Memo To: John Cassidy, The New Yorker
From: Jude Wanniski
Re: Bubbles on Wall Street
You know, John, that nobody is a greater admirer than I of The New Yorker these days, with David Remnick at the helm. You also know I admire your work as a financial correspondent, at least when you stick to micro economics, i.e., writing about companies, industries and executives. Your long essay in the January 14 issue, "Striking It Rich," unfortunately, is another of your attempts to write macroeconomics into the ups and downs of Wall Street over the last several years, which you describe as "the rise and fall of popular capitalism." There is a great deal in the article that I found interesting, and I do look forward to reading your new book, Dot.Con when it is published next month. But I must tell you that every time I read an article about why the market is irrational, I automatically assume the author does not have an analytical framework that allows him to see the rationality of the markets. In other words, if the market goes up higher than you think it should be, you think it is a "bubble," and when it falls sharply, it is simply the bursting of the bubble. Your readers deserve better than Cassidy blowing bubbles at them. I did read the article twice, first assigning it a C-, but edging it up to a C for its micro content.
As you know, John, I believe I have the best analytical framework in the world, and if I found one better I would plagiarize it, but if you cited my forecasts, your bubble theories would have to fold. My only "bad call" in 23 years was in December 1999, when I believed there would be only a 20% chance that the Y2K "bug" would have no effect on the markets. My excuse then was I had to use a government number for prospective chip failures that was 20 times higher than it turned out to be. Otherwise, here are the "bubbles" you cite in your article that I have resolved with rational explanations:
1. The Crash of 1929 was not a bubble bursting, but Wall Street's correct assessment in the last week of October that the Smoot-Hawley Tariff Act would pass into law, which it did in June 1930 with President Herbert Hoover's signature. You can read this in detail in my 1978 book, which I think I sent you, The Way the World Works.
2. You correctly note the Reagan bull market began on August 12, 1982, when the DJIA came off its low of 776.92 and climbed to finish that year above 1000. You say it occurred because Fed Chairman Paul Volcker cut the funds rate by half a point on August 13, and the DJIA did rise a few points. It wasn't the rate cut, though, that sent the market skyrocketing from August 16 on, but the Fed's decision to bail out Mexico on August 15, a Sunday, which injected $4 billion of liquidity into the banking system, sending the price of gold up $56 that week! The 1981-82 deflation ended, just as I had advised Volcker it would if he could find a way to buy enough bonds to lift gold from its lows around $300 earlier in the year. You can read about this in Bill Greider's book, Secrets of the Temple. Gosh knows why you would credit the dinky rate cut when you also note Volcker had tried that route twice before in the previous month with no appreciate effect. The biggest casualty of the week was Monetarism, as from then on the Federal Reserve stopped targeting the monetary aggregates. A more accommodative monetary policy joined with supply-side tax cuts to produce the Reagan boom. You've been here from the British Isles for almost ten years, John. You should know this.
3. You note "The crash in October, 1987, shook the public's growing faith in stock-market investing, but it didn't break it. In August 1989, the Dow passed its 1987 peak." If you would have asked, I would have told you I went to Washington the week before the Crash and spent an hour and a half with Treasury Secretary James Baker III, pleading with him to do anything he could to defend the U.S. dollar, even if it meant selling gold bullion from Fort Knox, as the stock market was depending on the integrity of the Louvre Accord made early in 1987 to keep the foreign exchange markets in balance. When Baker instead indicated over the weekend that he would abandon the Accord, the crash occurred the following Monday. Still, I advised my clients there would be no recession and the market would resume its advance.
4. You recall the several prominent bears who in 1996 began advising clients to get out of the stock market. Polyconomics remained bullish even through the Clinton tax increase of 1993, arguing that Federal Reserve Chairman Alan Greenspan's pluses in monetary policy would more than offset the minus of the tax bill. In 1997, we began warning of the monetary deflation that had begun, with dire effects on commodity producers, in the Third World and among our own farmers and miners. Still, we were bullish on equities, which benefit in the first stage of a deflation, just as commodities benefit in the first stages of an inflation.
5. When the DJIA hit 10,000 in the spring of 1999, I wrote a client letter to which I will link here describing how and why it would be much more difficult to rise further, as most of the gains had come about already because of the Fed's defeat of inflation.
6. You write a good part of your article about Black Friday, April 14, 2000, when the "bubble" burst again. On that day the DJIA was down 617 points and the NASDAQ dropped 355 points. I had advised my clients in March that the market weakness was due to taxpayers discovering they would have to meet very high tax liabilities on their stock market gains of 1999, because the capital gains tax required a year's holding period before the tax rate would be 20% instead of 39%. I advised again in April that we should expect a great rush to sell on Friday, April 14, the last day cash could be raised to get the checks to the IRS on time. At the close of business Friday, I advised my clients by e-mail that it would be okay to buy again on Monday, as there would no longer be need for tax selling. On Monday the market bounded up. If it had not, the financial press would have written about my stupidity.
7. A year ago, as the Clinton administration gave way to the Bush administration, I made two trips to Washington to advise the incoming team that the deflation that began four years earlier was responsible for the recession that began in 2000, and that it would get worse if there were no change of policy to lift the price of gold, as had happened by accident in 1982. I advised them and also my clients that there was no reason to hold equities under these circumstances.
8. When September 11 occurred, of course everyone knew the market would open way down when trading resumed. We called the bottom, though, when it became clear that Secretary of State Colin Powell was able to put together the broad Islamic coalition to support the military strike in Afghanistan. If Secretary of Defense Don Rumsfeld had pushed for military action before Pakistan were brought aboard, the market would have continued lower. If Rumsfeld now persuades the President to attack Iraq, with no Islamic coalition behind the effort, the market will again move lower, expecting a second major terrorist shoe to drop.
If you would like more examples of how we have been seeing the markets unfold over the last 23 years, John, please come out to the New Jersey suburbs and we will show you there are always good reasons why markets go up and why they go down. You note in your article, for example, that on "Black Thursday, September 18, 1873," there was a panic as one bank failed and others followed. The New York Stock Exchange closed for ten days and "the public's faith in the financial markets was destroyed for a generation." If you bother to check, you will find out that 1873 was the year the U.S. Grant Administration gave into the banks’ insistence on returning to a gold standard at the pre-Civil War rate of $20.67 per ounce, when the greenback had floated to more than $40 an ounce. This was the gravest monetary deflation in our history and it did take a generation before nominal asset prices returned to the level they had reached prior to September 1873. You can be excused for not knowing about this because I have not previously written about it in connection with the 1873 panic. Nor do they teach it in our colleges and universities, where almost everywhere it is popular to ascribe all market declines to "bubbles."