2001 - The Morning After

So, what follows after an investment bubble has burst? Several issues are relevant. Major waves of discoveries, inventions and innovations occur in a weak pricing environment. This is so because when prices are weak, the only way to boost profits is to produce more efficiently through the application of major technological breakthroughs.

Thus, the construction of canals and railroads, as well as the invention of telephones, cars, electricity, and more recently of the Internet all took place at times of deflationary pressures in the system. Also, major innovations and the application of new inventions always act as a catalyst for major capital spending or investment booms because the invention, being pervasive and promising huge profits, tempts everybody to jump on the bandwagon.

Lastly, in a deflationary environment, the financing of the investment boom is never a problem, as weak prices, especially for commodities, are accompanied by declining interest rates and loose monetary conditions.

Hence all major new technology-driven investment booms also lead to speculative investment orgies, such as was the case for the canal boom of 1835/36, the railroad boom of 1868-1873, the 1920s radio, aerospace, car and electric utility boom, and more recently the PC, telecom and Internet boom.

During the boom a virtuous economic up-cycle takes place: corporate profits and stocks soar as a result of declining commodity prices, weak wage increases and declining interest rates. In turn, soaring stock prices and declining interest rates lower the cost of capital and artificially boost consumption because of the wealth effect and a declining saving rate.

The investment boom in one sector of the economy, therefore, is reinforced and also releases impulses, which stimulate all sectors of the economy.

The boom does usually not, as is commonly believed, come to an end because of rising interest rates. Instead at some point investors' expectations are not met, as the phase of accelerating growth, common to all new innovations, gives way to decelerating growth rates, which inevitably disappoint the investment community.

In addition, while growth rates were over-estimated, the supply was under-estimated. The new invention with its seemingly huge profit potential attracts far too many new participants. Their common aim to gain market leads to cutthroat price competition and losses for the majority of them.

Moreover, during waves of major innovations, technological breakthroughs take place at a breakneck speed and, therefore, a great new technology, today, can become obsolete almost overnight as a result of an even better invention. So it is not only competition from existing technologies, but also competition from newer and more advanced technologies that will depress profits.

And when the expected profits fail to materialize, stocks for which investors were willing to pay any price during the boom collapse. At the same time, the credit quality deteriorates and spreads on bonds issued by 'boom' companies widen dramatically. Therefore, it is not tighter monetary policies or the 'cost of money,' which bring the boom to an end, but the first 'unfulfilled expectations' and then the 'availability of money,' as the new issue market shuts down and as bonds can only be placed at prohibitively high interest rates.

Faced with these conditions, every central bank makes the same mistake. They move aggressively to lower interest rates by injecting liquidity into the system in the hope to revive the boom. But does it help or does it aggravate the problem? The nature of every new technology driven investment boom is that, on top of the disinflationary environment in which it takes place, each revolutionary new technology is by itself extremely deflationary.

Canals and railroads cut long distance transportation costs dramatically, and opened up new territories for agriculture, industry and urban centers. Cars cut short distance transportation and distribution costs. The tractor led to huge productivity gains and falling prices in the agricultural sector. Electric utilities brought about cheaper energy costs, and the Internet made communication almost free of charge. Thus, we see that new technology driven capital spending booms reinforce the deflationary environment the longer it lasts and the more new capacities are completed.

Therefore, the problem of an investment boom bursting is not insufficient demand, but far too much supply, which depresses prices and leads to disappointing profits. In this situation, easing moves by the central bank can temporarily alleviate the crisis, but worsen the situation in the long run. By easing aggressively the central bank merely allows the weaker market participants to complete their projects and prolongs the capital-spending boom.

This in turn leads to even more over-investment and even weaker prices, which was the very cause of the crisis. Hence, regardless of monetary policies, every capital spending boom, which bursts is followed by a massive corporate profit deflation and a very painful deflationary recession such as occurred after 1836, 1873 and 1929 and in Japan after 1989.

The virtuous cycle, which drove the boom, is then replaced by a vicious self-reinforcing down spiral. Falling corporate profits bring about even weaker stock prices, soaring debt defaults, a reduction of capital spending, and a reverse wealth effect. I expect the year 2001 to be no different, except that excessive easing by the Fed could bring about a collapse of the dollar.

In such a case deflation in the US may not occur in the domestic price level, but through a massive adjustment in the dollar exchange rate. Still, with a weaker US dollar or without, declining US corporate profits, collapsing consumer confidence and a sobering up of investors should lead to further sharp declines for stocks. In particular, I expect the NASDAQ, which still sells for 100 times earnings, to fall by another 50% or so from the current level.