Niall Ferguson: A stock market bubble is nothing new

'What drove up shares in the South Sea Companyin 1719 was wildover-optimism about profits. Sound familiar?'

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I have a good friend - an artist - who has made a good thing in the past few years out of painting rather splendid pedigree bulls. He was drawn to these creatures, in all innocence, by their aesthetic charm and painted a series of striking bovine portraits. It took him a while to realise why they were selling faster than anything he had painted before. Every single one was being bought by a City stockbroker. Unwittingly, my friend was painting bulls for the bulls.

I have a good friend - an artist - who has made a good thing in the past few years out of painting rather splendid pedigree bulls. He was drawn to these creatures, in all innocence, by their aesthetic charm and painted a series of striking bovine portraits. It took him a while to realise why they were selling faster than anything he had painted before. Every single one was being bought by a City stockbroker. Unwittingly, my friend was painting bulls for the bulls.

Now he has a problem. The bull market has turned into a bear. He could of course take a trip to the Rockies and paint some picturesque grizzlies. The trouble is that bankers don't buy paintings in a bear market - they sell them. So, is it time for us all - artists as well as brokers - to open the window, climb out and jump? To put it more precisely: is there a danger that this stock-market rout could turn into another Great Depression

There are certainly enough superficial resemblances between the bubbles of the 1990s and the 1920s to rule out facile optimism. Indeed, the more recent bubble is the bigger. Between January 1920 and the market's peak in September 1929, the Dow Jones industrial average rose by a factor of 3.5. In the equivalent 10 years after January 1990, the increase was fourfold.

Just as in the 1920s, the boom has been fuelled by over-optimism about new technology (then it was the car and the fridge), an increase in the number of small and inexperienced investors, share-promotion in the media, "hot" international money and miscalculations in monetary policy. What Alan Greenspan called "irrational exuberance" back in 1996 was rampant in the late Twenties, too.

Yet there is a need to keep a sense of perspective. A crash on the 1929-32 scale would, if history were to repeat itself exactly, take the Dow down from over 11,723 (where it stood at its peak in January last year) to around 1,266 by November next year. On Friday it was down to 9,504, so we have quite a long way to go before we are in Great Depression territory.

The Great Depression was special - and is unlikely to be repeated - for five reasons. First, American monetary policy was disastrously inept, especially in 1931, when the banking system was all but left to collapse. Second, the crisis was deepened by a worldwide rush to protectionism, a mistake we have surely learnt not to repeat. Third, international financial institutions were far feebler than today; the Bank for International Settlements was no International Monetary Fund. Fourth, the banking system of Europe and North America was a house of cards even before the crash. And fifth - and above all - the international gold standard, a system of fixed exchange rates that has no counterpart today, turned out to be a lethal mechanism for transmitting financial shocks from country to country. So 2001 is not 1931.

Even allowing for the disaster of the 1930s, it is worth remembering that the US stock market performed exceptionally in the 20th century. At Yale University, financial historians William Goetzman and Philippe Jorion have calculated that investors in Wall Street enjoyed a 4.7 per cent annual compound real return between 1921 and 1995, a figure unmatched by any other stock market. Any 30-year old who had the nerve to begin tracking the index in the depths of the Great Depression would have increased his investment roughly tenfold by the time he retired in 1957. If his 30-year old son had held on to his inheritance and continued tracking the index, he would have celebrated his 72nd birthday in 1999 having notched up a further twentyfold gain. If you had started tracking the FT All-share index in 1949, you would have quadrupled your money by the end of last year. In the past hundred years, no investment has performed as well as shares. The real point about the past week's events is that they are part of the bursting of a bubble in a particular sector: technology.

Stock-market bubbles like this are nothing new. Everyone has heard of the South Sea Bubble of 1719-20, but the parallels between the distant past and the present are closer than is generally realised. As in our own time, the background to the 1719 bubble was economic globalisation, as European trade with the New World boomed. Then, as now, the market was led by a few big companies. What drove up share prices in the South Sea Company and the French Mississippi Company was wild over-optimism about their future profits. Sound familiar?

Moreover, the bubble was underpinned (especially in France) by monetary policy, with John Law playing the part of Alan Greenspan, relaxing policy every time the stock market threatened to slide. Then, as now, foreign money played a crucial part in pushing share prices up. Then, as now, the suckers who bought at the top of the market were mainly first-time investors, lured by press hyperbole.

One lesson of the 1719 bubble is that the severity of the bust can have major macroeconomic consequences. In France the market didn't just crash, it collapsed, taking the entire financial system with it. In Britain the South Sea stock merely reverted to pre-Bubble values, and the system was largely unscathed. This helps to explain why France lagged so far behind Britain in the subsequent development of banking and finance.

What happens now as the Nasdaq bubble deflates mainly depends on the way investors react to their losses. In the expansionary phase of the bubble, investors apparently regarded the capital gains they made as real additional wealth and increased their consumption accordingly. The so-called "wealth effect" may have added as much as one percentage point to the annual growth rate since 1996. The question is whether this could now work in reverse; in other words, will investors react to losses by reducing their consumption and increasing their saving?

If that were to happen across the board - and there are those who think it has already begun - events on Wall Street could have a painful impact on Main Street, and the financial bubble could turn into a full-blown recession in the "real" economy.

For a much more recent illustration of what can happen, turn to Japan, which had a bubble and bust of its own between 1986 and 1992. Growth has been negative in 15 of the last 26 quarters. But the most alarming aspect of the Japanese story is that none of the conventional policy responses to the economy's stagnation seem to have worked. Interest rates have been cut literally to zero, just as classical theory recommends. Huge fiscal deficits have been run, just as Keynes prescribed. Neither has worked.

Then again, there are profound structural and institutional differences between the US and Japan. It is inconceivable, for example, that US banks could get away with the systematic cooking of the books their Japanese counterparts have engaged in to conceal the scale of bad debts.

The optimistic conclusion is that what happened this week was simply part of a long overdue market correction, restoring the world's most successful stock market to rationality after the irrational exuberance of the "new economy" bubble. If that means we will hear a little less from Abby Joseph Cohen of Goldman Sachs - who forecast a year ago that the Dow would end the year 2000 at 12,600 - then the cloud even has a silver lining.

Yet the possibility of an asset price deflation on the Japanese pattern cannot wholly be ruled out; and that is a far from comforting thought. If the world's biggest economy follows the world's second biggest into a prolonged period of stagnation, then my artist friend may have painted his last prize bull.

The author's 'The Cash Nexus: Money and Power in the Modern World' is published by Penguin. An 'e-lecture' based on the book is at www.boxmind.com

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