An Update To “When Will the Bubble Burst?”

by | Feb 26, 2000 | MARKETS

It May Be Bursting Now, and Faulty Economic Analysis Could Cost Investors Dearly

The first page of today’s (February 26, 2000) New York Times reports an analysis of the effects of rising interest rates on stock prices that is apparently widely accepted by investors and at the same time is so grossly deficient as to be potentially disastrous for those who accept it. The erroneous analysis is reported, without in any way being identified as erroneous, in an article by Gretchen Morgenson titled “Stocks in Turmoil As Worries Grow on Higher Rates.” The analysis is described in the following three paragraphs:

The Dow finished the week down 3.5 percent. It is off 14.22 percent for the year, while the broader Standard & Poor’s 500 stock index has lost 9.25 percent of its value. The Nasdaq composite index, which has been impervious to the selling pressures seen in the Dow and is dominated by shares of technology and other so-called new-economy companies, fell yesterday, but is up 12.81 percent this year.

This extraordinary divergence in the market reflects two views held by investors: that Alan Greenspan, the chairman of the Federal Reserve, continues to be deadly serious about raising interest rates to curb the economy’s growth and that these rate increases will hurt some industry groups far more than others.

The older, more established companies that make up the broader market indexes will be hurt by rising interest rates, investors believe, because these companies’ borrowing costs may rise substantially. But because the fledgling technology companies found in the Nasdaq composite do not rely as heavily on banks for capital, these concerns will not face rising costs as a result of a few interest rate increases.

What is wrong with this analysis is that it is ignorant of the actual connection between rising interest rates and stock market activity, or economic activity in general. The main connection is not the extent to which rising interest rates affect the costs of doing business. The main connection is that rising interest rates engineered by the Federal Reserve System signify a slowing down in the creation of new and additional monetary reserves for the banking system and thus the slowing down of the creation of new and additional money by the banking system. That, in turn, as I have explained in “When Will the Bubble Burst?,” represents pulling the rug from under the whole financial bubble on which most of the last few years’ rise in the stock market rests.

If the Federal Reserve really is serious about raising interest rates and thus about cutting back on the increase in the quantity of money (which, unfortunately, one cannot yet say with certainty), then Nasdaq and its high tech stocks will be pulled down along with the rest of the stock market. Indeed, they will fall much further, for it is they, even more than the older, more familiar stocks, that have been driven up by the pouring of new and additional money into the stock market. Their values are in the clouds, resting on the vapor of hope that in turn has been supported and fanned by the transitory passage of ever more new and additional money from buyers to sellers. Once the manufacture of sufficient new and additional money ceases, that will be the end of the tech-stock bubble.

The rise in Federal Reserve interest rates, i.e., the rise in the Federal Funds Rate, is a rise precisely in the rate of interest banks charge and pay to one another in the lending and borrowing of reserve funds. These are funds that banks are obliged, either by law or by the circumstances of  their business to have available either in the form of actual currency or in the form of checking deposits of their own with the Federal Reserve System. A rise in the Federal Funds Rate signifies that the Federal Reserve is feeding new and additional reserves into the banking system more slowly. That is why more banks find themselves in need of borrowing reserves, or borrowing greater amounts of reserves, and fewer banks find themselves in possession of excess reserves or excess reserves of the magnitude they previously possessed. It is this change in the conditions of the demand for and supply of bank reserves that then serves to bring about the rise in the Federal Funds Rate that the Federal Reserve targets. At the same time, this tightening of availability of reserve funds chokes off the ability of the banking system to create new and additional checking deposits, which it can do only to the extent that it possesses excess reserves. Without large quantities of such new and additional money pouring into the stock market, a significant part of the demand for stocks falls away. And if and when that happens, as it appears to be happening now, or is expected to happen in the near future, it will be followed by the unloading of stocks by those who have bought them for no other reason than the anticipation of their going on rapidly rising for ever.

Nothing in this update should be taken as a prediction, still less a prediction with respect to timing. As I have indicated, the actual policy of the Federal Reserve is a major uncertainty. So too is the extent to which there may still be people out there with substantial funds already in their possession and waiting to go into the stock market. What is certain is that once the great majority of those who are capable of going in have gone in, there will be nothing to make the market go on rising if the Federal Reserve does not continue to supply the reserves needed to support the creation of substantial quantities of new and additional money. At that point, those who have bought in anticipation of endless rapid rises will have no new buyers sell to. At that point, there is no way for the market to go but down, and, it may well be, go down as though the bottom had fallen out.

Related: When Will the Bubble Burst? (Aug 17, 1999)

To learn about every aspect of the case for capitalism, read my Capitalism: A Treatise on Economics. Originally published at the blog of George Reisman. Copyright 2019 George Reisman. All rights reserved.

George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and the author of Capitalism: A Treatise on Economics. See his author's page for additional titles by him. Visit his website and his blog Watch his YouTube videos and follow @GGReisman on Twitter.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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