Nothing But Flexibility in Stock Allocations Can Stabilize the Economy

Nothing But Flexibility in Stock Allocations Can Stabilize the Economy
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I have seen a lot of articles lately about what can be done to keep the economy on a good footing. Is inflation getting out of control? Are further cuts in interest rates needed? Is it time to start increasing interest rates instead? How would stock investors react to an increase in interest rates?

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The Influence Of Stock Prices On The Economy

My view is that all of those considerations are secondary ones. The biggest influence on the economy is the amount of irrational exuberance present in the stock market. I don’t recall ever hearing anyone else say that. So I feel that I have to doubt myself. But the case seems so clear and strong that I cannot dismiss the thought from my mind.

The other factors can have either a positive or negative effect. Some people think that higher interest rates would be a disaster. But some think that higher interest rates might be a good thing. The same is so of other factors that influence the economy. Some believe that it would be a good thing if consumer demand got stronger and some think it would be better if consumer demand slackened a bit. Some think that we need to see lower oil prices but others think that the economy can do fine if oil prices stay where they are or even if they increase a bit.

A drop in irrational exuberance cannot possibly be a good thing for the economy. I think that high stock prices make the economy unstable. So in a long term sense I believe that a drop in irrational exuberance would be a very good thing. But that cannot possibly be so in the short term. Irrational exuberance is pretend money, money that we have convinced ourselves we can use to buy things but money that in reality was created out of thin air and that will at some point disappear into thin air. The disappearance of irrational exuberance has to have a negative effect on the economy in the short term. Before the pretend money disappears, businesses are counting on it to fuel their growth. And then, suddenly and surprisingly, it is gone. How could that not cause an economic contraction?

And the irrational exuberance factor is by far the biggest factor. Stocks are today priced at two times their fair-market value. So, if prices were to return to fair-value levels, we would see trillions of dollars in spending power taken out of the economy. No other factor could have anything close to that sort of impact.

Why don’t economists talk about irrational exuberance all the time?

The biggest reason is that there are long stretches of time in which irrational exuberance has little effect. Stock prices have remained high for the past 25 years, with the exception of a few months immediately following the 2008 crash. An economist who made it a practice of warning of the effect of a price crash every time stock prices were at super high levels would be treated like the boy who cried wolf. The danger has been there for those 25 years. But outside of the 2008 crash, those warnings have not proven out. It’s not much fun to advance warnings that seem never to play out. I know whereof I speak.

Irrational Exuberance Matters

The fact that the collapse of a mountain of irrational exuberance is a rare event does not suggest that irrational exuberance doesn’t matter. The reality is quite the opposite. If the market corrected for the irrational exuberance factor every year or every two years, the loss of spending power experienced on those occasions would be far more manageable than what we see when the market corrects for irrational exuberance only after the passage of 10 or 20 years. The passage of 10 or 20 years permits a lot of irrational exuberance to accumulate. Imagine if the economy corrected for the effect of inappropriate interest rates only after the passage of 25 years. What a mess that would be!

A second reason why economists don’t like to talk about irrational exuberance is that it is such a scary thing. A lot of irrational exuberance disappeared in the early years of the 20th Century, when we came within a whisker of suffering a great depression. We really did see a great depression when the CAPE value rose to a level of 33 in 1929. There was no depression in the 1970s. But the stagflation that we experienced at that time left a mark on people strong enough to discredit the Carter presidency and usher in the Reagan Era. The effects of the 2008 crash were short-lived. But a case could be made that the political frictions that have become so difficult in recent years had their origins in that crash (both the Tea Party movement on the right and the Occupy Wall Street movement on the left gained altitude because of frustration with the effects of the economic collapse).

You have heard of banks being too big to fail. Irrational exuberance is the economic issue too big to consider in discussions of what to do about the economy. It is overwhelming to think about what it would mean if stock prices were to fall to fair-value levels or even lower. They always do. So it seems to me that the responsible thing would be to take the possibility into account for planning purposes. But it is common for people who are at great risk of experiencing a heart attack to ignore their doctor’s orders on grounds that it is too late in the game to make the needed changes. Stock price crashes are the economic equivalent of a heart attack.

The only sensible approach to take on a going forward basis is to deal with irrational exuberance before it gets so out of control. If we all made an effort to pull stock prices down once the CAPE value rose above 20, doing so would not bring on an economic crisis. We would be like the overweight person dealing with the issue when it is 20 pounds that need to be lost and not 60. There is only so much good we can do for our economy by adopting sound interest rate or inflation policies. But we could do a world of good by becoming more vigilant about irrational exuberance and by taking immediate steps to rein it in once it becomes even a bit dangerous.

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