The market volatility currently giving investors and economists anxiety pangs is a reminder to us about stocks. Just as in “Those Magnificent Men in their Flying Machines,” a movie about the early days of flying, “they go up tiddly up up, they go down tiddly down down.”
Amid unhelpful observations such as “the market was overdue for a correction,” there are a few thought-provoking explanations for the market’s recent volatile, downward biased, behavior. They are very different, though, and that tells us something about taking those who pretend to speak for the market too seriously.
The first of these explanations is that the correction was due to the era of easy money ending. Encouraging borrowing and money flow was our monetary policy to counter the forces of economic contraction following the Wall Street collapse and global financial crisis of 2008-2009.
Within this explanation is the idea that the Federal Reserve’s reducing its portfolio of U.S. Treasury bonds purchased during the recession would increase interest rates. A secondary idea is that all the talk in Washington, D.C. about the budget deficit was setting the stage for higher rates.
This explanation may or may not be right. There is no practical way to validate it. It makes sense on one level, but leaves some big question marks. The first is timing. The Federal Reserve has made no secret of its intention to gradually reduce its holdings of Treasury securities, which now total nearly $ 2.5 trillion. The reduction plan was announced last year and will take years to complete. Both the early announcement and the small monthly installments would tend to make Fed policy an unlikely suspect for setting off a sudden, major sell-off.
The budget deficit, too, seems unlikely to have triggered near-panic. While deficit spending by government is a serious economic problem it is not a sudden one. It has been building for decades. And the Trump administration claims that the proposed federal budget under discussion would shrink the accumulated deficit, not expand it.
Economic growth will put upward pressure on interest rates, surely. It will set up a competition for funds between Treasury and other government debt instruments and the private sector’s need for borrowed capital — a bidding war, essentially. And when economic growth is widespread throughout the globe the competition for borrowed capital will be intense.
One of the under-discussed effects of the recent tax reform may be its reducing the impact of economic growth on our interest rates — by lowering the intensity of the bidding war for funds. The tax changes poured cash into corporate portfolios that were already heavy with available funds. If nothing else, this will reduce the immediate demand for borrowed capital and delay the impact of economic expansion on the interest rate market.
While the first explanations blamed economic growth, the second reason given for the stock market’s sudden sell-off blames it on just the opposite. This theory is that the U.S. economy is in a lot worse shape than the standard reports reveal.
This is always a possibility, of course, especially in the short run. Reports on the economy can often seem slow compared with market moves, and this can be a problem for monetary policy decision makers. There really is no evidence of a gap between reports and reality in current situation, though. Our robust economic expansion is confirmed by the employment picture, investment and consumption strength, and consumer confidence. The whole idea that our economy is secretly faltering lacks credibility as an explanation for the recent financial market behavior.
The theories put forth so far as to what caused the stock market rout and its continued volatility have been unconvincing. We do know what made it worse: the artificial intelligence algorithms that control buying and selling for over a third of the market transactions. These act as accelerants that amplify any motion, up or down, in the market.
In the end, we don’t have a reasonable explanation. John Maynard Keynes, in addition to his influential work as an economic theorist, was an experienced and successful investor, for himself and as manager of the endowment funds of King’s College, Cambridge. He understood financial markets as well as anybody, and concluded that, “the market can stay irrational longer than you can stay solvent.”
James McCusker is a Bothell economist, educator and consultant.
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