THE ECONOM ICS OF EUPHORIA

In the mid­1960s the U.S. economy exper i enced a change of state. Political leaders and offi cial econom ists announced that the economic system had entered upon a new era that was to be char ac ter ized by the end of the busi­

ness cycle as it had been known.8 Starting then, cycles, if any, were to be in the posit ive rate of growth of income. The doctrine of “fine tuning” went further and asser ted that even reces sions in the rate of growth of income could be avoided. Contemporary busi ness comments were consist ent with these offi cial views.

The substance of the change of state was an invest ment boom: in each year from 1963 through 1966 the rate of increase of invest ment by corpor ate busi ness rose.9 By the mid­1960s busi ness invest ment was guided by a belief that the future prom ised perpetual expan sion. An economy that is ruled by such expect a tions and that exhib its such invest ment beha vior can prop erly be labeled euphoric.

Consider the value of a going concern. Expected gross profits after taxes reflect the expec ted beha vior of the economy, as well as expec ted market and manage ment devel op ments. Two imme di ate consequences follow if the expect a tion of a normal busi ness cycle is replaced by the expect a tion of steady growth. First, those gross profits in the present­value calcu la tions that had reflec ted expec ted reces sions are replaced by those that reflect continu ing expan sion. Simultaneously there is less uncer tainty about the future beha­

vior of the economy. As the belief in the reality of a new era emerges, the decrease in the expec ted down or short time for plant and equip ment raises their present values. The confid ent expect a tion of a steady stream of prosper ity gross profits makes port fo lio plunging more appeal ing to firm decision­makers.

A sharp rise in expec ted returns from real capital makes the economy short of capital overnight. The will ing ness to assume liab il ity struc tures that are less defens ive and to take what would have been considered in earlier

times, undesir able chances in order to finance the acquis i tion of addi tional capital goods means that this short age of capital will be trans formed into demand for finan cial resources.

Those that supply finan cial resources live in the same expect a tional climate as those that demand them. In the several finan cial markets, once a change in expect a tions occurs, demanders, with liab il ity struc tures that previ ously would in the view of the suppli ers have made them ineligible for accom mod a tions, become quite accept able. Thus, the supply condi tions for finan cing the acquis i tions of real capital improve simul tan eously with an increase in the will ing ness to emit liab il it ies to finance such acquis i tions.

Such an expan sion ary new era is destabil iz ing in three senses. One is that it quite rapidly raises the value of exist ing capital. The second is an increase in the will ing ness to finance the acquis i tion of real capital by emit ting what, previ ously, would have been considered as high­cost liab il it ies, where the cost of liab il it ies includes risk or uncer tainty borne by the liab il ity emitter (borrower’s risk). The third is the accept ance by lenders of assets that earlier would have been considered low­yield—when the yield is adjus ted to allow for the risks borne by the asset acquirer (lender’s risk).10

These concepts can be made more precise. The present value of a set of capital goods collec ted in a firm reflects that firm’s expec ted gross profits after taxes. For all enter prises there is a pattern of how the busi ness cycles of history have affected their gross profits. Initially the present value reflects this past cyclical pattern. For example, with a short horizon

where Q1 is a prosper ity, Q2 is a reces sion, and Q3 is a recov ery gross profits after taxes, (Q2 < Q3 < Q1). With the new era expect a tions Q2′ and Q3′, prosper ity returns replace the depres sion and recov ery returns. As a result we have: V (new era) > V (tradi tional). This rise in the value of extant capital assets as collec ted in firms increases the prices that firms are willing to pay for addi tions to their capital assets.

Generally, the will ing ness to emit liab il it ies is constrained by the need to hedge or to protect the organ iz a tion against the occur rence of unfa vor able condi tions. Let us call Q2″ and Q3″ the gross profits after taxes if a possible, but not really expec ted, deep and long reces sion occurs. As a risk averter the port fo lio rule might be that the balance sheet struc ture must be such that even if Q2″ and Q3″ do occur no serious consequences will follow; Q2″ and

Accepting Accepting Accepting Accepting

Q3″—though not likely—are signi fic ant determ in ants of desired balance sheet struc ture.11 As a result of the euphoric change in “state,” the view grows that Q2″ and Q3″ are so unlikely that there is no need to protect the organ iz a tion against them. A liab il ity struc ture that was expens ive in terms of risk now becomes cheap when there were signi fic ant chances of Q2″ and Q3″ occur ring. The cost of capital or of finance by way of such liab il ity struc­

tures decreases.

Financial insti tu tions are simul tan eously demanders in one and suppli ers in another set of finan cial markets. Once euphoria sets in, they accept lia ­ bil ity struc tures—their own and those of borrow ers—that, in a more sober expect a tional climate, they would have rejec ted. Money and Treasury bills become poor assets to hold with the decline in the uncer tainty discount on assets whose returns depend upon the perform ance of the economy. The shift to euphoria increases the will ing ness of finan cial insti tu tions to acquire assets by enga ging in liquidity­decreasing port fo lio trans form a tions.

A euphoric new era means that an invest ment boom is combined with pervas ive liquidity­decreasing port fo lio trans form a tions. Money market interest rates rise because the demand for invest ment is increas ing, and the elasti city of this demand decreases with respect to market interest rates and contrac tual terms. In a complex finan cial system, it is possible to finance invest ment by port fo lio trans form a tions. Thus when a euphoric trans for ma­

tion of expect a tions takes place, in the short run the amount of invest ment financed can be inde pend ent of monet ary policy. The desire to expand and the will ing ness to finance expan sion by port fo lio changes can be so great that, unless there are serious side effects of feed backs, an infla tion ary explo­

sion becomes likely.

A euphoric boom economy is affected by the finan cial herit age of an earlier, more insec ure time. The world is not born anew each moment. Past port fo lio decisions and condi tions in finan cial markets are embod ied in the stock of finan cial instru ments. In partic u lar, a decrease in the market value of assets which embody protec tions against states of nature that are now considered unlikely to occur will take place, or altern at ively there is a rise in the interest rate that must be paid to induce port fo lios to hold newly created assets with these char ac ter ist ics. To the extent that such assets are long lived and held by deposit insti tu tions with short­term or demand liab il it ies, pres­

sures upon these deposit insti tu tions will accom pany the euphoric state of the economy. In addi tion the same change of state that led to the invest ment boom and to the increased will ing ness to emit debt affects the port fo lio

pref er ences of the holders of the liab il it ies of deposit insti tu tions. These insti tu tions must meet interest rate compet i tion at a time when the market value of the safety they sell has decreased; that is, their interest rates must rise by more than other rates.

The rising interest rate on safe assets during a euphoric boom puts strong pres sures on finan cial insti tu tions that offer protec tion and safety. The link­

ages between these deposit insti tu tions, conven tions as to finan cing arrange­

ments, and partic u lar real markets are such that sectoral depress ive pres sures are fed back from a boom to partic u lar markets; these depress ive pres sures are part of the mech an ism by which real resources are shifted.

The rise in interest rates places serious pres sures upon partic u lar finan cial inter me di ar ies. In the current (1966) era the savings and loan asso ci ations and the mutual savings banks, together with the closely related home­

build ing industry, seem to take a large part of the initial feed back pres sure.

It may be that addi tional feed back pres sures are on life insur ance and consumer finance compan ies.

A little under stood facet of how finan cial and real values are linked centers around the effect of stock market values.12 The value of real capital rises when the expect a tion that a reces sion will occur dimin ishes and this rise will be reflec ted in equity prices. The increased ratio of debt finan cing can also raise expec ted returns on equit ies. Inasmuch as owners of wealth live in the same expect a tional climate as corpor ate officers, port fo lio pref er ences shift toward equit ies as the belief in the possib il ity of reces sion or depres­

sion dimin ishes. Thus, a stock market boom feeds upon and feeds an invest­

ment boom.

The finan cing needs of the invest ment boom raise interest rates. This rise lowers the market value of long­term debt and adversely affects some finan­

cial insti tu tions. Higher interest rates also increase the cost of credit used to finance posi tions in equit ies. Initially, the compet i tion for funds among various finan cial sectors facil it ates the rapid expan sion of the economy; then as interest rates rise it constrains the profits of invest ing units and makes the carry ing of equit ies more expens ive. This first tends to lessen the rate of increase of equity prices and then to lower equity prices.

All in all, the euphoric period has a short lifespan. Local and sectoral depres sions and the fall in equity prices initi ate doubts as to whether a new era really has been achieved. A hedging of port fo lios and a recon sid er a tion of invest ment programs takes place. However, the port fo lio commit ments of the short euphoric era are fixed in liab il ity struc tures. The recon sid er a tion of

invest ment programs, the lagged effects upon other sectors from the resource­shifting pres sures, and the inelasti city of aggreg at ive supply that leads to increases in costs combine to yield a short fall of the income of invest ing units below the more optim istic of the euphoric expect a tions.

The result is a combin a tion of cash flow commit ments inher ited from the burst of euphoria and of cash flow receipts based upon lower­than­expected income. Whether the now less­desirable finan cial posi tions will be unwound without gener at ing signi fic ant shocks or whether a series of finan cial shocks will occur is not known. In either case, invest ment demand decreases from its euphoric levels. If the boom is unwound with little trouble, it becomes quite easy for the economy once again to enter a “new era”; on the other hand, if the unwind ing involves finan cial instabil ity, then there are prospects of deep depres sions and stag na tion.

The pertin ent aspects of a euphoric period can be char ac ter ized as follows:

1. The tight money of the euphoric period is due more to runaway demand than to constraint upon supply. Thus, those who weigh money supply heavily in estim at ing money market condi tions will be misled.

2. The run­up of short­ and long­term interest rates places pres sure on deposit savings inter me di ar ies and disrupts indus tries whose finan cial chan­

nels run through these inter me di ar ies. There is a feed back from euphoria to a constrained real demand in some sectors.

3. An essen tial aspect of a euphoric economy is the construc tion of lia ­ bil ity struc tures which imply payments that are closely artic u lated directly, or indir ectly via layer ings, to cash flows due to income produc tion. If the impact of the disrup tion of finan cing chan nels occurs after a signi fic ant build­up of tight finan cial posi tions, a further depress ive factor becomes effect ive.

III. CASH FLOwS

Financial crises take place because units need or desire more cash than is avail able from their usual sources and so they resort to unusual ways to raise cash. Various types of cash flows are iden ti fied in this section, and the rela­

tions among them as well as between cash flows and other char ac ter ist ics of the economy are examined.

The varying reli ab il ity of sources of cash is a well­known phenomenon in banking theory. For a unit, a source of cash may be reli able as long as there is no net market demand for cash upon it, and unre li able whenever there is such net demand upon the source. Under pres sure various finan cial and

nonfin an cial units may with draw, either by neces sity or because of a defens ive finan cial policy, from some finan cial markets. Such with draw als not only affect the poten tial vari ab il ity of prices in the market but also may disrupt busi ness connec tions. Both the ordin ary way of doing busi ness and standby and defens ive sources of cash can be affected.

Withdrawals on the supply side of finan cial markets may force demand ing units that were under no special strain and were not directly affected by finan cial strin gen cies to look for new finan cing connec tions. An initial disturb ance can cumu late through such third­party or innocent­bystander impacts. Financial market events that disrupt well­established finan cing chan nels affect the present value and cash flows of units not directly affected.13

For most consumers and nonfin an cial (ordin ary) busi ness firms the largest source of cash is from their current income. Wages and salar ies are the major source of cash to most consumers and sales of output are the major source for busi ness firms. For finan cial inter me di ar ies other than dealers, the ordin ary cash flow to the unit can be derived from its finan cial assets. For example, short­term busi ness debts in a commer cial bank’s port­

fo lio state the reserve money that borrow ers are commit ted to make avail­

able to the bank at the contract dates. A mort gage in a savings and loan asso ci ation’s port fo lio states the contrac tual “cash flow to” for various dates.

For finan cial market dealers cash receipts usually result from the selling out of their posi tion, rather than from the commit ments as stated in their invent ory of assets. Under ordin ary circum stances dealers as going concerns do not expect to sell out their posi tions; as they sell one set of assets they proceed to acquire a new set.

The ordin ary sources of cash for various classes of economic units will be called cash flow from oper a tions. All three types of cash flow from the oper­

a tions described—income, finan cial contracts, and turnover of invent ory—

can be considered as func tions of national income. The ability to meet payment commit ments depends upon the normal func tion ing of the income produc tion system.

In addi tion to cash flow from the sale of assets, dealers—and other finan­

cial and non­financial units—can meet cash drains due to the need to make payments on liab il it ies by emit ting new liab il it ies. This second source of cash is called the refin an cing of posi tions.

Furthermore, liquid at ing, or running off, a posi tion is the third possible way for some units to obtain cash. This is what retail ers and whole salers do

when they sell invent or ies (seasonal retail ers actu ally do liquid ate by selling out their posi tion).

The finan cial assets and liab il it ies of an economic unit can be trans formed into time series of contrac tual cash receipts and payments. The various items in these contrac tual receipts and payments depend upon national income:

the fulfill ment of the terms of mort gage contracts depends upon consumer dispos able income and so forth.14 Estimates of the direct and indir ect impact of vari ations in national income upon the ability of units in the various sectors to meet their finan cial commit ments can be derived.15

Each economic unit has its reserve, or emer gency, sources of cash. For many units the emer gency source consists of posi tions in some market able or redeem able assets. Savings bonds and time depos its are typical standby sources of cash for consumers. A corpor a tion may keep a reserve in Treasury bills or other money market instru ments to meet either unusual needs for cash or an unex pec ted short fall in cash receipts. Hoards of idle cash serve this purpose for all units. Cash has the special virtue that its avail ab il ity does not depend upon the normal func tion ing of any market.

In prin ciple the normal and second ary sources of cash for all units can be iden ti fied and their ratio to finan cial commit ments can be estim ated. By far the largest number of units use their income receipts to meet their finan cial commit ments. Mortgage and consumer install ment payments for consumers and interest and sinking fund payments for busi nesses would be financed normally by income cash flows.

The substi tu tion of a deposit by customer B for a deposit from customer A in a bank liab il ity struc ture may be viewed as the refin an cing of a posi tion.

The typical finan cial unit acquires cash to meet its payment commit ments, as stated in its liab il it ies, not from any cash flow from its assets or by selling assets but rather by emit ting substi tute liab il it ies. (The only finan cial organ­

iz a tions that seem to use cash flows from assets to meet cash flow commit­

ments are the closed­end invest ment trusts, both levered and un­levered.) When a unit that normally meets its finan cial commit ments by drawing upon an income cash flow finds it neces sary, or desir able, to refin ance its posi tion, addi tional pres sures may be placed upon finan cial insti tu tions.

Some finan cial rela tions are based upon the peri odic liquid a tion of posi tions—for example, the seasonal invent ory in retail ing. Capital market dealers or under writers liquid ate posi tions in one set of assets in order to acquire new assets. However, if organ iz a tions that normally finance their payments by using cash from either income or refin an cing of posi tions