Memo on the Margin

April 12, 2000

The Irrational Economist

To: Paul Krugman, NYTimes
From: Jude Wanniski
Re: The Crazy Stock Market

When I turned to your column last Wednesday, Dr. Krugman, I had hoped you would devote it to the previous day’s dizzy NASDAQ drop of 575 points and sharp 500-point rebound. You did not disappoint me. I automatically assumed you would inform your readers that this crazy day on Wall Street was further evidence that the market is comprised of dopes and retards who don’t know the correct prices of financial assets. As you put it: "If you are one of the people who, despite all the evidence, retain some lingering illusions about the rationality of financial markets, yesterday should have cured you. And yesterday’s events also proved that worries about the growing practice of buying stock on margin – in effect, borrowing in order to speculate – are completely justified."

The case is now CLOSED, you wrote, which means the government should 1) place greater limits on margin buying and 2) favor companies that have earnings over companies that are attracting capital on the sheer speculation that someday they might have earnings. Inasmuch as brick and mortar Old Economy companies have earnings and high-tech Internet companies of the New Economy do not, we can see you favor the status quo. Your last line is another in a long series of assertions you have been making about the inefficiency of the market in setting prices and allocating capital: "When things are going well there is a strong tendency to suppose that financial markets can take care of themselves. Well, they can’t."

Your belief that government wise men can do a better job than the market of setting prices and allocating capital takes more than a small step in the direction of the Soviet system. You see that, don’t you, Professor? The very idea of central planning was to eliminate the volatility of the marketplace, which led to crashes, depressions and wars. Since you took your leave of academia in January to write this twice-weekly column for the Times, you have practically boasted that you do not understand why financial markets move as they do. Now, you have declared yourself a follower of Robert Shiller, whose "important new book, ‘Irrational Exuberance’," you say proves that the "excess volatility" of the markets shows there is little rational connection between prices and "any possible rational forecast of prospective profits." Logically, this suggests that either you and Shiller are rational and markets are not, or markets are rational and you and Shiller do not understand them. Let me try and help you out.

The Wall Street market is like a giant computer, Professor, one that links the judgements of everyone who is in the market, and may at any moment choose to get out, and everyone who is not in the market, but who at any moment may choose to get in it. If you have been to a racetrack, you have noticed the tote board, which changes constantly prior to a race, as the bettors place their bets. At a horse race, betting volatility increases not only when news comes to all the players at once that there has been a change of jockeys or post positions or a scratch of one of the favorites. It also occurs as bettors watch the changing odds on the tote board before placing their bets. Where one person might look at a financial asset and refuse to make a bet when the odds on the board are 5-to-1, that bet might be made if the odds went to 10-to-1. Others, seeing no chance of a profit when the odds are 10-to-1, may give it a closer look if the odds suddenly drop to 5-to-1. It takes all kinds of people to make the market, which is especially interesting as the universe of players on Wall Street, where the betting windows never really close.

In the races on Wall Street, the same kind of analysis and "play" occurs. This is why it is nonsensical for Shiller to pin the blame on "speculators" for the 1987 market crash, because, as you say, "the only reason any significant number of investors gave for selling stocks was – surprise! – that prices were falling." When I put forward my argument that the 1929 crash had been caused by the increased chances of passage of the Smoot Hawley Tariff Act, any number of economists insisted this could not have been the case, because none of the sellers mentioned it at the time. I argued that even a small number of careful analysts could tip the entire market into a decline, by getting out when they had intended to stay in. You certainly can observe the dizzy swings that occur in prices when there is an unfounded rumor that takes hold among traders. In any event, I finally was told that the original E.F. (Bud) Hutton had written in his biography that the tariff act’s progress spooked him and he got out of the market at the right time.

If you don’t believe surprise passage of a high protective tariff could throw a monkey wrench into global trade and the value of financial assets attached to those trades, you would of course assume the market was high because of irrational exuberance; eventually the speculative "bubble" burst with no real news of prospective profits. I don’t know your opinion on why 1929 happened, but I assume you are with John Kenneth Galbraith and Milton Friedman in attributing it to irrationality. As for October 1987 crash, I think it can be well documented that the broad market was suddenly surprised by the decision of the Fed and the Treasury to allow a dollar devaluation – thus breaking the Louvre Accord of February 1987. Because the capital gains tax had not been indexed to protect against inflation, any weakening of the dollar would cause dramatic increases in the effective tax on capital. Right? If you don’t believe the markets care about capital gains tax and inflation when assessing prospective earnings, you will of course buy into Shiller’s bubble theory.

As to the role of margin debt, I think you and Shiller should pause and consider that a shareholder’s debt can’t possibly have an effect on the price of a share. For every dollar of debt, there is a dollar of savings. If I choose to borrow against my assets to buy shares on Wall Street, believing the shares are undervalued relative to the interest I have to pay on the debt incurred, I have to find someone willing to sell me those shares, someone who believes the better play is to lend the money at interest. The value of equities cannot in any way cause "inflation," nor can the size of debt. For every dollar I have earned – or borrowed from someone else who has earned it – there has been something produced at the value of a dollar. Only when the Federal Reserve forces a new dollar into the banking system, with no palpable demand for it, can there be an inflation.

Why is NASDAQ swinging around so crazily then? I have been advising Polyconomics’ clients for more than a year to expect crazy swings, because the Internet stocks are like newborn babies. Any little change in the weather can threaten their very lives. The brick-and-mortar companies are able to withstand the occasional flu bug, because they have hard assets that can be collateralized. The market knows these new kids can grow up to be as big as Gulliver among the Lilliputians, but little bits of news about taxation of the Internet or threats to patent laws can cause stocks to fall sharply in the morning and rebound in the afternoon. Hey, John Crudele, the financial columnist of the NYPost, last week wrote of suspicions that the Clinton Treasury and White House had inside information on what Fed Chairman Alan Greenspan was up to, and they whispered it to pals on Wall Street at just the moment the NASDAQ was bottoming out. It was no coincidence that the rebound began when Gene Sperling, who chairs the National Economic Council at the White House, confidently told reporters that everything was going to be okay.

Maybe yes, maybe no. But instead of telling your readers the market is plain nuts and the government should step in to fix it, you should spend a little more time thinking about the New Economy and how it can grow mightily or how it might be strangled in its cradle. And think back a hundred years. In 1900, the buggy-whip manufacturers had high earnings and the auto manufacturers were still dreaming about them. What are you doing with the buggy whips?