Memo To: Floyd Norris
From: Jude Wanniski
Re: Thinking About Bubbles
[Two economic writers I respect — Floyd Norris of the NYTimes and Wayne Angell of Bear Stearns — yesterday had columns on stock market "bubbles," musing on the Internet stocks. Angell' s appeared on the op-ed page of the WSJournal I will share my exchange with Angell in this space when it runs its course, but today I will send you the memo I e-mailed to Norris, who writes the economic editorials for the Times. The piece he did Wednesday ("Is That a Bubble or Is the Outlook Fabulous") was signed and is well-worth reading.]
Floyd: It appears you have not read Chapter VII of The Way the World Works. If you recall, when I gave it to you at our lunch, I recommended that chapter because in it I explain the reason why the stock market crashed in 1929. Because Charles Kindleberger's book which you cite (Manias, Panics and Crashes) came out roughly the same time as mine, he had to take on my argument, but was unable to do much more than point out that nobody else agreed with me. If you would read Chapter VII, you could make up your mind for yourself, but a great many economists have told me that they do accept my explanation, although they say the profession will not accept it until long after I'm dead. This is because my thesis upends all the work that the Nobel prize-winners have done in the area, which rests on the assumption that markets are irrational at times, and the government has to control them to prevent bubbles from occurring.
That you have written the column on bubbles as they relate to the Internet is a useful exercise. You should bear in mind, Floyd, that it is not as easy to price the unknown as it is to price the known, but the market has been handed the assignment and it is doing its best. The bubbles Kindleberger discusses in his book, which involve the prices of single assets — tulip bulbs or real property in the South Seas or Florida — were good examples of how sharp corrections can occur with the addition of a single piece of information. It is only a single piece of information — a pinprick, as it were — that is needed to quickly reverse expectations about future prices. And the future is what the market attempts to do when it prices assets. The "price" of a piece of paper that represents a claim on the fbture is determined by all those who believe it will rise in value in the future against those who believe it will fall.
Almost all "people" who go long or go short in pricing an asset do so because of the opinion of someone they regard as having information superior to their own. This is why prices can change sharply even when the press announces the news that a major brokerage firm has changed its view from "buy" to "sell." What looks like the "greater fool theory" is simply the chain reaction that follows on the way up or on the way down when a small number of people come into the possession of a new piece of information that expands or contracts what looks like a "bubble."
You say in your column that everyone agrees that the Japanese stock market constituted a "bubble" that burst in 1990. Here again, I put my staff to work on the problem, insisting that there had to be a new piece of information the Tokyo market received in January 1990 which caused optimism to turn quickly to pessimism. It took a few years, but we finally discovered that on January 1, 1990, the effective capital gains tax on real property in Japan increased sharply. This new piece of information correctly advised the stock market that real property prices would decline in Japan, as their future tax liabilities suddenly had increased. Because most of the wealth of Japan is held in real property, which is capitalized into the value of equity prices traded on the stock exchange, this was sufficient to cause the first round of decline in the Nikkei. Subsequent declines occurred as the government sought to make up lost revenue by raising taxes. Bill Kucewicz, then on my staff and most recently editor of Markets magazine, co-authored a long report on this for our clients at Polyconomics on August 31, 1995, which was condensed in Barron's of September 18, 1995, as "What Ails Japan," in the event you wish to increase your understanding of bubbles.