And so the stock market bubble pops, as we said in an interview with the BBC and with Reuters exactly one month ago, like a light turned on at last call in a dive bar. One's companions seem suddenly far less attractive and witty than just moments before. 

Just how ugly and stupid are we all going to look once we sober up from a four-year credit binge and stock market bubble? That depends on how much leverage there was in the market when the crash began. We won't know the answer for a few weeks. But, as the title suggests, that's not the point of this story. 

Last weekend, between pints of Maalox, equity investors feverishly flipped newspaper pages and TV channels to an endless stream of theories on the cause of the worldwide stock market crash now in progress (the Nikkei is down 8.5% at this writing). 

The question on the minds of the experienced and opportunistic: Is this the run-of-the-mill worldwide financial panic we predicted in March? Blood-in-the-streets buying opportunities for the levelheaded with dry powder, as in 1987, when the market ended up for the year? 

Or is this The Big One, the collapse of a complex and highly leveraged financial system due to the combined folly of millions of speculators drunk on paper profits gambling a quarter trillion dollars of margin debt? 

If the latter's the case, what is the Fed likely to do? For instruction, turn to the words of Alan Greenspan as he spoke to the House Committee on Banking and Financial Services following the LTCM fiasco (October 1, 1998). 

In the interest of comprehensibility, we offer plain English translation in parentheses.

"Quickly unwinding a complicated portfolio that contains exposure to all manner of risks (stupid bets), such as that of LTCM, in such market conditions amounts to conducting a fire sale. The prices received in a time of stress do not reflect longer run potential, adding to the losses incurred. Of course, a fire sale that transfers wealth from one set of sophisticated market players to another (a bunch of really rich guys to another bunch of really rich guys), without any impact on the financial system overall (without destroying the markets for everyone else), should not be a concern for the central bank." 

This is no normal market crash. It represents the collapse of a very large asset bubble. 

In other words, the Fed has to bail the system out, even when the source of systemic risk is a bunch of morons playing the world financial system for a few billion bucks. Otherwise we can't have a sophisticated economic system. Presumably instead we'd wind up with an unsophisticated one, perhaps drawn by oxen. 

Certainly millions of clever institutional investors and Joe Sixpack speculators, blithely heaving buckets of cash into the Nasdaq cash disposal and now going down the drain together deserve the same protection as rich speculators if the systemic risks they pose are similar. Maybe it's fair to hope for a 1987-type outcome, citing the power of the Fed to rescue the markets, the tendency for the Fed to do so in an election year, the strong "fundamentals" of the U.S. economy, the apparent resiliency of world financial markets, and so on. But the truth is that we will not know until the crash has run its course. But, of course, we have a theory. We believe that this crash is the result of the market pricing in a long overdue U.S. recession. 

We have no hard evidence of this, and won't until long after the recession has been in progress. But there's strong circumstantial evidence. Ask around, you'll find some, too. Recessions start in people's heads. 

Just as a market crash starts when someone, for some reason, starts to sell, recessions start when people stop buying things. Houses, cars, microwave ovens, beanie babies... stuff. Perhaps they have decided they have enough stuff. Maybe their credit card debts are getting out of hand. Or they somehow sense that they may not have the income in the future to pay debts. 

No one really knows. 

All we know is that friends who sell houses and mortgages, design additions to houses, sell cars and furniture, and so on, say that business has been falling off, inexplicably and rather suddenly, starting in March. 

We're old enough to recall the significance in hindsight of these kinds of conversations in the past, so we decided to ask around. Lo and behold, from coast to coast business seems to be falling off. Historically, market crashes presage recessions about 80% of the time. That's why the 1987 crash was such a pleasant surprise. With its quick rebound, 1987 was probably an exception, just as The Great Depression was also likely an aberration in the other direction. 

The average recession in the U.S. over the past 50 years is 18 months long. In the scheme of things, no big deal. But the recession we think will be traced to Q2 2000 is likely to be longer than the average and accelerated by several factors. This is no normal market crash. It represents the collapse of a very large asset bubble. 

The bubble took over where the bull market ended in 1996, meaning it's been developing for over four years. The market would have likely become a brief bear and the economy mildly recessionary if not for the largesse of the Fed since 1996. That means the markets are due to fall below 1996 levels, with intermittent rallies that may last for weeks or months, before the markets begin to recover in earnest. 

That puts the Dow around 5000 and the Nasdaq around 1000 at the bottom. We'll see the Dow at 10,000 again in, say, 2010. Needless to say, the U.S. economy will not be looking quite so bright to foreign investors on the way down. Certainty of repayment of the trillions the U.S. owes the world may be questioned. In return for the added default risk, the world will ask for a better return, meaning higher interest rates. 

The Fed has a choice of two evils: 

A) Lots of credit defaults, credit contraction and a shrinking money supply, rocketing unemployment, rising real incomes for the few that have jobs, a strong dollar and stable or falling prices 

B) Fewer credit defaults, less credit contraction, a steadily growing (ideally) money supply, less unemployment, and rising nominal wages for those who have jobs (more than in the deflation case) and prices rising faster than wages. 

If you believe that the Fed has a choice, B looks a whole lot better. 

True, inflation lowers real return on capital and hurts creditors, and the rich and the financial community have pull in elections. But inflationary government spending is much more politically viable than the alternative. As was discovered in the 1930s, the unemployed, who greatly outnumber owners of capital, vote for jobs and increased nominal wages -- in other words, for inflationary government programs.
 

Further, the Japanese experience with hyperinflation after WWII is as deeply imbedded in the culture, just as post-Depression deflation is in the U.S. culture. A rate of inflation that is acceptable in the U.S. may cause Japanese savers to flee yen-denominated assets. With trillions of yen in savings to fall back on before the bubble burst, the Japanese have been able to take a deflationary approach with little risk of creating either a deflationary spiral or exposing the yen to exchange-rate risk. The U..S experience with The Great Depression makes the U.S. intolerant of deflation, which may quickly take on a life of its own and run out of control. 

In a deflationary environment, few want to pay back debts with more expensive dollars later and credit-worthy borrowers are few, so borrowing and lending grinds to a halt. Purchasing slows as everyone waits for the next price reduction before buying. Redistribution of wealth via taxation is not so viable in the U.S., where economic equality is not a widely accepted political goal. Inflation is the most politically viable method of redistributing wealth from creditors and owners of capital to wage earners in the U.S. after the recession gets underway. 

Inflation allows more wage earners (voters) to stay employed and gives them the perception of increasing wealth, even though real incomes are falling, since prices will rise faster than incomes. Inflation also spurs further spending, as purchases are made in anticipation of future higher prices. Inflation also allows debts to be paid off quickly with cheap dollars. 

Best of all, unlike taxation, inflation can be created by the "independent" Fed without any politician having to explain to his or her constituency why they voted for it. The Fed makes itself the whipping boy for a few years. Better yet, a fall guy appears, such as OPEC or, in the present case, all those foreigners turning in their dollar-denominated assets for cash in their own currency. 

Maybe that's why Greenspan decided to stay on, as penance for allowing the bubble to develop in the first place.
 

• Ouch: No Nasdaq Bottom Yet

The Blair Hull Project - how a single trader turned the last big crash around
• David Peterschmidt, CEO of Inktomi

This fighter pilot flies a different mission: Navigating one of the Net's very best companies 
• Good vs. Not-So-Good in Cyberspace

The SEC is always outnumbered and always outgunned -- but they still catch quite a few bad guys
• Making Tracks Riding Greenbacks

A lone world traveler recounts his days as a self-made currency speculator 
• Report from the Broadband Summit

I saw the best minds of my generation talking about compelling content