Are we Hearing Voices from the Past?

What will result from the ensuing bust:

The likely result of the post-boom bust will obviously be a severe recession if not depression, but as with all disasters government policy makers will attempt to come up with new laws and programs to prevent the same disaster from happening again.

Mutual funds as we know them today are likely to be vastly different in the bust period. Not only will their number be greatly reduced as baby-boomers begin retiring and liquidating what's left of their stock portfolios, but calls for regulation are likely to limit their size and available trading options in the future. Hedge funds could be banned or heavily regulated as they will likely be blamed for the disaster despite them not being the cause. Bankruptcies will obviously soar as companies that at one time were seeing booming demand encounter declining margins and drastically slower business conditions. Many will see their salary costs soar as well since most public corporations today pay much of their salary costs with stock options (all part of the last great pyramid scheme in America). What employee will want worthless options in a bear market? Litigation costs are also likely to soar as many suddenly unhappy investors start looking for someone to blame for their own foolishness.

On the monetary policy side, the Fed will likely continue to lower interest rates in a vain attempt to stimulate the economy. This will undoubtedly put the death nail in the dollar as the world's reserve currency. Imports from Asia will rise dramatically in price while commodities are likely to stabilize at current dollar levels. Of course, when the world eventually does emerge from the current funk and demand picks up once again, the U.S. will see rampant inflation. Over time, this will be beneficial to the U.S. economy. It can once again begin exporting and return the economy to a more balanced state, but that will take time, and the intervening period will be ugly.

Corporate tax rates are likely to rise in order to replace the revenue that is lost due to a slowing economy. Social Security might not even be around. If it is still in place, income tax rates on individuals will have to rise as well. This is probably the more likely outcome as most baby-boomers will lose the majority of their retirement in the stock market's decline as they will likely hang on and continue to buy as stocks decline (as they have been trained by recent history to do). In a perverse function of the market, just when the majority of participants realize the importance of buying and holding and the power of compounding, it will be the exact wrong thing to do. At some point they will likely sell out in disgust at the very bottom just as things look the most dire. Of course, due to the fact that they have blown their retirement money they will DEMAND social security. So the result will be a smaller workforce as a percentage of the population supporting the larger retirement age class. The only way this can be accomplished is through higher taxes.

In the international arena, capital controls are likely to be put in place in various countries as capital flees less stable areas seeking safety as risk is shunned like the plague. Additionally, trade wars are likely to erupt as import restrictions and tariffs rear their ugly heads again. Expropriations are also highly likely in the more distressed countries as the need for new sources of revenue increases in the slowing world economy. Gold is likely to shine again as well, as currencies are yanked around from day to day based on the whims and fears of investors.

The hope is that Japan will turn its economy around generate demand to get the world economy started. Their recent committal to a higher yen, fiscal spending, and the growing spread between their long term and short term interest rates are likely to stimulate investment and spending and pull that country and the world out of its deflationary spiral. It should be noted that when the US market tops, this will be cited by bulls as actually even more bullish so we should go higher. It will be perversely ironic that just as the rest of the world appears to be recovering that our bubble will top and pop slowing the world recovery with a whole new set of problems.

Some might consider this a worst-case scenario. In fact, it is likely a somewhat hopeful one, as I can think of much worse. The one thing to be sure of is that the bust will not be pretty. As famed economist John Kenneth Galbraith has said, "speculative episodes end, not with a whimper, but with a bang."

In conclusion, and what steps should be taken by government and the Fed:

The Fed has recklessly printed money and allowed the creation of credit in unlimited quantities since 1987 to manufacture this historic bubble. Having learned nothing from 1920's or Tokyo of 1989, the Fed and nearly everyone believes that nothing can be wrong if there is no CPI inflation. However, it is only during such a period of low inflation that the printing press can be run long enough to form an asset bubble or mania like we have today. The same forces that came together in the 1920's to form the bubble are at work again, namely the productivity gains seen from technology, reckless printing of money, massive leverage through debt, as well as a post-war boom that have all worked together to mask the current reckless acts by the Fed. Asset inflation has replaced CPI, and yet the Fed appears oblivious to the problem.

Unfortunately, the Fed has allowed the current bubble to get so far out of hand that there is really nothing to do at this point but face the music. The longer the eventual day of reckoning is put off, the worse it will be. As the U.S. has repeatedly told Japan over the last couple of years, they need to take their medicine and take the tough steps necessary to clean up their banking system and overhaul their economy. It will be interesting to see if the U.S. follows its own advice in the years to come.

Is today's U.S. stock market a mania much like the one we saw in the 1920's? All the signs appear to give a resounding "YES." When will the mania end? Nobody knows. Manias by their very nature are unpredictable. One thing is certain, however. When the U.S. bubble economy pops, it is likely to be the worst financial disaster of this century. In the future, the Fed should learn from this period as well as the mistakes of the 1920's in order to prevent the rank speculation and credit excesses that result from an extended period of low interest rates. The Fed could have put a stop to the current mania back in 1995 when stocks began soaring far beyond what the fundamentals said they were worth. The last time we had a global deflation and a corresponding financial mania in stocks, it took 20 years and a great World War before America and the rest of the world dug itself out. An entire generation was scarred. The Dow Jones Industrial Average did not return to its 1929 high until 1955. As someone once said… "those who do not learn from the mistakes of the past are doomed to repeat them."