Ed Lotterman: Investor reaction not based on sound, rational economic theory


The financial markets' extreme reactions last week to sundry pronouncements by the Federal Reserve's policy-making Open-Market Committee, and its individual members, call into question some of the assumptions of contemporary economic theory.

If people really are highly rational in their decision-making and, as a group, have the best possible understanding of current events and of the future, why such extreme reactions?

And the reactions were extreme. While the initial market moves were positive after the committee issued its official summary statement at 1:15 p.m. Central time on June 19, both the S&P 500 and the Dow indexes fell more than 9 percent over the following two trading days.

Chairman Ben Bernanke, who elaborated on the committee's position during a news conference later that afternoon, was blamed by some for muddying the waters or intimating doom by suggesting that the Fed would crimp growth of the money supply sooner than many expected. After that, two regional Fed presidents, James Bullard of St. Louis and Narayana Kocherlakota of Minneapolis, felt moved to issue clarifications of their own views.

But regardless of what any Fed official said, everyone in the market knows that the current policy of the Fed of buying tens of billions of dollars of securities each month and paying for them by creating new bank reserves is necessarily a temporary one. Everyone knows both long-term and short-term interest rates have to go up eventually.

The uncertainty is whether such tightening will start in a few months or in several months and whether it will be gradual or extremely gradual. But the question is whether these nuances alone are enough to determine that the fundamental total value of U.S. corporations is $1.5 trillion more or less than it was just a few days earlier.

Yes, higher interest rates make some businesses potentially less profitable and others more profitable. Higher rates increase borrowing costs for capital-intensive businesses. They mitigate against firms that sell long-term goods like locomotives or industrial machinery. They make any firm with substantial debt levels less profitable.

Moreover, higher rates, all things being equal, increase the value of the U.S. dollar relative to currencies of other nations. A "stronger" dollar makes U.S. exports more expensive to foreign buyers. Thus it is a blow to U.S. farmers, including Minnesota corn and soybean growers, and manufacturers, including medical technology firms such as Medtronic, that either export much of their output or compete with imports. So a stronger dollar because the Fed is tightening down does hurt profitability and growth in employment.

But again, we all have known for a long time that such tightening was going to happen and what its effects would be. We all know that as the economy returns to growth, even tentative, the Fed will moderate its unprecedented easy money policy. So why the extreme reaction to veiled clues that this will finally occur?

Contemporary economic theory, at the micro level that of "efficient markets" and at the macro level "rational expectations," assumes that market participants as a group understand what is going on and plan accordingly.

As an example, economists cite an argument made by British economist David Ricardo 190 years ago. Ricardo questioned whether the public would respond to a tax cut by spending more money. No, he concluded, they would not. If prudent, rational people saw government cutting taxes but not cutting spending, they would be savvy enough to know that eventually the government would be forced to raise taxes again, to deal with the budget deficits and growth in national debt that the tax cut would cause.

Not wanting to be found short when taxes were again raised, rational people would take money available from the tax cut and save it to be prepared for the inevitable day when taxed would be hiked.

Personally, I think this "Ricardian equivalence" is bunk. People are not that rational and don't have such foresight. Over the past 30 years, we certainly have not responded to tax cuts by increasing savings. But some of the best and brightest minds in the discipline of economics do think that people are indeed so rational and so foreseeing.

So we return to the question: Why should our collective estimate of the value of publicly traded U.S. businesses fluctuate up or down trillions of dollars in response to mixed signals about minor differences in the expected degree and timing of an inevitable policy move?

The first answer is that decisions to buy or sell stocks and bonds are no more dominated by rationality than are economic decisions as a whole. In fact, two of the strongest factors in financial markets are fear and greed, neither of which is rational.

Secondly, through institutional changes, including the major investment banks changing from partnerships to publicly traded corporations, the growth of trading for one's own account on the part of large banks and the increasing market share of hedge funds, we have come to a situation where there are incentives for excessive focus on the short term.

The reactions to varied suggestions of what the Fed may do in coming months has such disproportionate effects on market levels because a disproportionate fraction of total financial capital is in instruments the value of which is driven by short-term forces. This is not healthy for a sustainable economy.

Exactly what can be done about this in terms of public policies is more difficult to identify. But we certainly can see warning signs of remaining inherent instability in our financial markets, and hence in our economy.


Write Ed Lotterman at ed@edlotterman.com.

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