The past decade has seen three financial bubbles of enormous proportions.  One took place in Japan in the late 1980s, sending the Nikkei average to 39,000.  The next was in Southeast Asia in the middle
1990s.  The last, and biggest, is the one before your eyes on Wall
Street.  U.S. stocks have climbed to a combined value of $15 trillion,
double the nation's annual economic output.  A more normal relationship is a stock market priced at one times GDP.

STOCKS & BONDS

        Perhaps you are thinking that if so many companies are going public these days, the public equity market ought to be large in relation
to the economy.  If you think that, take another look at stock valua-
tions.  Compare them to corporations' net worth-their book value, that is.  This ratio, too, stands at an absurd height.  Each of the previous peaks in this ratio was followed by a crash, each crash by a major recession.  Today's bubble is the biggest yet.

        The bulls can offer yet another excuse here.  In the postindustrial economy, they will tell you, assets like bricks and mortar and railroad cars don't matter.  Intangibles like the Marlboro brand name or the code for Windows matter.  So book value is irrelevant.

        There are complicated reasons why book value still does matter, but rather than go into them let me offer this: Compare stock prices to earnings.  The S&P 500 index is trading at 35 times the trailing composite earnings of the stocks in the index. (Beware of market multiples that omit either nonrecurring writeoffs or moneylosing companies from the computation.) That multiple is more than twice the norm for this century.

        It all has to end, and it probably mill end badly.  During bubble times, hopes become unrealistic.  The high returns expected cause people to save less and companies to invest more.  In recent years U.S. savings have collapsed and investment has shot up.  Foreigners are financing our investment boom.

        When the market falls, these hopes don't subside slowly. They turn rapidly to fear. People suddenly want to save more and thus consume less. As consumption falls, companies respond to excess capacity by cutting new investment spending. So demand falls sharply, and the economy goes into recession.

        Does all this sound too theoretical? It happened in Japan, is still
happening in Japan. That's one reason the Japanese stock market remains mired at less than half its 1989 peak.

        Post-bubble economies are hard to manage. They don't respond to failing interest rates.  You don't buy a bigger house when the financing cost goes down if, at the same time, you realize you have overestimated the likely returns from the stock market and therefore have to save more for retirement.

        You can't go to the bond and money markets to make up lost ground because yields are also falling there.  Japan's economy has yet to recover from its post-bubble problems despite interest rates that are in the vicinity of 0%.

        Another unrealistic hope inflating Wall Street's bubble is that any weakness in the economy will be short-lived, as it will respond quickly to prompt fine-tuning by the Fed.  It might, it might not.  Japan is overrun with finetuners, many taking advice from the U.S. And still it's in recession.

        People are bidding up the prices of shares, homes in Greenwich and sport utility vehicles-all the while saving next to nothing.  Why hasn't inflation been more of a problem?  Because the private sector's deficit has been made good by an inflow of foreign capital, aided by the government's budget surplus in place of its usual deficit.

        This massive private-sector deficit could be financed either by selling equity or by floating debt.  In practice, all of it and more has been financed by debt.  Far from issuing new equity, U.S. companies have been reducing their share capital through buybacks and cash takeovers.  In 1998 the reduction was equal to more than 2% of GDP.  This is another way the U.S. has mirrored the Japanese bubble of the late 1980s, which was also driven by share buybacks, which the Japanese called zaitec.  Zaitec was based on the firm belief that shares could only appreciate.

        Wall Street is thus based on a vicious cycle of debt and deficit.  The rise in share prices has caused savings to fall and investment to rise.  Being financed by debt, the bubble will presumably go on being sustained until the debt buildup stops.  As Japanese experience has shown, however, the greater the debt buildup, the worse will be the subsequent pain and the more difficult the subsequent recovery.

        The two things that are most likely to stop the debt buildup are inflation or falling profits, the former because it will lead to higher interest rates and the latter because it will make bankers more wary of lending and companies less willing to borrow.

        Alan Greenspan has just warned that inflation remains a threat if the economy continues to grow rapidly.  Most economists, such as those at the International Monetary Fund, think that the U.S. can grow at around 2% a year without inflation.

        They may be too conservative, but experience suggests that the maximum pace of expansion cannot be much greater than this.
Profits are extremely sensitive to the amount of spare productive capacity in the economy.  One result of the stock market boom has been to encourage a huge expansion in investment.  As a result, capacity is now growing at over 5% a year, compared with an average of more than 2% a year over the past 30 years.

        Past experience suggests that if demand grows by less than 5%-falling behind capacity, that is-profits will fall; but if demand grows by more than 3%, inflation will pick up. From now on it seems that there is no rate of growth for the economy that will not cause either falling profits or rising inflation.  Either would have a devastating effect on stock prices.

        Optimists will claim that these threats will not materialize because the past is no guide to the future.  They may be right, but no one has yet suggested an alternative guide.