How can you believe in markets when they seem so wrong?

To be more specific, world stock markets sprinted like scantily clad beach volleyball players on July 26^th and 27^th purportedly because both the Fed and the ECB gave signals that they are ready to save the planet from space invaders. Well not exactly space invaders but that is not out of the question. I can just see Mario Draghi dueling with ET! Because of actions and statements from these two mighty central banks, the world seems to be reassured the worst will not happen to our shared global marketplace. Evidence of this reassurance was the Dow’s climb to back over 13,000. Why would investors buy stocks at higher prices unless they were optimistic that things will get better and that stock values will increase even more? This is the market working – central banks act brave – people get more optimistic -- people buy stocks – and stock prices rise.

Just because markets are working it does not mean that markets are always correct. When I was a toddler in graduate school I learned about something called rational expectations (RE). My colleague at Indiana, Jack Muth, invented this idea and several macroeconomists (notably Thomas Sargent, Robert Lucas, Robert Barro, and others) were adding the RE hypothesis into otherwise dumber macroeconomic models (that assumed adaptive expectations). The cool thing about RE is that it assumed that people learn. That is – we are not consistently fooled. If Chuck Jolly sneaks up behind you in fifth grade and pulls your pants down enough times – you eventually learn to avoid Chuck Jolly or find a stronger pair us suspenders. In macroeconomics RE states that on average over time the public is able to forecast prices correctly. The words ”On average” mean that you learn. Sometimes you forecast too high. Other times you guess too low. But as an average over time you learn from your mistakes and get is about right. That doesn’t sound too crazy unless you think people are simply irrational and don’t much care. In that case I do not know what assumption to put into a macroeconomic model.

The point of the last paragraph is that there are no assumptions in useful economic models that assume that the public guesses right all the time. Thus, one can believe in the power of markets and still believe that the strong response in the stock markets was simply off base. RE says that when markets learn that they were wrong, then the market will adjust. In the case of the July performance cited above, it seems to me that the stock markets will soon reverse.  As a retiree who will live off the value of whatever stocks are left in my portfolio, I take no joy in making this point.

So why am I so pessimistic about the results of the Fed actions?

It is true that central banks have a lot of ammo. Central banks can inject trillions of dollars or euros at will and it’s as easy as slipping on a banana peel. So it is true that central banks can easily slip a bunch of money into banks. It is also true that in doing so, they can influence some interest rates. So if they buy a bunch of slip-shod mortgages, it is likely they can force the interest rate on slid-shop mortgages down a notch or two. If they buy Spanish bonds they can do the same. They can also promise to keep interest rates low until hell freezes over. In doing this they can try to convince people that the central banks will make it as easy to borrow tomorrow as it today. So why am I not skipping down Kirkwood whistling a happy tune?

First, look around you. There is no lack of money in banks and interest rates are not high enough to stop anyone from borrowing money. In the USA you can borrow gobs of money to buy that 19 bedroom house you always wanted as an assistant professor with a wife, 1.2 children, and a pet boa. This week you could borrow that money for 30 years at about 3.5%.

Second, pushing that rate to 3.2% by adding another trillion or so in dollars/euros will do nothing to get the economy moving. You can put more gas in the car but if it is on the side of the road with a dead battery, going from quarter of a tank to half a tank just isn’t going to do anything.

Why aren’t banks lending more money? One reason is that people are deeply in debt and they don’t want more.  Even devoted greens won’t buy another Chevy Volt if they are worried about the weak economy. Another reason is that the banks know the economy is weak and they do not want to be back where they were in 2008 when a weak economy wiped out their assets and made them look dumber than a bunch of rocks.  Notice the predicament here. If bankers and their customers were optimistic then there would be more lending and spending and the economy would grow. So if the Fed/ECB can make them more optimistic the whole problem is solved. But it doesn’t work that way now because there really is a dead battery and we all know it. If banks watch the Fed pour more gasoline into a car with a dead battery – it will make them MORE pessimistic not less! RE says that we learn. RE says that the central banks are making us worse off with their Dirty Harry approach to defending our jobs.

So what about this dead battery? What is really wrong? I don’t think any of this is a secret. Numerous governments in Europe are simply in trouble and this is leading to very slow growth if not a recession in Europe.  We use the term “fiscal cliff” to describe a pending fiscal disaster in the USA but the same problem is plaguing Europe. A fiscal cliff implies an unusually large reduction in government stimulus that would greatly reduce spending in an already weakened economy. China has its own problems as do many once hearty economies like Brazil, South Korea, and the Virgin Islands. Even Alfred E. Neumann knows that monetary policy is not the solution to a fiscal cliff.

There is no sense beating a dead horse. Monetary policy is being used to provide hope instead of a solution. Monetary policy is being used because we do not know what else to do. It is like the battery is on back-order and we don’t know when it will be delivered. So putting more gas in the car won’t hurt and it might make the driver feel a little better. But it is kicking the can down the road. Neither the EU nor the US is going to improve without serious attention to real problems. Private debt has to move towards normalcy. Banks need clearer guidance about what they can or cannot do in this uncertain environment. Governments have to bravely address their own debt problems without encountering a severe fiscal cliff. Business firms need more clarity about financial, health, environmental and other regulations. Central banks could hand out $1,000 gold bars to middle class people all over the world but that would do little to improve the economy or confidence about it. Since there is no thundering herd of politicians trying to solve any of these problems it is hard to see the stock market being happy much longer.