In a must-read book, “The Great Reckoning”, the authors, James Dale Davidson and William Rees-Mogg, write on stock markets and the rise and fall of empires.
“The higher absolute levels of prosperity achieved during the decades of Pax Americana, especially in the stable industrial democracies, mask the long-term megapolitical trend toward disorder. For all America's might and wealth at the close of World War II, it was never strong enough to restore a world system as liberal and open as that which existed before 1914. Even during the peak years of American hegemony, a significant fraction of the world’s peoples lived in closed Marxist systems, where international property rights were recognized minimally or not at all. In other areas of every continent the treatment of property rights was far from the ideal of universal protection for private investment that was the mainstay of international law before 1914. Even at the height of its power in the wake of war, America was too weak to enforce such a standard. The generally reduced growth of financial assets relative to tangible assets measures like a seismograph the growing instability in the world.
Prior to this century, economic growth was reflected in a higher ratio of financial to tangible assets. Financial assets essentially reflect trust, the trust that promises to pay will be honored. This trust must decay when property becomes less secure and contracts more violable. During this century, it has improved only in those countries that were backward when the twentieth century opened. They have tended to see a growth in financial assets from very low levels because of modernization. This was true in India, South Africa, Mexico, Yugoslavia, and even Italy. But it has not generally been true of countries that were in the first tier of advanced economies before World War I. Belgium, Denmark, France, Norway, Sweden, the United States, and especially Great Britain have seen their financial interrelations ratios tumble since World War II. Only in Switzerland, which remains a model of middleclass rectitude. in a disordered world, has the financial interrelations ratio continued to grow. It was appreciably higher in the last quarter of the twentieth century than it had been early in the century.
At the turn of the twentieth century, the West Shore Railroad 4 percent bond traded to a high of 114 3/4, to yield 3.48 percent. The bond was not due for redemption until the year 2361. Today, no one could sell a bond set for redemption three or four centuries hence. It would be easier to peddle insurance against nuclear war. The trust that obligations will be met is shakier than it was at the turn of the century. And the trust in governments to sustain the value of money is even shakier. This is reflected in an increase in long-term interest rates during the twentieth century, which may either be a temporary blip or a reversal of the trend to lower long rates that had continued since the end of the Middle Ages. If you consider the value of financial assets in 1990 compared to what they would have been if trends in place at the beginning of this century had held intact, it is apparent that the breakdown of order in the twentieth century has cost the world tens of trillions in missing financial assets.
Reflagging and Flagging Power
Consider that in 1912, before the stability of the British Empire was ruptured, anyone who could plausibly have passed for British had protection almost anywhere on the globe. American traders took advantage of it running caravans of tea and silk from Kalgan to Urga over the plains of Outer Mongolia. They were able to protect their property at practically no cost to themselves. They merely flew the Union Jack from the lead and trailing camels. Mongolian bandits, hardened fighters as they were, had learned that violence against British merchants invited deadly punishment. A small detachment of British troops, armed with Maxim guns, could wipe out almost any number of Mongolian horsemen. Consequently, commerce and property rights were secure in 1912, even in Outer Mongolia, a region as remote then as it is today. The entire British military budget at that time was just seventy-five million pounds.
In 1990, America’s military budget was about three hundred billion dollars, a huge multiple in real terms of what Britain spent seventy-five years earlier. Yet the costs of projecting power have risen so far that to show the American flag in remote areas of the globe today is to invite attack as often as to forestall it. The famous contemporary incident of American reflagging in the Persian Gulf was possible only under the cover of a huge armada, ships that cost more to build than the entire gross national product of Iran. Even then, the Kuwaiti tankers that ran up the Stars and Stripes were attacked and several were severely damaged. And Kuwait's apparent alliance with the United States clearly counted for little in the mind of Saddam Hussein when he invaded and seized the whole country in an attempt to force up oil prices.
Costs Rising on a Geometric Curve
The technological trends that have led to the devolution of power throughout the twentieth century appear to be accelerating. As they do, the cost of policing the globe is rising on a geometric curve. The logical expectation, therefore, must be that Japan, or another country, will face far more difficult obstacles as the emerging empire of the twenty-first century than America or Britain ever did. The transition between American and Japanese hegemony may drag out longer than the thirty years it took to reorganize the world economy under American leadership. The results could be unhappy for Japan.
The period when the old power is no longer effective, yet no new power has emerged, is a time of rising borders and obstacles to trade. It is a time of economic reversal and instability, when the contradiction between the integration of world markets and the separateness of selfish political entities is most acute. Functions crucial to growth simply go undone. The old power is no longer willing or able to serve as the guardian of commerce. It is no longer rich enough to be the guarantor of money and debts or the buyer of last resort. Until some new power steps into the void, the world economy will struggle in disorder. In the words of Sir Martin Jacomb, “An unpoliced community is hell for those who inhabit it.”
The Japanese Assets Collapse
The first edition of this book forecast “a collapse of the value of Japanese stocks and real estate more drastic than any that has yet occurred.” It was a simple forecast based upon the assumption that the classic pattern of the credit cycle would repeat itself. We saw it unfolding in Japan even before the initial 1990 crash, which took the Nikkei Dow down by 49 percent-a greater drop than Wall Street suffered in 1929. We warned that the greatest asset boom in history would be followed by history's greatest asset bust. So far, at least, events have not altered that expectation.
Every nation that has yet emerged as a leading financial power in the modem world has ridden a roller coaster of boom and bust during the transition period. It is a wild ride that lasts for decades. First comes a property rights shock, like the OPEC Shock of 1973, touched off by the military weakness or vulnerability of the fading power. For the better part of a decade, inflation ensues. During this period, the emerging power starts to outperform the fading power decisively. This happened for Japan in the late 1970s, when its auto and electronics industries began to accumulate massive profits in world trade.
During the early stages of the transition, asset prices in the emerging economy are capitalized at modest or even trivial levels. In the early seventies, the market value of IBM exceeded that of the whole Japanese stock market. It takes years for the buildup of liquidity to drive up investment assets to prices that are lofty by international comparison. Through the late 1970s and early 1980s, real estate and stock prices in Japan compounded rapidly. But it was only after 1985 that they began to reach levels that seemed expensive. They later become extreme.
The manic phase of the boom lasts for several years. By 1988, it was said that a single prefecture of Tokyo was worth more than all of Canada. Yet this was not the peak. Even after assets reach extreme valuations, they go on to still greater extremes. At the peak of its value, when NTT, the one-time Japanese telephone monopoly, was privatized, it was worth more than the entire German stock market. In the classic assets mania, markets outrun any rational valuation based on yield or cash return. Stocks and properties come to sell at absurd prices on the expectation that they will appreciate to still more absurd prices. And they do. They defy gravity, moving from one lofty new high to another, month after month, year after year, long enough to lure otherwise prudent people into mortgaging their gains to reinvest in the inflated assets on margin. Before the market can top, everyone who could conceivably be drawn in must have already become a buyer. And debt levels supporting the asset prices must be many times higher than any that could conceivably be serviced out of the cash flow yielded by the investments themselves.
Then comes the bust. Just as everyone has come to count on the idea that the lofty asset valuations are permanent, there is a crash. This tends to happen nine to ten years after the peak in commodity prices, and fifteen to twenty years after the initial property-rights shock that set in motion the decade of inflation. Tokyo's 1990 crash fits that pattern exactly. It is one of the strongest hints that the troubles in Japan, as well as those in the rest of the world, are not the result of a superficial inventory cycle, or recession, but those of a major world depression that is still to reach its deepest stage.
Commodity prices peaked in London in 1711. The South Sea Bubble burst in 1720. Depression followed.
Producer prices peaked in London in 1763. The London stock market crashed again in 1772. Depression followed.
Commodity prices peaked in London in 1816. The London stock market crashed in 1825. Depression followed.
Wholesale prices peaked in New York in 1864. A worldwide assets crash began in May 1873. Depression followed.
Wholesale prices peaked in the United States in 1919. Wall Street crashed in 1929. Depression followed.
Commodity prices peaked in Tokyo in 1980. The Tokyo stock market peaked in 1989 and crashed in 1990.
The crash is then followed by a long wind-down period, interrupted by numerous suckers' rallies, which absorb cash from optimists expecting an early recovery. Ultimately, assets are deflated by about 90 percent. As we write, the process is only about 60 percent complete. The Nikkei Dow is rotating between 16,000 and 17,000, with a prospect of a sharper bear market rally before it resumes its plunge back to late-1970s levels.
Of course, the authorities in Japan, along with many informed observers in the West, express confidence that the markets have already bottomed out and begun to recover. They share the conviction, apparently supported by several recent decades of experience prior to 1990, that Japanese markets do not function as those in the West do. Many smart people really believe that. We don’t. Notwithstanding the fact that the Japanese are culturally more amenable to rigging markets, with their traditional respect for gaman, the virtue of bearing losses and pain without complaint, the Nikkei Dow has followed much the same course as the Dow Jones average on Wall Street followed after 1929. Indeed, the Japanese market has tumbled 10,000 points beneath where it stood when the first edition of this book was typeset.
We continue to believe that the deepest stage of depression is to come, and that Japanese markets will provide the key to determining how severe the depression will be and how quickly it will run its course.
Stock Markets and the Rise and Fall of Empires
For all that has been written about investment booms and busts over the centuries, seldom has the connection between the asset booms and the rise and fall of empires been clearly drawn. Undoubtedly, a major reason for the obscurity of the connection is that its major regularity is counterintuitive. It would be easy to guess that major busts occur in the markets of fading powers. It is certainly true that the relative performance of such markets suffers as the old power is eclipsed. But the conditions of economic decline are not suited to engender collapses of historic proportions, precisely because the symptoms of decline are ordinarily widely recognized. Imperial decline (or even the perception of imperial decline) is likely to create extraordinary buying opportunities when pessimism is overdone-provided the system survives. When the evidence of growing difficulty is on the minds of investors, it is difficult to sustain the kind of optimism that drives up prices to preposterous levels. You cannot fall off the floor.
On the other hand, the ingredient of optimism is available in abundance precisely when a new power is emerging. It is probably for this reason that many of history's epic busts have occurred in the markets of rising powers during the transition after the defeat or retreat of the old empire.”