic system.
What keeps the stock market rising is repeated and progressively larger
injections of new and additional money of the kind described above. These further
injections not only more than offset the inevitable movement of funds from the stock
market to the rest of the economic system, but, by virtue of establishing a pattern of
continuing gains in the stock market and thereby creating and sustaining the belief in the
virtual inevitability of its gains, succeed in drawing into the market still more funds.
In its nature, the whole process is one of inflation and must serve to
raise not only stock prices but prices throughout the economic system.(6)
Several times I
have used the word “inflation” and now it is time to explain how my
usage of the term differs from the one that has become customary.
Most people, and
most commentators, use “inflation” as a synonym for generally rising
prices, especially of consumers’ goods. So long as prices on the whole are
not rising, or are rising only modestly, it is assumed that there is no
inflation, or only very little inflation.
I believe that such a procedure is comparable
to saying that so long as someone shows no visible signs of illness, he has
no illness—that his illness begins only when its symptoms become
contrast, my view, and that of the British classical economists and of the
economists who have comprised the Austrian school—from Adam Smith to
Ludwig von Mises—is that inflation does not come into existence when
prices start rising noticeably, any more than heart disease or cancer come
into existence when a person finally has a heart attack or experiences the
acute symptoms of cancer. On the contrary, these diseases are already well
advanced before their obvious
symptoms appear. Just so with inflation. Inflation is not the rise in
prices. Rather, it is the undue increase in the quantity of money, which
operates ultimately to cause a
rise in prices.
Thus, in my view, the rates of increase in the money supply
we have had in recent years constitute substantial inflation in and of themselves. And
this substantial inflation has indeed already caused a substantial rise in prices, namely,
the rise in the prices of stocks and, to a lesser extent, the rise in real estate prices.
to now, much or most of a general rise in prices
has been postponed by a variety of factors that have served to increase the supply of goods and thus to hold down their prices. These
have included an increase in the number of workers employed, not only
absolutely but also relatively to the population as a whole. This has been
reflected in rising rates of participation in the labor force
(particularly on the part of married women) and in a declining rate of
unemployment. At the same time, there has been an apparent acceleration in
the rise in the average productivity of labor. Both of these factors--more
work being done and done more productively--have served to more rapidly
increase the supply of goods and services at the same time that a more
rapid increase in the quantity of money has served to accelerate the
increase in the monetary demand for goods and services.
In addition, the general rise in prices has been slowed as the result of a virtual
depression in much of Asia, Latin America, and the former Soviet Union in 1997 and 1998.
In sharply reducing demand from these areas, their depression served substantially to
increase the supply of many internationally traded commodities that was made available in
the United States and correspondingly to reduce their prices in the United States. The
ability of this factor further to reduce prices, of course, must end as soon as those
foreign economies stabilize and, indeed, it will be thrown into reverse as soon as those
economies begin to recover and thus to increase their demand for internationally traded
commodities. That will serve to reduce the supplies of internationally traded commodities
in the United States and correspondingly to restore their prices in the United States. In
fact, it appears that the recovery of important foreign economies may already be underway.
Of course, without increases in foreign supplies, the rise in domestic demand in the
United States will exert greater upward force on prices. The upward pressure will be
compounded by any decrease in foreign supplies.
Similarly, once the decline in the unemployment rate comes to an end, which soon it
must do, given that it is already at little more than four percent, that factor can no
longer serve to increase the production and supply of goods and services and thus to
retard the rise in prices. Indeed, a more rapid rise in the demand for labor in the face
of a supply of labor that increases more slowly must serve to accelerate the rise in wage
rates, with corresponding implications for prices.
Perhaps most important of all, however, is the fact that the rise in the rate of
spending to buy goods and services has thus far lagged far behind the rise in demand for
stocks and in stock prices and that this cannot continue indefinitely. Eventually, the two
rates of increase in demand must more and more tend to coincide. The process can be
understood as roughly analogous to that of filling a bathtub with water. At first, only
the tub fills. But if one leaves the water running, the tub will soon overflow and water
will start to fill the whole house. If one wants to avoid flooding the house, one must
turn off the water. But when one does that, the tub stops filling.
The application to the stock market is that the market will stop rising as soon as the
Federal Reserve becomes sufficiently alarmed about the inflationary flooding of the
economy as a whole that emanates from the stock market bathtub so to speak. When the
Federal Reserve is finally moved to turn off the water--the new and additional
money--flowing into the stock market, its rise will be at an end. Indeed, not only will
the stock market stop rising, it will necessarily suffer a sharp fall.
The fall must result from a combination of money leaving the stock market for the rest
of the economic system, for the reasons already explained, and from the fact that a
substantial part of the valuation of the stock market now reflects the anticipation of its
continuing to rise. As soon as it becomes clear that the rise is over, at least for a very
long time to come, the market will necessarily fall. It will fall simply because it can no
longer be expected to go on rising.
In order to understand more precisely why the stock market simply cannot go on rising
as it has without prices exploding in the rest of the economic system, one need only
realize two things. The first is that in order to keep the stock market rising at any
given rate on the basis of new and additional money coming into it, the magnitude of that
new and additional money must become greater and greater. The second is that so long as
the stock market rises not only absolutely but also relatively to the rest of the economic
system, as reflected in such a measure as the ratio of the combined value of all
outstanding shares to Gross Domestic Product (GDP), the magnitude of any given percentage
increase in the quantity of money and volume of spending in the stock market necessarily
looms larger in relation to the economic system as a whole. As a result, the rate of
increase in the quantity of money and volume of spending in the economic system as a whole
grows and it becomes progressively more urgent to shut off the inflationary flow.
The extent to which the rate of increase in the stock market in the last several years
is unsustainable without the accompaniment of rapidly rising prices can be inferred by
estimating the long-term sustainable rate of increase in the production and supply of
goods and services from year to year. If, for example, the production and supply of goods
and services could go on increasing at a rate of, say, three percent per year, then it
would be possible every year to have a three percent increase in the quantity of money and
volume of spending in the economic system without prices rising.
of no rise in prices follows because one can think of the general consumer
price level as obeying a simple arithmetical formula, in which the average
of the prices at which goods and services are sold is equal to the amount of
money spent to buy them, divided by the quantity of them sold.
This is a very
easy formula to understand in the case of a single good. For example, the
average price at which a can of soda was sold last week in the supermarket
nearest to one’s home is arithmetically equal to the amount of money spent
by the store’s customers in buying cans of soda from it, divided by the
number of cans they bought from it. The formula obviously applies to the
average price at which any individual good is sold at any given location
over any given period of time—for example, to the average price at which a
given bookstore sold its books over the course of a month, and to the
average price at which new automobiles were sold by a given dealership over
the course of a year. At the level of the economy as a whole, i.e., at the
level of aggregate
demand and aggregate supply, the
trick is to conceive of the sum of all consumers’ goods and services
together, from aerosol cans to zebra skins, as representing some definite
overall quantity of consumers’ goods and services, i.e., as some definite
number of abstract
units of supply, which is then divided into the overall volume
of consumer spending to buy goods and services. In fact, everyone already
thinks in terms of such abstract units of supply every time he expresses a
thought such as the supply of goods and services produced in the United
States is larger than the supply of goods and services produced in Canada or
in Great Britain, or that it is larger in the United States of today than it
was in the United States of a generation ago.
apologize for the digression. However, many people find it necessary.)
Returning to the present instance of three percent more spending buying
three percent more goods and services, it would be a case of dividing 1.03
by 1.03. As a result, the quotient—the general consumer price level—would
remain the same.
At the same time, however, the effect of the same three percent rate of
increase in the quantity of money and volume of spending operating in the stock market
would be to tend to raise the combined value of all outstanding shares by
three percent (either stock prices would tend actually to rise by three
percent or there could be three percent more outstanding shares with the
same average price per share, or any combination of a change in share prices
times number of shares outstanding resulting in a three percent increase in
the aggregate value of outstanding shares). In this way, the stock market
could rise three percent per year, and there would be no rise in the general
average of prices of consumers’ goods and services.
If the production and supply of goods and services could be made to increase more
rapidly, say, at four percent or five percent per year, then the increase in the quantity
of money and volume of spending in the economy that would be compatible with no rise in
the general price level would be that much greater. At the same time the greater increase
in the quantity of money and volume of spending operating in the stock market would be to
tend to raise the total value of all outstanding shares by that higher percentage. Thus,
the stock market could rise more rapidly and the greater gains would still be real in
terms of buying power, for prices of goods and services would still not rise on average.
However, it should be obvious that given any reasonable assumptions
about the rate of increase in the production and supply of goods and services,
continuation of the ten- or twenty-percent annual increases in the stock market of recent
years is absolutely impossible without prices rising to the extent to which ten or twenty
percent exceeds the rate of increase in production and supply. This is because the money
needed to go on raising the stock market must increasingly show up in a rising demand for
goods and services that will far outstrip the increase in their supply. In the long run, a
three percent annual increase in production and supply is compatible with stock prices
rising twenty percent a year only if prices in general rise on the order of the
seventeen-percent-a-year difference. For that will come to be the difference between the
rise in the spending to buy goods and services and the increase in the quantity of goods
and services sold. In other words, if one divides 1.2 by 1.03, the quotient, which, of
course, represents the general price level, equals approximately 1.17, which represents a
rise in prices of approximately seventeen percent.
Of course, in the context of today's situation, as soon as consumer prices did begin to
rise at any significant rate, the actual effect would almost certainly be a sharp drop in
the stock market. That is because, if for no other reason, the rise in prices would be
expected to cause the Federal Reserve to sharply curtail the increase in the quantity of
money in general and the increase entering the stock market in particular. And even if the
Federal Reserve went on with the inflation, the negative effects of such sustained
substantial inflation on capital accumulation would be to make the stock market sharply
fall relative to the rest of the economic system and, for a time no doubt, absolutely as
well, for the reasons previously explained.
The inescapable implication is that sooner or later, the stock-market boom must end.
The bubble must break. It would almost certainly have ended in the Fall of 1998 with the
failure of Long-Term Capital Management, had the Federal Reserve not arranged for its
rescue and quickly re-accelerated its own policy of money creation.
That event, it must be stressed, shows the extent to which the Federal Reserve has
become a highly politicized institution. Today, millions, perhaps tens of millions, of
American citizens see their financial well-being as intimately bound up with the stock
market and want the boom to continue. They also see the Federal Reserve as having the
power to give them what they want, by means of continuing an easy money policy. The
people's representatives see matters the same way and are in a position to impose their
will on the Federal Reserve, by means of changing the laws under which it operates. In the
circumstances, the Federal Reserve has chosen to yield to the wishes of the mob and to go
on increasing the quantity of money in order to keep the boom alive. Its most recent
decision, at the end of June of 1999, to enact a merely token rise of a quarter of one
percent in the federal funds rate and then to declare in effect that it sees no need at
present to be further concerned with inflation, is a confirmation of its policy of
continued rapid money creation--i.e., of continued inflation.
As a result, the stock market boom can probably not be expected to end until it becomes
clear that the general level of consumer prices is once again rising at a more substantial
rate and is likely to further accelerate. Then, hopefully, the Federal Reserve will at
last choke off the inflation of the money supply. By that time, the stock market will
almost certainly fall whether the Federal Reserve does so or not, because of the
perception of the negative effects of inflation on capital accumulation.
How far the stock market will fall cannot be scientifically predicted except to say
that in the nature of things the fall must be great enough to destroy the conviction that
the stock market is an easy source of gains.
The end of the stock-market boom is something earnestly to be desired. This is because
its continuation entails a growing state of mania, in which fortunes are created without
any rational cause, merely by virtue of the pressure of a flood of money seeking outlet in
channels no more real than empty hopes and dreams, and in which increasing numbers of
otherwise highly intelligent and perfectly sane people are lured into sacrificing the
serious work of their chosen occupations to the pursuit of such causeless and ultimately
At the same time, because the mere inflation-induced appearance of wealth is made to
substitute for the fact of wealth, the boom gives rise to a consumption that takes place
at the expense of essential saving and capital accumulation and thus serves ultimately to
cause impoverishment. Indeed, it may well be that the sudden appearance of prospective
government budget surpluses, and the eagerness to devote them to new and additional
government programs, will turn out to be one of the leading forms of such destructive
consumption, whose actual nature and real cost will become apparent once the boom ends.
The continuation of the boom means the return of the kind of problems experienced in the
United States in the 1970s and early 1980s.
M2 is by no means a perfect or even a very good measure of the
money supply, but it is better than M1 has been for the last
All the above calculations are based on data
appearing in the Federal Reserve Bulletin, June 1999, p. A13.
George Reisman, Capitalism: A Treatise on Economics,
p. 951. See also ibid., pp. 930-938.
Calculations are based on data appearing in Federal
Reserve Bulletin, ibid., p. A49.
See ibid., p. A50.
This analysis of inflation is essentially that of the great Ludwig von
Mises, who always stressed that inflation never raises all prices at the
same time and to the same extent, but rather moves through the economic
system unevenly and over time. See, for example, his discussion in Human
Action (Chicago: Henry Regnery Company, 1966) pp. 416-424.
© 1999 by George Reisman. All rights reserved.
Reisman, Ph.D., is professor of Economics at Pepperdine University’s
Graziadio School of Business and Management and is the author of
Capitalism: A Treatise
(Ottawa, Illinois: Jameson Books,
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