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Vernon Smith, professor of economics at the Interdisciplinary Center for Economic Science at George Mason University, was awarded the Nobel prize in economics in 2002 for his pioneering research on the behavior of financial markets and alternative market mechanisms. He spoke with GEV editor Nathan Gardels on Jan. 14, 2003.

Looking down the road, where do you see financial markets headed?

VERNON SMITH: I'm optimistic. I'm a buyer. Especially since late December. Will stocks go lower? Maybe. But they are certainly lower now than they were two years ago. And it appears lately that a lot of people have been holding back. They haven't been buying yet, perhaps. But they haven't been selling. To me, that is an invitation to start putting more money in the market.

This is classic economics. We've been through a crash, following a big bubble. In the 19th century, the bubble was built on the steam engine and the locomotive. Railroad stocks got overextended. Then there was a shakeout. A lot of companies went bankrupt. But a great deal of long-term value was created for the economy.

Then, in the 20th century, came automobiles, electric power and telephones. Another bubble, more bankruptcies and a shakeout -- with great value added to the economy after it all.

I'm from the American Midwest, from Witchita, Kan. In the 1920s, light-plane manufacturing emerged. In 1929, at the time of the Great Crash, there were 11 light-plane manufacturers in Witchita. After the shakeout, only two or three were left standing -- Beechcraft, Cessna and, years later, Lear Jet.

That is the history. It happens over and over. And it is happening again.

Investors have always been over-optimistic about their ability to pick winners. Personally, I didn't invest in the bubble with all those sky-high prices for companies with no earnings. I stayed away. But, clearly, if you were agile and knew what you were doing, you might have made money.

Today, the market has picked the winners, and great values are out there for the picking. In fact, a lot of these New Economy information companies that went bankrupt have greatly benefited the Old Economy. The new diesel engine now manufactured by Cummins Diesel -- with computer control of every cylinder -- is just remarkable.

Clearly, this cycle of innovation is not over. It will come back as people throw new money at the surviving companies. I'm looking for bargains, now.

GEV: Historically, it took the stock market more than a decade to recover its values after the 1929 crash. Are we looking at the same long, slow climb back?

SMITH: That is true. But there were a huge number of complicating factors then. We didn't know to run the monetary system. Then, the banking and monetary system was very rigid and exacerbated the disaster. These days, (Federal Reserve Chairman) Alan Greenspan has done a good job, and Paul Volcker before him who, painfully, put the brakes on inflation.

Look, today, we have had a boom in the economy and a stock market crash without inflation. That doesn't mean this downturn has not been painful. But it means the recovery is coming much more quickly.

GEV: How will the Bush economic plan -- centered on cutting dividend taxes -- affect the stock market?

SMITH: I always welcome tax breaks because they get more money in the hands of private consumers and investors. I would favor this whether we need a stimulation or not.

The double taxation of dividends is something we should have gotten rid of a long time ago. It is essentially a tax on investment. The evidence is that dividend payouts are the type of income an investor readily re-invests.

The Bush policy will positively affect the stock market -- we've already seen prices move upward.

Further, it will have the effect of making value stand out in the market. Most new issues of stock don't pay dividends for the simple reason that few new companies are making any money, at least for several years. Removing dividend taxes restores the incentive to buy the more established, solid companies in the market. Their clear values relative to other stocks will be reflected in the market without ''tax bias,'' attracting buyers and pushing the overall market up.

The Bush provision for expensing -- or writing off -- capital expenditures will also help boost the solid companies. I have long opposed the idea that you can write advertising or training off as an investment, but not the bricks and mortar of the factories and refineries.

GEV: You've also written extensively on extending the market mechanism to new areas that had been regulated. What is the key frontier you see here?

SMITH: Electric power production is the area where I think the market can do the most good. The essential issue in liberalizing electric power is the importance of freeing up entry into retail competition for energy provision. There is very inadequate ''demand responsivity.''

For new investment in monitoring and switching infrastructure -- such as real time meters in homes -- the consumer must have an incentive to go for the lowest price of electricity or to consume in off-peak hours.

Here is the problem: generators, transformers and transmission wires for most utility systems today are built to accommodate peak consumption, not average consumption of energy. Government control and regulation have thus stimulated more investment in supply than the market would have yielded based on actual average use by the consumer.

In the hotel business, for example, investors don't build enough hotels in Washington, D.C., say, to house everyone on the peak day of the peak season. They hold back and use prices -- they slash rates off peak and jack them up on peak. It is the increase on peak when you make your return on capital.

Across the world, in electric-power production, we need market-designed systems sensitive to the needs of investors who can come in and compete with the local monopoly that is either state owned or has a rate-based system centered on building out a whole system to meet peak capacity -- even when they don't need it. You need to separate ''wires'' -- the transmission infrastructure -- from the energy price itself.

(c) 2002, Global Economic Viewpoint. Distributed by Tribune Media Services International.
For immediate release (Distributed 1/15/03)

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