Financial markets lately have been “in a dynamic state.” That was a phrase we used in Vietnam to mean “no one knows what the hell is going on.”
The whole world, but especially the United States and European Union, faces enormous uncertainty. We not only do not know what the future holds, we cannot even list the possible outcomes, much less the likelihoods of any of them occurring.
Such uncertainty undermines efficient use of resources, especially for long-term investment in productive facilities and infrastructure. It undermines economic growth at a time when it is most needed.
The volatility of recent stock-trading days raises questions about the “efficient markets hypothesis.” Once widely accepted by financial economists, this is the belief that at any time, the price of an asset fully reflects all of the information available about all the factors that may affect its current and anticipated value. It depends heavily on assumptions that humans are rational and motivated by self-interest.
This does not mean that markets have perfect information about the future or never get things wrong. Nor does it mean that some individuals’ ideas of what something is worth cannot be better or worse than the market as a whole at any given point.
It does mean, however, that no one can outdo the markets systematically. Some person may be smarter than the collective sentiment of the market at times but cannot be consistently so.
People not conversant in finance theory may wonder why this is important.
And they certainly may question why, if markets are so good at digesting new information, stock markets can plunge 5 percent one day and soar an equal amount the next, supposedly in response to news that, on reflection, had been largely available for days or even months.
That is the Achilles heel of this much-vaunted theory. It may be correct in many situations, but it also is of exceedingly little relevance when uncertainty is great and people acting in financial markets are driven primarily by fear and greed, two of the most irrational factors possible in human decision-making.
The more volatility there is in markets, the warier individuals are about saving and investing their money and the more cautious businesses are about investing in new machines, software or training for employees. They hesitate to initiate new ventures, to take any risks. This all results in slower economic growth and more persistent unemployment.
All the Fed can do is to try to change public and market sentiment. It chose to do so by committing to keeping short-term interest rates low for another two years.
But three of the committee’s 10 voting members publicly dissented from this gesture. One dissent is common and two not unknown. But having three dissenters is extremely rare.
Eventually, all this uncertainty will be resolved. The outcome, however, may well be painful for many.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at ed@edlotterman.com.
