The Conclusion: November 1986 295 be formulated by the user; the model provides only a general hy- pothesis about prevailing market expectations-namely, that they are likely to prove self-defeating. The user's own prediction may turn out to be false; if so, it is up to him to correct it. When he is a participant in financial markets, he has a stronb financial incentive to do so. In the case of financial advisers, academics, or politicians, it may be more advantageous to obfuschte one's mistakes than to admit them. The model can also be useful in that regard. Indeed, it could legiti- mately be asked whether I have tried to cover up my inability to predict the course of events by creating the "brink" model. If so, I shall pay a heavy price, because I intend to use the model in dealing with the renewed bull market. That is to say, I operate on the assumption that we are in a 1929-type bull market which will, however, abort long before it reaches the lofty heights of 1929. Clearly, there is a loag way to go before the internal dynamics -or, more accurately, dialectics-of the market render it ripe for a reversal. If anything, the correction in the second half of 1986, coupled with the further decline of the dollar, has extended the "natural" life span of the boom. If it is to be aborted again, the causes will have to be external. What these external constraints are has been amply discussed: a recession, coupled with protec- tionism, would be more dangerous than a buoyant economy. Eventually, the monetary authorities are unlikely to tolerate a runaway boom-but that point is a long way swab-at least as far as the U.S. stock market is concerned. Not so in Japan. The valuation of Japanese stocks has long ceased to bear any relevance to the fundamentals. Pricelearnings mu:tiples are excessive even h relation to the low and declining interest rates that prevail in Japan. Moreover, the reported earn- ings of many companies are artificially inflated by profits from stock transactions. The outlook for industrial profits is poor, and companies use their surplus cash to speculate in the stock market. Specialized funds have been set up to attract corporate investors, and they have been illegally promising a guaranteed minimum return. A governmental investigation of these so-called "tokkin funds" received a lot of publicity at the time of the stock market break of October 1986. Nevertheless, the market has recovered its poise and reached new highs early in 1987. How far can the boom go? Just as Italy was the market to watch for impending trouble in 1986, in 1987 it is Japan. 296 The Real-Time Experiment The Japanese stock market is fueled by liquidity and the liquid- ' ity is generated by the combination of a weak economy and a strong yen. When either Japanese or non-Japanese holders of dol- lars convert them into yen, some of those yen find their way into the stock market. The tendency is particularly strong when the yen are supplied by the central bank in an endeavor to keep the exchange rate from rising. When the central bank is not involved, there is at least a chance that the sellers of yen sell, or fail to buy, Japanese stocks in order to acquire assets denominated in dollars. The Japanese government has engaged in a campaign to encour- age investment abroad and, on the whole, it has been very suc- cessh!: capitc;! outflows consistently exceed the trade surplus. The yen continues to strengthen only because of an inflow of 1 foreign capital and hedging by Japanese investors. Once market participants gain conviction that the trend is changing, they re- duce their hedging, and the yen falls of its own accord. That is what happened last October, although the break in the stock mar- ket preceded the decline of the yen. It is likely to happen again. Since the end of the year, the upward pressure on the yen has built up again and the stock market boom gained a new lease on life. When the pressure abates, involuntary selling by the Bank of Japan will be replaced by voluntary selling by holders of yen. That is when the pool .of liquidity will spring a leak. Given the inflated level of stocks prices, a decline could easily turn into a rout. There is a noteworthy similarity between the position of Japan today and that of the United States in the 1920s: it is emerging as the leading economic power and its stock market is less seasoned than that of the mature economies. But that is where the simflarity ends. The Japanese authorities have a tradition of intervention and a firm grip on the participants in financial markets. Once before, in 1965, when the stock market collapsed, the government set up a corporation to buy, and hold, shares dumped on the market by distressed holders. Nineteen twenty-nine is not likely to repeat itself, even in Japan. The initial impact of a decline in the Japanese stock market could well be positive for other markets because it is likely to be associated with a wholesale movement of funds from the Japanese to other stock markets. But if the decline turns into a rout, it is bound to send a shiver through the world. PART FOUR [...]... aim at the optimum allocation of resources has dominated political thought-and political action-since the middle of the nineteenth century Those on the left wanted the State to take charge of the allocation; those on the right wanted to leave it to the market mechanism Under the influence of Marxism, the pursuit of the optimum led to the total abandonment of the market mechanism in large parts of the. .. reflect the same concerns; otherwise my false expectations could not have proven so rewarding This raises an interesting possibility Perhaps some of the developments I predicted were preempted by the very fact that they were anticipated by the market and the market provoked a reaction that prevented them from happening This seems to hold true of the collapse of the banking system and of the collapse of the. .. the distortions are far worse than the excesses of the market Winston Churchill once said that democracy is the worst form of government except for all the others The same can be said about the market mechanism: it is the worst system of allocating resources except for all the others Indeed, there are significant similarities between the election mechanism and the market mechanism It would be difficult... science by making more unconditional predictions This has the operational effect of endangering the pursuit of truth in the study of social phenomena As long as the doctrine of the unity of science prevails, there is a direct conflict between the pursuit of truth and the pursuit of operational success It can be resolved only by renouncing the doctrine I have managed to claim exemption from the rigorous... international financial markets Some of these instabilities are caused by economic policies and can be altered only by pursuing different ones; others are inherent in the prevailing system and can be cured%nly by changing the system We can take as an example of the first kind of imbalance the desire of the Japanese to produce more than they consume and the apparent desire of the United States to consume... the collapse of the dollar, and also of the "bull market of our lifetime," which was to be followed by a crash 192 9 style The monetary authorities became so concerned about the excessive buoyancy of financial markets that in the end they refused to supply the excess liquidity that would create a speculative bubble Their action was neither deliberate nor unanimous In the U.S., Volcker was opposed to providing... influencs the course of events by making statements about it and the situation of the social scientist would be no different from that of the natural scientist It is the participants' thinking that creates the problems The structure of events that have no thinking participants is simple: one fact follows another in an unending causal chain The presence of thinking participants complicates the structure of. .. convention for the study of social phenomena Instead of demanding that contribdtions be cast in the D-N mold in order to qualify as scientific, theories of the D-N type would be treated as a form of social alchemy The convention would not automatically disqualify every theory, prediction, or explanation that claims scientific status but it would put the burden of proof on them to justify their claim It... that the market is always right there is little to be gained from having a feedback mechanism because the prospect of outperforming the market becomes a matter of pure chance, As I shall argue in Chapter 17, the contention of classical economic theory that the market mechanism assures the optimum 306 t t Evaluation allocation of resources is false; its true merit is that it provides a criterion by which... requirements of the D-N model by renouncing the doctrine of the unity of science I went even further: I asserted that the pursuit of truth prohibits unconditional predictions Does that mean that the kinds of conjectures I produced are the best that can be hoped for? Certainly not The real-time experiment is best regarded as an amateur effort that ought to be improved upon when the appropriate professional . true of the collapse of the banking system and of the collapse of the dollar, and also of the "bull market of our lifetime," which was to be followed by a crash 192 9 style. The. Size of Fund Dec. 31, 198 4 $3,057. 79 $488 ,99 8,187 Dec. 31, 198 5 $6,760. 59 + 121.1% $1,003,502,000 Dec. 31, 198 6 $9, 699 .41 + 43.5% $1,567,1 09, 000* Mar. 31, 198 7 $12,554.16 + 29. 4% $2,075,6 79, 000*. financial markets operate. That means that the markets themselves can be viewed as formulating hypotheses about the future and then sub- mitting them to the test of the actual course of events. The