The financial markets are in turmoil. We are dangerously close to the next financial crisis. The FTSE in the UK is down by 13% from its April peak. The Dow in the United States is off by 10%and the Hong Kong Hang Seng index, the market that is closest to the epicenter of the crisis, is down by a whopping 21%.
Why worry? Surely this is just a market correction. Traders in the financial markets are, after all, simply making the trades that are in all of our best interests. I don't think so!
Are the financial markets efficient? In one sense yes. In another sense no.
The financial markets are informationally efficient. It is difficult or impossible to make money trading in the markets unless you have inside information. There is no free lunch. That's what Gene Fama meant when he defined the term “efficient markets hypothesis”.
The financial markets are not Pareto efficient. They do not allocate capital across time in a socially optimal way. They are not Pareto efficient because almost all of the people who are affected by the trades we make today are not yet born. That is what explains Bob Shiller’s finding that long-run returns are predictable.
Real interest rates, and their close cousin, price earnings ratios, are incredibly persistent. They are persistent because the mistakes that our parents and our grandparents made in the past are carried into the present through the generational wealth distribution.
For the past hundred years, we have managed the economy with a single tool; monetary policy. Central banks raised the interest rate when inflation was high or when unemployment was low. They lowered the interest rate when inflation was low or when unemployment was high. For the past thirty-five years, there was no conflict between those objectives. Times have changed.
The stock market crash is screaming out for the Fed to lower interest rates. That option is closed as the interest rate has reached its lower bound. Some economists are calling for a huge fiscal stimulus. That is not the answer. Although I have stated publicly that I don't believe in fairies: Unlike Paul, I DO believe in the confidence fairy. Pessimistic beliefs about the value of private wealth are as destructive to the economy as a hurricane.
For monetary policy to work effectively as a lever to control inflation, the interest rate must be positive. We must raise the interest rate. And we must do it now.
If we raise interest rates now, the stock market will fall further. The U.S. market correction will turn into a full scale rout. Unemployment will soar. Unless.
Unless we use the deep pockets of the Treasury to step in on behalf of unborn generations and prevent that from happening.
For the economy to function at a high level of activity, the value of paper assets must be high. When we feel wealthy we spend. When we spend, firms create jobs. When firms create jobs, earnings and dividends increase and the high value of paper assets is validated.
What can we do? What should we do?
First: Give the Fed the power to buy a value weighted Exchange Traded Fund that contains every publicly traded stock. Commit to support the ETF by buying stocks. Pay for the shares by borrowing, or by trading Social Security Trust Fund.
Second: Raise the money interest rate to bring us back to normality and restore normal functioning of monetary policy.
If we do not act, and act soon, we are headed for another Great Depression.