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When Will the Bubble Burst?

Mises Daily: Wednesday, August 18, 1999 by


For several years the stock market has made major gains, adding up to what has probably been the greatest bull market in all of history. Setbacks that appeared threatening, such as those that occurred in April of 1997 and August/September of 1998, have proved temporary and have served merely as renewed buying opportunities. With each renewal of the upward trend, the conviction has grown that if one buys a diversified list of good stocks (and even many that are not so good), one simply cannot lose in the stock market, except temporarily. Indeed, the persistence and size of the gains has drawn a growing number of new players into the market--to the point where it is now common to hear stories about doctors, lawyers, accountants, and people in practically all other walks of life cutting back on their normal activities in order to devote time to day trading on the internet.

Clearly, something is wrong. It simply cannot be that we can have a society in which everybody lives by day trading in the stock market. While the stock market does make an important contribution to capital accumulation and the production of wealth, it is far from an unlimited one, and its contribution is not enlarged by hordes of essentially ignorant people dabbling in it on the basis of tips and hunches. Yet such an absurd outcome of practically everyone being able to live by means of buying stocks cheap and selling them dear is what is implied by an indefinite continuation of the bull market. As a result, it is inescapable that the bull market must end. Something must occur that will destroy the conviction that the stock market is an easy source of gains. That something, of course, will be a major and prolonged drop in the market, in which much of the gains that have been made in the last few years will be wiped out and in which millions of investors will rue the day that they began playing the stock market.

To understand precisely how and when this will come about, one needs to understand what has been feeding the current bull market. Then one can understand what will put an end to it--what will constitute pulling its foundation out from under it.

First of all, stock prices are determined in essentially the same way as the prices of anything else that exists in a limited supply at any given time, such as real estate, skilled and unskilled labor, paintings by old masters, and rare books and coins. That is, they are determined by the combination of their limited supply and the extent and intensity of the demand for them. What is directly and immediately responsible for the current bull market is a sustained and rapid increase in the demand for stocks. This increase in demand in turn has been the result of the repeated pouring into the market of large sums of new and additional money, created by the banking system under the umbrella of the Federal Reserve System and related government intervention.

What this means is that stock prices have been rising on the foundation of nothing more than an increase in the quantity of money. In essence, their rise is no different in principle than the rise in the prices of goods and services in San Francisco during the California gold rush. Then, new and additional gold money was being dug out of the ground in large quantities in the surrounding area and spent largely in San Francisco, with the result that at one point a single fresh egg sold for a whole gold dollar. Today, the new and additional money is paper, i.e., checkbook money, which is being rapidly created virtually out of thin air and is being spent mainly in the stock market, with the result of comparably high and, almost certainly, comparably fleeting valuations of many securities. Since December 1995, the money supply as measured by M2 has grown by almost twenty-five percent.[1] More significantly, the increase in checking deposits specifically of the kind commonly held with brokerage houses, i.e., so-called money-market-mutual-fund accounts, has been at double digit rates: 17.5% in both 1996 and 1997 and 29% in 1998.[2]

Of course, none of this is to say that an increase in the money supply is the only possible cause of a rise in the stock market or that it must always cause the stock market to rise. A higher degree of saving and provision for the future would also be capable of raising it. If the average person wanted to have greater accumulated savings relative to his current income and consumption, a substantial portion of the additional savings accumulated would undoubtedly be in the form of stocks.

Furthermore, the increase in the quantity of money exerts its favorable effect on stock prices only when, as in the last few years, the increase is concentrated in the stock market and has not yet sufficiently spread throughout the rest of the economic system. When it does spread throughout the economic system and begins substantially to raise commodity prices, the effect on the stock market becomes negative. This is because the effect of inflation at that stage is to undermine capital formation.

A leading way in which inflation undermines capital formation at that point is by subjecting business profits to sharply higher effective rates of taxation. For example, when a seemingly substantial rate of profit, say, twenty percent, is accompanied by a rise in the replacement prices of assets that is not much less, say, fifteen percent, and businesses must pay taxes of fifty percent on the whole of such profits, they end up with an after-tax return of only ten percent, while what they need merely in order to be able to replace their assets is an after-tax return of fifteen percent.

Such considerations help to explain the badly depressed stock market of the 1970s and the early part of the 1980s. Once inflation begins substantially raising prices, to quote what I have written elsewhere, "The customary forms of investment [such as the stock market] lose because of all of the ways in which inflation undermines capital formation. The customary forms of investment can be compared to the purchase of equipment which inflation will cause to end up as mere heaps of scrap iron [because of the lack of ability to replace assets]. At some point, of course, as the result of inflation, even the price of scrap iron in the future will be higher than the price of the equipment today. But when it is, the prices of everything else will obviously have increased by much more. Thus the purchaser of ordinary business assets, or any form of claim to such assets, ends up, on average, a major loser. He starts with the price of equipment, and ends with the price of scrap iron, while the prices of the things he wants to buy advance more or less in line with the price of replacement equipment. The example may be somewhat exaggerated, but it is correct in describing the nature of what happens. For such is the result of the taxation of funds required for replacement, of the prosperity delusion, of widespread malinvestment, of the loss of safety of all the traditional, conservative forms of investment, and of the withdrawal-of-wealth effect."[3]

It was precisely the substantial overcoming of such conditions since 1980 that helped greatly to restore the value of the stock market relative to the rest of the economic system. Starting around 1980, the Federal Reserve began systematically reducing the rate of increase in the money supply. The reduction in the rise in prices followed, as did a greatly increased ability to save and accumulate capital. This was the foundation of the stock market's recovery.

The rise in the stock market in the last few years, however, is not the result of any increase in the ability to save and accumulate capital. On the contrary, personal saving has been very low and has been declining even further in recent years--from an insignificant 2.5 percent of personal income in 1996, to 1.8 percent in 1997, to a barely existing .4 percent in 1998.[4] Most recently, in the spring of 1999, it has declined into actual negative territory. Similarly, no sudden vast burst of foreign investment in the United States can explain the stock market boom. Indeed, the increase in foreign private assets in the United States was substantially less in 1998 than in 1997.[5]

The only thing that explains the current stock market boom is the creation of new and additional money. New and additional money, created virtually out of thin air, has been entering the stock market in the financing of corporate mergers and acquisitions and of stock repurchases by corporations. Its consequent driving up of stock prices and concomitant creation of a sense of general enrichment is what is largely responsible for the decline in personal saving, inasmuch as it encourages people to consume in the belief that they are now substantially richer than they were before.

The connection between money creation and the financing of corporate mergers and acquisitions and of stock repurchases by corporations is that, under present conditions, to the extent that such activities are financed by loans from banks, what the banks lend out is not only funds obtained from savings deposits, which the depositors give up the right to spend so long as they continue to have their savings deposits, but also the far greater part of the funds obtained from checking deposits. In the case of checking deposits, the depositors have the right to spend the deposits themselves, which they do when they write checks. When the banks lend out the funds that created the checking deposits, the funds lent out represent new and additional spendable money. This is because the checking depositors continue to be able to spend their checking deposits and, in addition, the banks' borrowers obtain the right to spend the money that the checking depositors put into the banks. In other words, there are now two sums of spendable money where initially there was only one.

Not only does this new and additional money raise the prices of the stocks of the companies being acquired or of the companies engaged in buying back their shares. It also ultimately raises the prices of almost all other stocks as well. This is because the recipients of the new and additional money, who receive it in exchange for the sale of their shares, turn around and use all or most of it in the purchase of other shares, in the process driving up the prices of those other shares. The sellers of those other shares in turn use the proceeds to buy still other shares, driving up their prices. In effect, the new and additional money passes through the hands of successive sets of stock buyers, in the process driving up the prices of all of the stocks it exchanges for.

An important aspect of this process is that while the new and additional money begins as conventional checking deposits, it quickly sheds its initial character and assumes the form specifically of deposits in money-market-mutual-fund accounts, in which form the sellers of stocks readily hold it in preparation for their own subsequent stock purchases. The fact that money is being created specifically in the form of money-market-mutual-fund deposits is of further significance because unlike the case of conventional checking deposits, the Federal Reserve imposes no reserve requirements on such deposits. In the case of conventional checking deposits, there are legal reserve requirements, which have the effect of limiting the total volume of deposits created to roughly ten times the amount of currency and other reserves in the possession of the banks. In the case of money- market-mutual-fund accounts, however, there is no legal limit to the ratio of deposits to reserves.

The ability of any one injection of new and additional money to raise stock prices is limited. Eventually some substantial part of the new and additional money is absorbed into cash balances needed in order to finance trading activity at a higher level of stock prices. Furthermore some significant part of the new and additional money that originally entered the stock market is drawn away from it, in order to finance other areas of buying and selling. These other areas initially include such things as the purchase of houses and real estate and various luxuries, whose purchase takes place on the foundation of the financial gains achieved in the stock market. Probably even more importantly, the rise in stock prices encourages the sale of new stock and the incurrence of new business debt for the purpose of building new physical capacity. In effect, it becomes relatively less expensive to buy or build new plant and equipment rather than to acquire it by means of purchasing a controlling interest in the stock of other companies, which later is made more and more expensive as stock prices rise.

In these ways, funds move into the rest of the economic system, ultimately increasing the level of spending for virtually everything. Furthermore, it is implicit that the rise in stock prices resulting from any single injection of new and additional money must be followed by some significant reduction in the market's gains, once any substantial portion of that new and additional money has completed its passage through the stock market and moved on into the rest of the economic system.

What keeps the stock market rising is repeated and progressively larger injections of new and additional money of the kind described above. These further injections not only more than offset the inevitable movement of funds from the stock market to the rest of the economic system, but, by virtue of establishing a pattern of continuing gains in the stock market and thereby creating and sustaining the belief in the virtual inevitability of its gains, succeed in drawing into the market still more funds.

In its nature, the whole process is one of inflation and must serve to raise not only stock prices but prices throughout the economic system.[6]

Several times I have used the word "inflation" and now it is time to explain how my usage of the term differs from the one that has become customary.

Most people, and most commentators, use "inflation" as a synonym for generally rising prices, especially of consumers' goods. So long as prices on the whole are not rising, or are rising only modestly, it is assumed that there is no inflation, or only very little inflation.

I believe that such a procedure is comparable to saying that so long as someone shows no visible signs of illness, he has no illness--that his illness begins only when its symptoms become unmistakable.

In contrast, my view, and that of the British classical economists and of the economists who have comprised the Austrian school--from Adam Smith to Ludwig von Mises--is that inflation does not come into existence when prices start rising noticeably, any more than heart disease or cancer come into existence when a person finally has a heart attack or experiences the acute symptoms of cancer. On the contrary, these diseases are already well advanced before their obvious symptoms appear. Just so with inflation. Inflation is not the rise in prices. Rather, it is the undue increase in the quantity of money, which operates ultimately to cause a rise in prices.

Thus, in my view, the rates of increase in the money supply we have had in recent years constitute substantial inflation in and of themselves. And this substantial inflation has indeed already caused a substantial rise in prices, namely, the rise in the prices of stocks and, to a lesser extent, the rise in real estate prices.

Up to now, much or most of a general rise in prices has been postponed by a variety of factors that have served to increase the supply of goods and thus to hold down their prices. These have included an increase in the number of workers employed, not only absolutely but also relatively to the population as a whole. This has been reflected in rising rates of participation in the labor force (particularly on the part of married women) and in a declining rate of unemployment. At the same time, there has been an apparent acceleration in the rise in the average productivity of labor. Both of these factors--more work being done and done more productively--have served to more rapidly increase the supply of goods and services at the same time that a more rapid increase in the quantity of money has served to accelerate the increase in the monetary demand for goods and services.

In addition, the general rise in prices has been slowed as the result of a virtual depression in much of Asia, Latin America, and the former Soviet Union in 1997 and 1998. In sharply reducing demand from these areas, their depression served substantially to increase the supply of many internationally traded commodities that was made available in the United States and correspondingly to reduce their prices in the United States. The ability of this factor further to reduce prices, of course, must end as soon as those foreign economies stabilize and, indeed, it will be thrown into reverse as soon as those economies begin to recover and thus to increase their demand for internationally traded commodities. That will serve to reduce the supplies of internationally traded commodities in the United States and correspondingly to restore their prices in the United States. In fact, it appears that the recovery of important foreign economies is already underway. Of course, without increases in foreign supplies, the rise in domestic demand in the United States will exert greater upward force on prices. The upward pressure will be compounded by any decrease in foreign supplies.

Similarly, once the decline in the unemployment rate comes to an end, which soon it must do, given that it is already at little more than four percent, that factor can no longer serve to increase the production and supply of goods and services and thus to retard the rise in prices. Indeed, a more rapid rise in the demand for labor in the face of a supply of labor that increases more slowly must serve to accelerate the rise in wage rates, with corresponding implications for prices.

Perhaps most important of all, however, is the fact that the rise in the rate of spending to buy goods and services has thus far lagged far behind the rise in demand for stocks and in stock prices and that this cannot continue indefinitely. Eventually, the two rates of increase in demand must more and more tend to coincide. The process can be understood as roughly analogous to that of filling a bathtub with water. At first, only the tub fills. But if one leaves the water running, the tub will soon overflow and water will start to fill the whole house. If one wants to avoid flooding the house, one must turn off the water. But when one does that, the tub stops filling.

The application to the stock market is that the market will stop rising as soon as the Federal Reserve becomes sufficiently alarmed about the inflationary flooding of the economy as a whole that emanates from the stock market bathtub so to speak. When the Federal Reserve is finally moved to turn off the water--the new and additional money--flowing into the stock market, its rise will be at an end. Indeed, not only will the stock market stop rising, it will necessarily suffer a sharp fall.

The fall must result from a combination of money leaving the stock market for the rest of the economic system, for the reasons already explained, and from the fact that a substantial part of the valuation of the stock market now reflects the anticipation of its continuing to rise. As soon as it becomes clear that the rise is over, at least for a very long time to come, the market will necessarily fall. It will fall simply because it can no longer be expected to go on rising.

In order to understand more precisely why the stock market simply cannot go on rising as it has without prices exploding in the rest of the economic system, one need only realize two things. The first is that in order to keep the stock market rising at any given rate on the basis of new and additional money coming into it, the magnitude of that new and additional money must become greater and greater. The second is that so long as the stock market rises not only absolutely but also relatively to the rest of the economic system, as reflected in such a measure as the ratio of the combined value of all outstanding shares to Gross Domestic Product (GDP), the magnitude of any given percentage increase in the quantity of money and volume of spending in the stock market necessarily looms larger in relation to the economic system as a whole. As a result, the rate of increase in the quantity of money and volume of spending in the economic system as a whole grows and it becomes progressively more urgent to shut off the inflationary flow.

The extent to which the rate of increase in the stock market in the last several years is unsustainable without the accompaniment of rapidly rising prices can be inferred by estimating the long-term sustainable rate of increase in the production and supply of consumers' goods and services from year to year. If, for example, the production and supply of consumers' goods and services could go on increasing at a rate of, say, three percent per year, then it would be possible every year to have a three percent increase in the quantity of money and volume of spending in the economic system without prices rising.

(The conclusion of no rise in prices follows because one can think of the general consumer price level as obeying a simple arithmetical formula, in which the average of the prices at which goods and services are sold is equal to the amount of money spent to buy them, divided by the quantity of them sold.

This is a very easy formula to understand in the case of a single good. For example, the average price at which a can of soda was sold last week in the supermarket nearest to one's home is arithmetically equal to the amount of money spent by the store's customers in buying cans of soda from it, divided by the number of cans they bought from it. The formula obviously applies to the average price at which any individual good is sold at any given location over any given period of time--for example, to the average price at which a given bookstore sold its books over the course of a month, and to the average price at which new automobiles were sold by a given dealership over the course of a year. At the level of the economy as a whole, i.e., at the level of aggregate demand and aggregate supply, the trick is to conceive of the sum of all consumers' goods and services together, from aerosol cans to zebra skins, as representing some definite overall quantity of consumers' goods and services, i.e., as some definite number of abstract units of supply, which is then divided into the overall volume of consumer spending to buy goods and services. In fact, everyone already thinks in terms of such abstract units of supply every time he expresses a thought such as the supply of goods and services produced in the United States is larger than the supply of goods and services produced in Canada or in Great Britain, or that it is larger in the United States of today than it was in the United States of a generation ago.

I apologize for the digression. However, many people find it necessary.)

Returning to the present instance of three percent more spending buying three percent more goods and services, it would be a case of dividing 1.03 by 1.03. As a result, the quotient--the general consumer price level--would remain the same.

At the same time, however, the effect of the same three percent rate of increase in the quantity of money and volume of spending operating in the stock market would be to tend to raise the combined value of all outstanding shares by three percent (either stock prices would tend actually to rise by three percent or there could be three percent more outstanding shares with the same average price per share, or any combination of a change in share prices times number of shares outstanding resulting in a three percent increase in the aggregate value of outstanding shares). In this way, the stock market could rise three percent per year, and there would be no rise in the general average of prices of consumers' goods and services.

If the production and supply of goods and services could be made to increase more rapidly, say, at four percent or five percent per year, then the increase in the quantity of money and volume of spending in the economy that would be compatible with no rise in the general price level would be that much greater. At the same time the greater increase in the quantity of money and volume of spending operating in the stock market would be to tend to raise the total value of all outstanding shares by that higher percentage. Thus, the stock market could rise more rapidly and the greater gains would still be real in terms of buying power, for prices of goods and services would still not rise on average.

However, it should be obvious that given any reasonable assumptions about the rate of increase in the production and supply of goods and services, continuation of the ten- or twenty- percent annual increases in the stock market of recent years is absolutely impossible without prices rising to the extent to which ten or twenty percent exceeds the rate of increase in production and supply. This is because the money needed to go on raising the stock market must increasingly show up in a rising demand for goods and services that will far outstrip the increase in their supply. In the long run, a three percent annual increase in production and supply is compatible with stock prices rising twenty percent a year only if prices in general rise on the order of the seventeen-percent-a-year difference. For that will come to be the difference between the rise in the spending to buy goods and services and the increase in the quantity of goods and services sold. In other words, if one divides 1.2 by 1.03, the quotient, which, of course, represents the general consumer price level, equals approximately 1.17, which represents a rise in prices of approximately seventeen percent.

To be sure, in the context of today's situation, as soon as consumer prices did begin to rise at any significant rate, the actual effect would almost certainly be a sharp drop in the stock market. That is because, if for no other reason, the rise in prices would be expected to cause the Federal Reserve to sharply curtail the increase in the quantity of money in general and the increase entering the stock market in particular. And even if the Federal Reserve went on with the inflation, the negative effects of such sustained substantial inflation on capital accumulation would be to make the stock market sharply fall relative to the rest of the economic system and, for a time no doubt, absolutely as well, for the reasons previously explained.

The inescapable implication is that sooner or later, the stock-market boom must end. The bubble must break. It would almost certainly have ended in the Fall of 1998 with the failure of Long- Term Capital Management, had the Federal Reserve not arranged for its rescue and quickly re-accelerated its own policy of money creation.

That event, it must be stressed, shows the extent to which the Federal Reserve has become a highly politicized institution. Today, millions, perhaps tens of millions, of American citizens see their financial well-being as intimately bound up with the stock market and want the boom to continue. They also see the Federal Reserve as having the power to give them what they want, by means of continuing an easy money policy. The people's representatives see matters the same way and are in a position to impose their will on the Federal Reserve, by means of changing the laws under which it operates. In the circumstances, the Federal Reserve has chosen to yield to the wishes of the mob and to go on increasing the quantity of money in order to keep the boom alive. Its recent decision, at the end of June of 1999, to enact a merely token rise of a quarter of one percent in the federal funds rate and then to declare in effect that it sees no need at present to be further concerned with inflation, is a confirmation of its policy of continued rapid money creation--i.e., of continued inflation.

As a result, the stock market boom can probably not be expected to end until it becomes clear that the general level of consumer prices is once again rising at a more substantial rate and is likely to further accelerate. Then, hopefully, the Federal Reserve will at last choke off the inflation of the money supply. By that time, the stock market will almost certainly fall whether the Federal Reserve does so or not, because of the perception of the negative effects of inflation on capital accumulation.

How far the stock market will fall cannot be scientifically predicted except to say that in the nature of things the fall must be great enough to destroy the conviction that the stock market is an easy source of gains.

The end of the stock-market boom is something earnestly to be desired. This is because its continuation entails a growing state of mania, in which fortunes are created without any rational cause, merely by virtue of the pressure of a flood of money seeking outlet in channels no more real than empty hopes and dreams, and in which increasing numbers of otherwise highly intelligent and perfectly sane people are lured into sacrificing the serious work of their chosen occupations to the pursuit of such causeless and ultimately ephemeral wealth.

At the same time, because the mere inflation-induced appearance of wealth is made to substitute for the fact of wealth, the boom gives rise to a consumption that takes place at the expense of essential saving and capital accumulation and thus serves ultimately to cause impoverishment. Indeed, it may well be that the sudden appearance of prospective government budget surpluses, and the eagerness to devote them to new and additional government programs, will turn out to be one of the leading forms of such destructive consumption, whose actual nature and real cost will become apparent once the boom ends. The continuation of the boom means the return of the kind of problems experienced in the United States in the 1970s and early 1980s.


1. M2 is by no means a perfect or even a very good measure of the money supply, but it is better than M1 has been for the last several years.

2. All the above calculations are based on data appearing in the Federal Reserve Bulletin, June 1999, p. A13.

3. George Reisman, Capitalism: A Treatise on Economics, p. 951. See also ibid., pp. 930-938.

4. Calculations are based on data appearing in Federal Reserve Bulletin, ibid., p. A49.

5. See ibid., p. A50.

6. My analysis of inflation and of its uneven effects in raising prices is essentially that of Ludwig von Mises, who always stressed that inflation never raises all prices at the same time and to the same extent, but rather moves through the economic system unevenly and over time. See, for example, his discussion in Human Action (Chicago: Henry Regnery Company, 1966) pp. 416-424.

George Reisman is Professor of Economics at Pepperdine University's Graziadio School of Business and Management and is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996).

This article is copyright 1999 George Reisman and the Jefferson School and is reprinted here with permission of the author.

See also the business cycle section of the Austrian Study Guide.