The key question for the prudent investor is whether the sharp rise in asset prices since 1995 reflects a fundamental change in financial markets and the rise of a New Economy or merely a bubble that is bound to burst. Many investors apparently are confident that the technology of computers and telecommunications has altered the economic landscape in a fundamental way. They are persuaded that "a new paradigm in economic thinking" is changing the scene just as the Industrial Revolution did from the middle of the 18th century to the middle of the 19th, bringing social and economic changes that marked the transition from an agricultural to a modern industrial society.

The American economy continues to be the envy of the world. Gross national product is said to rise at a 4% rate, creating some 1.5 million new jobs every year. The unemployment rate is at a 29-year low; inflation, as commonly defined, is rather inert, and Wall Street is as euphoric as ever. The fact that such growth occurs simultaneously with stable or even declining consumer and producer prices is extraordinary and outside the scope of mainstream economic thought; it calls for a new paradigm, a new brand of economics.

The phenomenal rise in stock prices has created multitudinous disciples of the new paradigm, especially in Wall Street and the halls of government. Average profits of 100% over a one-year period by investing in leading high-tech stocks make many believers in the New Economy. The corporate leaders are companies like Amazon, Microsoft, Intel, Cisco, Worldcom, Yahoo, America Online, etc. Even old-line companies are eager to join the New Economy and are quick to take advantage of the new-paradigm treatment, offering stock and raising billions of dollars. When United Parcel Service (UPS) recently joined the stampede UPS shares immediately soared to some 118 times its 12 months earnings, making several thousands of its employees instant millionaires. Many high-tech stocks realize returns of 1,000 percent or more. In September 1998, eBay Inc., an online trading company, completed its initial public offering of common stocks at $6 a share. Since then, the popularity of this web site has grown and eBay stock has risen to $162 on December 18,1999, trading at over 450 times its projected 2000 profits.

A few academic economists schooled in Austrian economic thought reject the new paradigm; they see a huge financial bubble and an unstable bubble economy. There is economy-wide inflation, they contend, but its composition is markedly different from other inflations in the past. It is an unprecedented asset inflation that emanates from the United States and contaminates many foreign markets. The asset inflation springs from Fed money creation and from massive credit expansion that provide the liquidity utilized in the asset markets.

Mainstream economists in Wall Street and government simply ignore the Austrian arguments because they are politically incorrect. At a time of great prosperity it is heedless to speak of booms and busts and warn of coming calamities. When investors enjoy the wealth effects of booming stock prices they don't want to hear about the poverty effects of a bear market. Austrian economists ask annoying questions such as: "What is the driving force behind the long boom of the American economy and the feverish stock market? What are the limits to the increase of fiat money and fiduciary credit? What will cause the bubble to burst?"

These economists are mindful of numerous social, political, psychological, and moral factors that may affect the institutional setting of economic activity and, therefore, economic productivity and prosperity, such as the ethos of work, the respect for and safety of private property, the burdens of government, the scope of man's division of labor, etc. But they always punctuate and feature just two economic driving forces of rising productivity and lasting prosperity: personal savings and business profits plowed back which are businessmen's savings; and certain technological inventions that make human labor more productive without the need of additional capital.

Saving is the first step on the way toward improvement of material wellbeing. It withholds an amount from current consumption and dedicates it to the improvement of future conditions by way of the formation of productive capital such as tools, dies, machines, factories, office buildings, means of transportation, communication, education, etc. Saving also is the indispensable condition of most technological improvements. More technological knowledge is no use if the needed capital is lacking. Businessmen in Sri Lanka and Bangladesh may be familiar with American technology. What prevents them from adopting American methods is not the low wages of their workers, but the lack of productive capital.

The American rate of saving is known to be the lowest in the industrial world. The so-called wealth effect from the surging stock market has fueled consumer confidence to high levels. Personal consumption has soared at record rates, at 20% during the last twelve months (Barron's, November 29, 1999, p. MW78). Gross national product has risen some $400 billion last year and some $200 billion during the first half of this year, but the indebtedness of consumers and businessmen has soared $995 billion and $532 billion respectively. Surely some of the business debt was invested productively despite the expenditure on mammoth mergers and acquisitions which may prove not to be very productive in the end. The consumer debt probably would signal economic stagnation and even decline if it were not for foreign investments and imports. The foreign-held U.S. government debt alone amounts to $624 billion or more than 10 percent of the gross debt (ibid., MW77). Moreover, the annual balance of trade deficit, that is, the excess of imports over exports, amounts to some $300 billion, more than 3 percent of GDP. In short, if it were not for foreign willingness to send their goods in exchange for American dollars and for the great confidence and trust which many foreigners have in American reliability, the stock market might not be surging and the consumer confidence might not be soaring.

If it is not American thrift and capital accumulation that are the driving force behind the long equity boom, is it the new high-tech revolution which makes human labor more productive without the need of additional capital? Many investors point at powerful computers and the cost-cutting power of the Internet that drive the Dow Jones Industrial average. It is true, a few corporations have used the Internet to increase their profits by cutting costs, eliminating middlemen and attracting new customers. They have implemented aggressive, wide-ranging Internet strategies designed to squeeze costs out of their operations, perhaps as much as two or three percent per year. It is estimated that, in five years, Internet-related efficiencies may add some 10 percent to the average Dow stock earnings. But the companies will have to spend most of their profits to put the Internet systems in place.

Such modest expectations obviously contradict the notion that the computer technology and the Internet strategies are the driving force of the soaring bull market which measures Internet success in hundreds, yea even thousands of percent. They also explode the popular belief that the computer and Internet age makes human labor more productive without the need of additional capital. It actually requires the investment of massive amounts of new capital and the loss of similar amounts of old capital, which will impair business profits for many years to come. Moreover, it is unlikely that, in the foreseeable future, Internet business with consumers will reach ten percent of retail business and that Internet business with business will exceed three percent of GDP. Yet, Internet stocks now have a market value of one trillion dollars, up from about $200 billion one year ago. Internet stocks amount to almost one-half of initial public offerings, up from some 20 percent a year ago. Surely, past and future profitability of the Internet cannot be credited with lifting Internet stocks to such lofty levels and NASDAQ from one record to another.

If it is neither American thrift nor the high-tech revolution that are the driving force behind the long boom, what then is the power that fuels the markets? The answer is the same given for all boom-and-bust cycles during the last two hundred years: fiduciary credit expansion, that is, credit creation without savings. It falsely lowers interest rates, distorts the loan market, and causes economic malinvestments and maladjustments.

Fed Chairman Alan Greenspan may talk about "irrational exuberance" and hint at possible Fed restraint but, at the same time, facilitate rapid expansion. Surely, we cannot speak of restraint when the Fed expands the monetary base at a rate of 10 percent or more. According to its own statistics, the Fed's adjusted credit base has risen at an annual rate of 10.3 percent since January 1999 and at 15.9 percent since late July. By the end of the year when the monetary demand tends to be seasonally strong and especially heavy on account of Y2K fears, it may approach 20 percent. Moreover, these percentages significantly understate the rate of credit expansion due to the proliferation of non-bank credit and the sale of securitized bank loans to non-bank investors.

During the last 12 years of the Greenspan Federal Reserve, the money-supply measure consisting of currency and all checking-type assets including money-market funds reached a high-water mark of some 15 percent expansion in 1986, 1992, 1998, and again in 1999. In every case the high tides of Fed liquidity lifted the equity markets to new peaks. Whenever the tides receded, as in 1987 and 1993 the stock market either crashed or turned lackluster. This is not to imply that the Fed by simply providing and demarcating the market liquidity can thereby guide the trends of equity prices. The market consisting of millions of participants plays a big, if not a bigger, role in determining liquidity. It constitutes the entire industry of lending and borrowing of loan funds and buying and selling of securities; the Fed is merely a small but powerful participant that seeks to facilitate economic growth and full employment through money and credit manipulation. It may readily embark upon currency expansion and encourage credit expansion and thus facilitate the asset bubble. The Fed may also burst it by engaging in currency contraction. It does not take much, perhaps only an inconsiderate remark by the chairman, to deflate a balloon that is floating on bubble air. But such a remark would draw the immediate ire and wrath by both the financial community and political authorities. If the Fed were to deflate the bubble deliberately, their anger would set the Fed house on fire. This is why Alan Greenspan and his governors have no real choice but to continue the expansion; they are snared by their own bubble.

The limits to federal credit expansion are set by the market. The confidence in the dollar, which has permitted the trade and investment distortions to persist so long, may not be permanent. They may continue for many years but suddenly cause failures and disruptions that frighten investors who may not only rush to liquidate their equities but also move into other currencies, such as the yen or euro. The U.S. is now the biggest debtor country in the world, with a total foreign debt well over a trillion dollars. Even if American investors were slow to react to financial failures and disruptions, foreigners are likely to be alert and swift to recall their funds. They were in 1979-1980 when they triggered a global dollar crisis with soaring interest rates and rampant price inflation.

The situation is much worse today than it was in 1979. Former Federal Reserve Chairman Paul Volcker, no friend of a gold standard, described it succinctly: "The economy of the world is dependent on the U.S. stock market. The U.S. stock market is dependent on 50 stocks, half of which had no earnings." And yet, the bull market roars on, fed by massive credit expansion that mounts and grows on the Fed dollar expansion.

The credit bubble consists of a many-layered mass with Federal Reserve credit at the base and massive layers of banking and nonbanking credits resting on the base. While the Fed presently is expanding its credits at a rate of some ten percent, and M3, which represents all forms of money and near-money, is growing at some fifteen percent, the nonbanking credit expansion builds on both. It is a formless and obscure mass created by insurance companies, brokerage firms, mutual funds, credit unions, and other intermediaries. Giant federal-government-related corporations add their credits by refinancing existing debt, usually reducing the monthly payments and often modifying interest charges.

The Government National Mortgage Association, nicknamed Ginnie Mae, which is an agency of the U.S. Department of Housing and Urban Development, guarantees full and timely payment on mortgage-backed Pass-Through Securities representing pools of residential mortgages. The Federal National Mortgage Association, commonly called Fannie Mae, is a shareholder-owned company that purchases both government-backed and conventional mortgages from lenders and securitizes them. It is the largest source of home mortgage funds in the United States, aggregating debt instruments in a pool, then issuing new securities backed by the pool. It is one of the driving forces of a booming housing market.

The nonbank layer of credit misdirects and maladjusts the credit markets in the same way as do both the Federal Reserve and commercial bank layers. But it differs significantly from the others in its effects on the stock of money. While the Fed creates high-powered money expanding the money base and commercial banks create demand deposits, nonbank issuers of credit do not originate money in any form. They merely intensify the use of money by lowering their cash holdings; in short, they increase the money velocity. The rising discrepancies between the various layers increase the vulnerability of the bubble.

What then will cause the bubble to burst? The answer to this question lies hidden in the emotional and behavioral reactions of individual investors, in the psychology of bubble behavior. Any unforeseen event may make investors suspicious and cause them to flee the equity markets. The announcement of unexpected corporate losses and bankruptcy, a sudden rise in the prices of consumer goods, the failure of a bank or nonbank financial institution, the insolvency of a foreign government, foreign threats and dangers, new legislation, regulation, or taxation that frighten investors, or just a rise in interest rates may spook investors and cause them to run for safety. Surely, the Federal Reserve would want to check the run with reassuring words and rescue operations. It may even succeed in allaying the fear and halting the run. The eminent position of the U.S. dollar as the paramount reserve currency of the world confers great weight to the dollar authorities. Yet, there are limits to the currency expansion even on the part of the Federal Reserve. A massive issue may rescue a few overextended debtors but also frighten countless investors, who may dash to the equity exits. It may alarm holders of dollar assets who may even choose to move into other currencies such as the yen or euro, or commodity money such as gold and silver. To exceed the confidence limits is to invite an evanescence of confidence and a flight to safety.

Market interest rates are proven indicators of liquidity, specifically, the one-year U.S. Treasury bill rate and the rate of overnight loans between banks, the so-called federal-funds rate. A U.S. Treasury bill is a short-term discounted government security sold through competitive bidding at weekly auctions in denominations from $10,000 to $1 million. The high degree of safety together with the liquidity provided by an active market make bills popular with corporate money managers as well as with banks. They constitute both liquid capital in the hands of investors and debt instruments denoting economic wealth consumed. Bill rates indicate the availability of funds, expressed as a rate per year, and reflect the judgments of both lenders and borrowers as to the future inflation and depreciation of the funds as well as their individual discounting of future needs and wants. In anticipation of higher inflation or larger budget deficits the rates are bound to rise; they will fall when inflation is expected to subside and the Treasury abstains from incurring large deficits. However, the rates are bound to fall when the Fed, for any reason, floods the loan market with newly created funds. It may temporarily succeed in lowering interest rates, but then encounter rising market rates as the new funds distort the market and boost inflationary expectations on the part of both lenders and borrowers. Consequently, the rates may rise even higher than they were before the Fed managed to lower them. While the Fed as the legal monetary authority has the power to interfere with market forces, these inevitably and invariably prevail in the end.

When we reflect on the history of one-year T-bills in recent years we cannot escape the conclusion that the extraordinary high rates of more than 8 percent in 1988 and 1989 preceded the crash of 1989 and that the 7 percent rates in 1994 preceded the lackluster market that followed; the extraordinarily low rates of some 3 percent in 1992 and 1993 led to a remarkable bull market. Similarly, the 1995 decline from 7 percent to 5 percent and even lower presaged major market advances. The 4 percent rate in 1998 and early 1999 bred the current bull market. At the present (Nov. 26, 1999) the bill rate is quoted at 5.65 percent when compared with 4.59 percent at this time last year. If this trend toward higher rates continues, we must brace for a new direction in the equity markets.

While the name of the game remains technology and New Economy, interest rates quoted on bills, notes, bonds, credit cards, and many kinds of consumer and business loans may shed light on the condition of the business cycle. They may indicate the extent of the distortion and deviation from unhampered rates which spring from the value judgments of all market participants, from their way of thinking about present and future. They do not change much over time unless economic conditions are expected to change significantly. The variations and deviations from true market rates are the inevitable consequences of fiduciary credit creation by the Federal Reserve, by commercial banks, and nonbank financial institutions. A bill rate that vacillates between two and ten percent, as the Treasury bill rate has in recent years, hints at much credit creation and cycle instability.

A prime rate is the percentage which banks charge their best and most credit-worthy customers. Although it also embodies the customer credit risk, it manifests the same value judgments as the bill rate. A brief comparison of the American prime rate with a few important foreign rates underscores the instability of the world cycle. While foreign rates are in a declining trend and the U.S. rate on a rising course, now at 8˝ percent, foreign funds continue to seek refuge and high returns in American credit markets. But what will happen when the foreign rates begin to reflect true rates, when they rise in reaction to the falsely low rates to which their monetary authorities have clung so long? Surely, they are bound to rise from present levels, in Japan from 1.375 percent, in Germany from 3 percent, in Switzerland from 3.125 percent, and in Britain from 5.5 percent. If nothing else would, they will puncture the bubble.

Hans F. Sennholz