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By George P. Brockway, originally published September 6, 1996

1996-9-6 Caught in a Boom Market Title

ON OCTOBER 15, 1929, less than two weeks before the worst crash in the history of any stock market anywhere, one of America’s most renowned economists, Professor Irving Fisher of Yale, announced that stock prices would be “a good deal higher … within a few months.”

Fisher’s prophecy is as good today as it was on the eve of the Depression. All it took to make the market go up then was an influx of money, and that is all it takes now. Per contra, without an influx of money nobody, not even the wisest professors in the land, can induce the market to levitate.

The stock exchanges are, after all, among the few remaining places where the law of supply and demand still runs according to script. Brokers, bankers and publicists who operate in the shadow of the exchanges come to feel the law obtains always and everywhere, imposing market discipline as it goes. But as anyone who has noticed the programmed gyrations of prices in malls and supermarkets knows, this is not the case.

For the law to work, supply must be limited. It no longer is limited in most transactions of daily life. When a bookstore runs out of a bestseller today, it can have fresh stock tomorrow. If you want a new automobile, there are, as my Vermont father-in-law once remarked, plenty of people ready to sell you one.

Supply used to be limited in isolated provincial markets of the sort familiar to Adam Smith, and it is still limited in the narrow confines of Wall Street. Only the issues of a certain number of companies, and only a certain number of shares of each, are admitted for trading on the exchanges. When millions of people with money in their fists start demanding to purchase some of the finite supply, the old law comes into play and prices go up. We have a bull market.

The 1920s upsurge was generated by what may be called exuberant greed. The Great War had liberated and greatly enlarged the middle class. Wall Street promised more liberation. Today greed is certainly just as crucial, but the mood is noticeably different, more desperate than exuberant. For a moment, it seemed like morning in America, but the Baby Boomer generation has grown up and begun to worry about its retirement years, because suddenly they bode to be less golden than those of its parents.

The problem is, at least initially, demographic. Generation X (or whatever it may ultimately be named) is substantially less numerous than its parents’ generation. It is said, therefore, that the Social Security and Medicare trust funds will be depleted, and that the burgeoning costs of these “entitlements” will fall on a smaller number of taxpayers. Much as they love their folks, the young are expected to revolt. Boomers are advised to start looking out for themselves.

Where to look is the question. Many financial advisers answer that, over the years, the stock market has out-performed all other kinds of investment – Treasury bonds, foreign currencies, real estate, collectibles, gold, pork bellies, the lot. The difficulty that few citizens are qualified to play the market seems solved by the existence of 7,000 or more mutual funds whose comparative performances are widely rated. It is unlikely there are 7,000 fund managers more qualified today than Irving Fisher was in his day, but let that pass: The 7,000 funds now manage close to $3 trillion.

Unfortunately, this astronomical sum must be multiplied many times if it is to do the job expected of it. The Boomer objective, after all, is a decent retirement income. Not to be too ambitious, let us say something around $35,000 a year, which is somewhat more than the present median family income. This will certainly not be enough if Medicare is privatized any further, or if the Social Security COLA is eliminated. Nor will it be enough if inflation continues at its current “optimal” rate of 2.5 per cent, since over 10 years this will raise the price level 31 per cent. We can’t, however, allow for every contingency, or we would give up at once.

So let’s assume $35,000 a year, and let’s assume further that Social Security will somehow be good for $10,000, leaving our typical Boomer with $25,000 a year to coax from Individual Retirement Accounts (IRAs), 401(k) schemes and other available fliers. Right now the average stock’s dividend is running at not much more than 2 per cent. At this rate, to rake in $25,000 a year in dividends, our Boomer’s portfolio would have to be worth roughly a million and a quarter.

Although I am no Irving Fisher, nor was meant to be, I think I shall not go far wrong in prophesying that the market will continue climbing, because the desperate Boomers are going to have to put their retirement money somewhere; and regardless of what Bob Dole’s new supply-side friends say, the country isn’t full of enterprises crying for new capital. As long as the Boomers’ annual contributions to IRAs and 40 1(k)s go into the market faster than other people take their money out, the weary bull is bound to keep scrabbling upward, at least for a while.

BUT ALL good things come to an end, and we have already received intimations of the mortality of this one. There are, to begin with, the worries about our corporations’ abilities to compete in the new global village, plus the uneasy suspicion that the information superhighway may turn out to be a curiosity, like the English Chunnel[1]. The principal sign of danger, however, is the 2 per cent dividend rate previously mentioned. Stocks paying only 2 per cent are an acceptable gamble as long as capital gains keep piling up. When they start falling (or turn negative), the stodgy 6 or 7 per cent yield of the Treasury long bond looks like an increasingly desirable port in what could develop into an unpleasant storm.

In 1983, when the present bull market began, the dividend yield of the Standard & Poor’s 500 was more than 6 per cent. When (post hoc and probably propter hoc) the dividend rate fell below 3 per cent, we had the “corrective crash” of 1987. Four years later, the rate had worked its way back to 4 per cent. Now, ominously, it is the lowest it has ever been.

It is by no means certain that even a 2 per cent dividend rate can last. The economy is strong enough to frighten the Federal Reserve Board, and all that, but the rate of profit has been maintained to a considerable extent by downsizing, and the thing about that is it frequently means exactly what it says. For when a company cuts staff, it cuts output, too-unless it has previously been unlucky or unbelievably inefficient or surprised by overwhelming technological change.

The trick is to cut jobs and wages faster than output. If a firm can manage that, its “productivity” will rise, though its production will probably fall. The lower cost per item produced may delight its economist and please its cost accountant; nonetheless, its total profits are likely to fall with its total output. Indeed, a company can be the most “productive” outfit in an industry (as Nissan’s and Toyota’s American automobile plants were rated last year), yet operate at a loss (as the Nissan and Toyota factories did).

For the nation all the time, and for the stock market in the medium and long run, what counts is production, not productivity. Production-goods and services created-can be used and enjoyed, and if so, can yield profits. Productivity which is merely an index number, a ratio of output to hours worked, nothing tangible – is not good to eat and pays no dividends.

The way things stand, if dividends fall much lower, capital gains will dry up as cautious money leaves stocks for bonds; the bull market will 1996-9-6 Caught in a Boom Market Nissanapproach its end. At some point before the end, or soon after, fall. Ever mounting capital gains would be a thing of the past, and to the extent that market and economic troubles are due to vanishing profits in relation to stock prices, an interest rate hike would have the wrong effect. The case for lowering the rate is not much happier, given the present temper of the Reserve Board. The initial consequence would naturally be to raise the price of bonds and, almost simultaneously, of stocks. The price/earnings ratio would stabilize, but again without encouraging capital gains. On the other hand, costs, sales and the profits of ordinary businesses would gradually improve. Up with this the Board could not put, so back up would go the interest rate.  Therefore, for the Boomer generation to enjoy a reasonably comfortable retire there will no doubt be calls for the Federal Reserve Board to intervene, and the Board will be tempted to comply. Besides wringing its hands, it will have two choices: to raise the interest rate, or to lower it. It will be leery of raising it, because someone on its staff may remember that in 1929 and 1930 the Reserve’s tight money policy was blamed for triggering the Crash and then turning it into the Depression.

In any event, raising the interest rate would lower the price of bonds; and almost immediately the price of every income-earning asset, including common shares, would follow. In other words, the stock market would fall, or at the minimum be impeded in its climb. In addition, the costs, and hence the prices, of ordinary businesses would sooner or later increase, and their sales and profits would fall. Ever mounting capital gains would be a thing of the past, and to the extent that market and economic troubles are due to vanishing profits in relation to stock prices, an interest rate hike would have the wrong effect.

The case for lowering the rate is not much happier, given the present temper of the Reserve Board. The initial consequence would naturally be to raise the price of bonds and, almost simultaneously, of stocks. The price/earnings ratio would stabilize, but again without encouraging capital gains. On the other hand, costs, sales and the profits of ordinary businesses would gradually improve. Up with this the Board could not put, so back up would go the interest rate.

Therefore, for the Boomer generation to enjoy a reasonably comfortable retirement, as every generation should, it can no longer consult its narrow self-interest. Instead, it must look forward to, and participate in, and help organize, a great surge in the gross domestic product. This can be accomplished in only one way in a free society. It is not enough for goods to be manufactured and services to be made available. To contribute to private profits and common wealth, commodities must be sold, and someone must be both willing and able to buy them. Otherwise, sensible producers will cut output and make up for the resulting drop in profits by laying off employees.

Mass industry requires mass consumption. But that will require a more generous and hopeful and responsible attitude toward the distribution of income than has been seen, in this country for many long years.

The New Leader

[1] Ed – so much for prognostication, neither turned out to be “merely a curiosity.”

By George P. Brockway, originally published June 12, 1989

1989-6-12 The Reserve's Silly New Equation Title

IN HIS EXCELLENT and comprehensive book about the Federal Reserve Board, Secrets of the Temple, William Greider properly fastens on the first word of his title, the Board being at least the third most secretive arm of the United States government. The rationale for the secrecy is that billions of dollars can be made by uncovering what, if anything, the Reserve is going to do next . Greider suspects, as I do, that the secrecy is useful mainly for instilling awe in us poor mortals.

1989-6-12 The Reserve's Silly New Equation Greenspan

Whatever the case, in contrast with its usual practice, the Reserve has recently gone to considerable trouble to call attention to a new equation that is supposed to predict inflation levels two years or so in advance. We are told that Chairman Alan Greenspan set a team of three economists to work on the problem when he took over in the spring of 1987, and that there is now light at the end of the tunnel. Remembering a New Yorker cartoon of a couple of years ago, I expect the apparent light will turn out to be New Jersey.

As constant readers know, I am, like Adam Smith, skeptical of all alleged mathematical solution to basic economic problems. Happily, the present formula is very elementary mathematics; something that kids probably do today in kindergarten, and that you used to toss off in fifth or sixth grade. So don’t panic.

First, a bit of background. Culminating a century of deep thinking by deep economists, Irving Fisher of Yale promulgated , 80-odd years ago, an equation sometimes said to be the essence of monetarism. Milton Friedman, in The New Palgrave (a four -volume economics encyclopedia I wish I could afford), assures us that monetarism is something else, and he’s entitled to his opinion; but it is Fisher’s formula the Reserve starts with.

 

Friedman also tells us, “There is no unique way to express either the nominal or the real quantity of money.” Nevertheless, some number is chosen and fed into an equation that says the quantity of money, multiplied by the velocity of its circulation, is equal to the general price level, multiplied by the goods produced. The equation, written all in capitals, looks formidable (MV = PQ) but expresses a simple, even a simplistic idea.

 

The money supply (M) is not the only term beset with difficulties. It turns out that the velocity (V) cannot be determined except by means of this equation. Fanciers of the theory contend that over the past many years V has been reasonably constant; MV is practically a single term.

 

The right-hand side of the equation presents different difficulties. Q stands for the total of the goods and services produced – that is, the “real” (stated in things), as opposed to the “nominal” (stated in money), gross national product. I have from time to time averred that the GNP, whether real or nominal, is less than it is cracked up to be, yet for the moment let’s accept it at its face value. We are immediately struck by the fact that its face value is expressed in money. Moreover, it cannot be expressed otherwise, for money is the sole relevant unit of measurement that applies to apples and oranges and tons of steel and all the rest. The paradoxical truth is that the “real” GNP can only be quantified “nominally.”

 

What, then, is the price level (P)? It is the sort of index I often grumble about, derived by combining the prices of a great variety of goods and services, each one weighted to allow its supposedly proper importance in the economy. But the prices of goods and services are already and necessarily included in the GNP. Many have therefore dropped P from the equation, effectively reducing it to M=Q. Translating it back into English, we learn that the total money spent for goods and services equals the total prices charged for those goods and services. Not much to learn from two centuries of study.

 

This is the reed the Federal Reserve leans on. It starts again with MV = PQ. Dividing both sides of the equation by Q. it gets P= MV/Q. Mainly because M2 yields a relatively constant value for V, which the Reserve wants, M2 is selected as the quantity of money. (M2 consists-you don’t have to pay attention here-of  currency, traveler’s checks, checking deposits, savings and ordinary time deposits, money market funds, and overnight Eurodollar deposits, but excludes time deposits of $100,000 or more.)

 

Next, the Reserve pretties up the equation with some asterisks or stars, like this: P* = M2 x V*/Q*. P* (or “P-star,” as insiders say) stands for the price level a couple of years down the road. V*is the determined constant, now with a suspiciously precise value of 1.6527. Q* is the future “real” GNP, assuming a steady growth of 2.5 per cent a year.

 

That last assumption is of course the secret of the game. The inflation-fighting Reserve wants the fraction to the right of the equal sign to be as small as possible, since it is equal to P*, or the future price level. As you remember from the fifth grade, you can reduce the value of a fraction either by reducing the numerator (1/3 is less than 2/3) or by increasing the denominator (1/3 is also less than 1/2). So taking the Reserve’s equation at face value, we could hold the price level (P*) down either by decreasing the money supply (M2) or by increasing production (Q*).

 

Faced with such an alternative, anyone who had not altogether taken leave of his (or her) senses would opt for increasing production, because after all that makes possible our standard of living. The Reserve, I’m sorry to say, opts for decreasing the money supply. It would unfair to imply that the Reserve doesn’t have a reason for its unnatural decision; the trouble is, the “reason” is erroneous. The Reserve, in fact, is not unlike one of my favorite characters in all literature, “The King of Korea I [who] was gay and harmonious: / he had one idea I and that was erroneous.”

 

The Reserve’s one idea is to control the money supply. For reasons that have taken me the better part of a book (to be published by Cornelia and Michael Bessie for Harper&Row about a year from now -advt.) to elucidate, the Reserve can very readily reduce the money supply -but it can’t be sure of increasing it. By “money supply” I don’t mean the gabble-gabble of items that make up M2; I mean the money actually at work in the economy. And in the capitalist economy everyone agrees we have, that is credit, the flip side of which is debit, or borrowing.

 

The textbooks say, I know, that bankers create money by lending it, yet actually they produce nothing except some useful services. Although bankers are often hyperactive in thinking up new financial “products” (index trading, etc.), they are passive partners in the work of the world. The active partners in the creation of money, and the uses it can be put to, are the borrowers. If no entrepreneur plans to produce a better mousetrap, if no consumers long for anything beyond their means, if no speculator schemes for a big killing, the banker sits idle. He can refuse to support plans, longings and schemes, but the first and essential step in creating money is taken by borrowers.

 

THE FEDERAL RESERVE –  the banker par excellence – can make it hard for ordinary banks to lend money, and hence hard for productive people to borrow money. Even if it makes borrowing easy, however, it can’t make people borrow. In other words, it can surely reduce the money supply, but can’t be sure of increasing it.

 

On the other hand, the Reserve can affect the interest rate, and that makes a difference the new equation does not take into account. By raising or lowering the Federal funds rate (the interest banks pay on temporary loans from each other, or from the Reserve itself) or the discount rate (the interest Federal Reserve banks charge commercial banks for short-term loans), the Reserve directly raises or lowers the interest banks have to pay, and consequently the interest they have to set. Naturally, too, by making it difficult for people and businesses to borrow money, the Reserve can indirectly raise the interest they have to pay.

 

Given that interest is a cost of doing business and a cost of living, raising the rate (whether directly or indirectly) ups those costs, thus certainly inhibiting or reducing output (Q*). But we remember that reducing Q* increases the value of the Reserve’s equation by increasing P* (the price level). So we find the Federal

 

Reserve deliberately reducing our standard of living and at the same time raising the price level. True to its one idea, the Reserve next solemnly goes about further reducing M2 (which might be the money supply if ours were a mercantilist system instead of a capitalist system).  In the process, it manages both to restrict the national output and to keep the inflation fires burning.

 

That is indeed the record the Federal Reserve Board has compiled since 1951, when it succeeded in abrogating its wartime agreement with the Treasury that kept the prime rate down to 1.5 per cent from 1939 to 1947. The abrogation was necessary, the Reserve argued, so it could be free to control the money supply (then said to be M1), as it dearly wanted to do.

 

Let’s go to the computer tape. Since the fateful year of 1951, the price level has increased 436.9 per cent. (That’s what the Bureau of Labor Statistics says; if food, shelter, clothing, and transportation have anything to do with the cost of living, I’ll say it has gone up a lot more than that.) More to the point, look at the figures that are left out of the Reserve’s equation: (l)interest paid as a percentage of GNP: up from 4.59 per cent in 1951 to 19.19 per cent in 1987; (2)pretax profits: down from 11.82 per cent of GNP to 6.92 per cent; (3) after tax profits (despite the best efforts of Ronald Reagan): down from 5.19 per cent of GNP to 3.94 per cent; (4)unemployment: up from 3.2 per cent to 6.1 percent; (5)Federal budget: from a surplus of 6.1 per cent of GNP to a deficit of 3.35 per cent; (6)foreign trade balance on current account, from positive $884 million to negative $153,964 million.

 

That is one sorry record. Monetarists say it is the consequence of failing to restrain M2 even further; but they know in their hearts that if the Reserve had in fact restrained it any further, the interest rate would have gone God knows how high, and we would have spent the subsequent years in a rapidly deepening depression that would have made 1932 seem idyllic.

 

How long must we allow ourselves to be deluded by silly equations?

 

The New Leader

 

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