Wall Street in Dreamland


</p> <p><script language="javascript" src="/scripts/commentary/gshilling.js"></script></p> <p> Financial markets and the U.S. economy parted company in the late 1990s as Wall Street lost touch with economic reality. That great disconnect still exists. By the late 1990s the post-1982 bull market's length and intensity put fear to flight, leaving nothing but intense greed. Speculation rivaled that of the 1920s.

So powerful was that 18-year bull market that even the following three-year bear market, which cut the Nasdaq index by 78%, did not put the financial world back in touch with economic reality. Massive monetary ease and huge fiscal stimuli actively promoted a continued separation. The nosedive in interest rates encouraged housing and cash-out mortgage refinancing. Tax cuts and leaps in defense and homeland security spending pumped big money into the economy.

Result: Financial speculation survived largely intact but shifted from stocks to residential real estate and hedge funds. Those private partnerships, along with banks, brokers and other pools of capital, took advantage of cheap short-term money to invest in Treasurys, junk bonds, convertibles, emerging market securities, currencies and commodities.

Sure, like most services, the financial sector grows faster than the overall economy. As U.S. business expands, financial services become more widespread, more complex and a bigger share of economic activity. Still, many measures of financial services remain far afield from consistent post-WWII trends; correcting the huge 1990s speculations should have pulled them below trend, at least temporarily.


Compare the Dow Jones Wilshire 5000 Market Capitalization Index, which contains almost all U.S. stocks, to the gross domestic product. The ratio (if you multiply the index by a billion) is now well below its 2000 peak, but at 96% it remains substantially above the 1971-96 norm, which is near 60%. Similarly, mutual fund assets in relation to GDP now stand at 64%, up from the 54% dictated by the 1984-96 trend line. (Good mutual fund data only go back 20 years.)

Stocks in the financial services sector, of course, benefited from the late-1990s surge, and the market capitalization of the financial stocks in the S&P 500 index leaped to 18% of the total. Yet after a brief setback when the market swooned, those companies were recharged by residential real estate and spread-lending activity. So their market caps now sum to 20% of the S&P 500 total. Meanwhile, the notional value of over-the-counter derivatives such as currency and interest rate swaps climbed from $90 trillion at the end of 1999 to $197 trillion at the end of 2003.

Pay in the financial sector did even better. In relation to average nonfarm wages and salaries, it continued to rise during the bear market and then jumped to the current 119%. Of the Forbes 400, the richest Americans, 77 made their money in finance or real estate.

Almost no one wants the financial sphere to reunite with the economic world, since the coming down to earth of speculative prices would be a financial shock that would cause a lot of real damage. The speculators don't want reality to intrude. Nor the brokers, bankers, hedge fund managers, money managers, venture capitalists, financial TV executives, consultants and financial research purveyors. Not even the Bush Administration or the Federal Reserve.

The Federal Reserve has broadcast its intention to raise the federal funds rate it controls. But that is not a plan to squeeze speculative excess out of the financial markets. Indeed, futures markets have already anticipated a further, modest credit tightening. Certainly Alan Greenspan cannot aim for sharply higher rates; that would be curtains for spread lenders and house prices. A serious financial crisis could turn my forecast of the good deflation of excess supply into the bad deflation of deficient demand as incomes are shattered.

But suppose the Fed succeeds in raising interest rates slowly enough that speculators can adapt without big failures. Most would probably figure that Washington had again raised the safety net so they could climb to an even higher perch. They would no doubt take even bigger speculative positions. The gap would widen and the prospects of closing it painlessly would fall. The Fed thus would have fostered the dangerous illusion that Wall Street can live permanently divorced from reality.

History says the two worlds will rejoin sooner or later. The great disconnect of the last decade between the speculative financial and the real economic worlds will probably persist, indeed expand, until a lot of people not only lose a lot of money but also give up all hope of being bailed out.

Don't be one of them. Don't buy a bigger house than you need, and don't buy stocks on margin. Buy Treasurys.

