There is something in us that likes to hear bad news – not only events that have already occurred but also bad things that might happen. In fact, the bigger the coming disaster, the better.
Our taste for stuff like this has spawned the silly and annoying “it could kill you” stories on television news, but in fairness we should remember that there is nothing new about the process. Nostradamus made his reputation by predicting cataclysmic events, not by forecasting that 2006 would be a particularly good year for the olive harvest in Sicily.
Even economic news is clinically dependent on headlines and stories aimed at scaring its audience. You might think that serious business people would have some immunity to this kind of stuff, but scare-their-pants-off journalism has no more loyal audience than Wall Street. The easiest way to get the attention of brokers and investors is to explain how all the signs portend a market meltdown, or how today’s markets bear an eerie resemblance to those leading up to the crash of 1929.
A recent report from the British firm, Barclay’s Capital, for example, points out some disturbing similarities between today’s financial markets and what was happening just before the stock market’s thud-bang crash of 1987. Feel free to call this an eerie resemblance if you wish.
The similarities shared by 1987 and today that the Barclay’s Capital report notes include a growing U.S. foreign trade deficit, a weakening dollar, inflation expectations, a topped-out housing market and the appointment of a new Federal Reserve chairman.
These are definitely worrisome things, with one exception. As a practical matter it is difficult to work up too much anxiety over the replacement of Fed Chairman Alan Greenspan by his hand-picked successor, Ben Bernanke. His only notable misstep thus far involved talking nonsense while bedazzled by CNBC’s Maria Bartiromo, something fully understandable and forgiven by approximately half the country’s adult population.
As to the rest of the parallels to 1987, it is helpful to remember that the market patterns involved are not independent events but reflections of our economy’s efforts to adjust to significant structural changes and recent major shocks.
It is not unusual, for example, for growth of the foreign trade deficit to be linked to a weakening dollar. Fortunately, a weaker dollar makes imports more expensive and this will act as a brake on the trade deficit as higher prices reduce demand.
The reason why that is not happening as fast as we would hope is that the trade deficit is aggravated by our dependence on foreign oil. Our demand for oil doesn’t change much when prices go up, at least not very quickly. It is what economists call “inelastic” in the short run – that is, demand is not very responsive to price changes, up or down.
The effect of the sharp rise in oil prices, then, has been to increase the trade deficit and exert a broad upward force on the overall price level. As financial markets attempt to adjust for that, we see securities prices reflecting revised expectations in terms of both prices and interest rates.
This is all pretty normal stuff, of course, but normal stuff can morph into a market correction by investors determined to do so.
Still, from an economics standpoint, U.S. financial markets today are different in two significant ways from what they were in 1987. The first difference is the participation of foreign investors. In 1987, non-U.S. investors bought less than $30 billion worth of our long-term securities. Last year they bought more than $1 trillion.
The second difference is the rapid expansion of financial derivatives and hedge funds. Both of these developments foster speculation of one sort or another, and tend to make stock and bond markets resemble commodities markets.
The debate over the impact of speculation on markets is almost as old as economics itself. And while there has been no satisfactory resolution of the argument, it appears that very much like cholesterol, there is good speculation and bad speculation. Good speculation tends to dampen market swings and is considered a positive influence. Bad speculation tends to stampede investors in whatever direction they were already headed, taking securities prices either to unsustainable highs or irrational, self-destructive lows, sometimes both.
There is no doubt that the huge increases in derivatives, hedge funds and foreign purchases of U.S. securities have changed our financial markets. They simply do not look or act like the financial markets of 20 years ago.
No one knows the future, and it is certainly possible for the market to experience bad as well as good periods. But whatever happens, it is extremely unlikely to be a replay of 1987. That’s rear-view mirror stuff.
James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101” monthly for the Snohomish County Business Journal.
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