With all the concern (some might say excessive concern) about impending rate hikes, we thought it might be helpful to review how we arrived at the present interest rate levels. We hope this will provide some insight as to what possible market reactions might be to the impending interest rates increases.
Indeed, notable by its absence was the word “Patience” in Alan Greenspan’s Congressional testimony last week. This leads us to expect that at the Fed meeting in May, they will produce a change in language in their official statement. That leaves them the option of increasing rates a ¼ point at a time, should they need to, at the August meeting.
As such, it may be instructive to compare analogous post bubble periods – 1990 to 2000 for Japan, versus 2000 – present for the U.S. As the nearby chart reveals, the Federal Reserve cut rates faster and more aggressively than the Japanese Central Bankers. Over the course of a year (2001-02), Greenspan & Company cut the discount rate from 6% to 2%. By contrast, the Japanese bankers took almost 4 years (1990-94) to slash rates that low. One year later, the Fed had brought rates down to 1%. That same process took Tokyo an additional 30 months or so.
In comparing the post-bubble experiences of both countries’ economies, the U.S. has enjoyed far more stimulus, and far sooner, than did Japan. This may be attributable to Central Bankers here learning from the mistakes of the Japanese. Additionally, the Keiretsu – the massive, vertically integrated, interconnected conglomerate – does not exist in the U.S. corporate universe. They are a prevailing form of corporate structure in Japan.
We also note that in the U.S., the bubble was primarily concentrated in technology, internet and telecom sectors. While the entire market did get overheated, these sectors had the greatest run ups – and the greatest crashes. Because of the way Japanese corporations are structured, their bubble cut across far more sectors of the economy: Banking, insurance, and real estate took a heavy beating as well technology and telecom.
The net result is that post bubble, the U.S. has enjoyed a much greater level of stimulus than Japan did. That is reflected in the past year’s market run up. Indeed, only now, some 14 years after their bubble popped, are some analysts first getting comfortable with the concept of buying Japan. The risk factor is that post-bubble excesses still exist which, have yet to be wrung out of the economy here. Under normal circumstances, we would not be too concerned with increasing rates. The problem is that these are anything but normal circumstances.
Delivered April 26, 1994 to the MIT Department of Economics World Economy
Laboratory Conference Washington, D.C.
When Rudi Dornbusch invited me to speak at this conference, he gave me
a totally free hand in deciding what I wanted to talk about. Well, I
want to discuss a subject which fascinates me but doesn’t seem to
interest others very much. That is my theory of reflexivity which has
guided me both in making money and in giving money away, but has
received very little serious consideration from anybody else. It is
really a very curious situation. I am taken very seriously; indeed, a
bit too seriously. But the theory that I take seriously and, in fact,
rely on in my decision-making process is pretty completely ignored. I
have written a book about it which was first published in 1987 under
the title The Alchemy of Finance; but it received practically no
critical examination. It has been out of print for the last several
years but demand has been building up as a result of my increased
visibility, not to say notoriety, and now the book is being re issued.
I think this is a good time to get the theory seriously considered.
I was invited to testify before Congress last week and this is how I
started my testimony. I quote: “I must state at the outset that I am in
fundamental disagreement with the prevailing wisdom. The generally
accepted theory is that financial markets tend towards equilibrium, and
on the whole, discount the future correctly. I operate using a
different theory, according to which financial markets cannot possibly
discount the future correctly because they do not merely discount the
future; they help to shape it. In certain circumstances, financial
markets can affect the so called fundamentals which they are supposed
to reflect. When that happens, markets enter into a state of dynamic
disequilibrium and behave quite differently from what would be
considered normal by the theory of efficient markets. Such boom/bust
sequences do not arise very often, but when they do, they can be very
disruptive, exactly because they affect the fundamentals of the
economy.” I did not have time to expound my theory before Congress, so
I am taking advantage of my captive audience to do so now. My apologies
for inflicting a very theoretical discussion on you.