Macroeconomics
In Praise of Market Volatility (WSJ Oped)

Talking heads on “financial” TV channels have always provided “infotainment” — information so blended with entertainment that you couldn’t tell where one stopped and the other started.  One rated the Fed Chair’s “performance” at his press conference on the Fed decision to hike rates an “F”.
But why should the Fed and its chairs have to “perform” for the market or soothe its tantrums, my just published oped argues.

WSJ OPINION   |   December 26, 2018  p. A21

Stock-Market Volatility Can Be Good for the Economy

Cheap, abundant capital doesn’t create good ideas. Scarce, expensive capital helps weed out bad ones.

Amar Bhidé

Financial savants were quick to lambaste Federal Reserve Chairman Jerome Powell last week for failing to reassure markets that the Fed would ease off on increasing interest rates next year. Some pundits also denounced Mr. Powell’s “disastrous” performance at the press conference following the rate hike. One awarded him an F for diffident delivery and confused “messaging.”

Fed rate hikes and uncertainty about more to come are said to discourage investment and increase the risk of a recession. When the Fed raises its benchmark “risk free” rate, higher rates for riskier, private borrowing follow. The higher rates then spill over into equity markets as investors demand higher returns on stocks. And according to modern finance theory, more-volatile prices increase the risk premium investors demand for holding stocks. Therefore, more uncertainty about what the Fed will do next year also increases the cost of equity.

But good investments that sustain productive growth require more than capital. They also need good ideas that serve unmet needs, and talented people who aren’t already engaged in some other productive enterprise. Good ideas and talented people are scarce, and abundant or cheap capital doesn’t create more of them.

To the contrary, scarce or expensive capital helps filter out bad ideas and improve imperfect ones. Great businesses— Microsoft , Dell, Hewlett-Packard , Walmart —were started with virtually no external funding or breakthrough ideas. Their founders relied on their wits and hustle until they found the products and technologies that could propel rapid growth.

Conversely, investors can do great harm by oversupplying capital to fashionable businesses that haven’t found a profitable trajectory. “You can call it the new economy,” says a skeptical CEO. “But I can’t take money from shareholders and give it to customers and call it a business.” Once indiscriminate investment has bloated a profitless venture, changing direction is almost impossible, as was evident when the internet bubble burst.

Cheap and abundant capital can even wreck mature companies by encouraging willy-nilly expansion. The origins of General Electric ’s recent implosion go back, according to a canny financial observer, to the low-cost capital that Jack Welch’s star status secured for the acquisitive conglomerate during his tenure as CEO from 1981 through 2001.

We should rejoice, not grieve, if market volatility forces users of capital to pay more attention to its cost, and improves the quality of their investments. Besides, stock markets will fluctuate, like it or not, as J.P. Morgan famously said. Share prices reflect not only current profits, but what investors expect to receive over decades to come. But how much profit a company will earn—and sensibly reinvest or pay out as dividends—is a wild guess. Even when Apple enjoyed unquestioned dominance in its markets, investors sensibly anticipated good times wouldn’t last forever. But they couldn’t reliably quantify this anticipation. As a result, the company’s stock price fell by nearly half in eight months after mid-September 2012—and then doubled in under a year and a half. Now Apple stock has lost a third of its value from its early-October peak.

Fortunately, even a stock-market crash doesn’t foreordain economic disaster unless it has a substantive systemic cause. On Oct. 19, 1987, the Dow Jones Industrial Average fell 22.6%—still the largest one-day drop ever. Thirty-three eminent economists issued a statement warning that without “decisive action” to “correct existing imbalances at their roots, the next few years could be the most troubled since the 1930s.” They were completely wrong: The crisis passed without any “decisive action.” The average finished 1987 with a small gain, and the real economy didn’t miss a beat.

Inexplicable market squalls can, however, provide valuable lessons in prudence. Financial executives planning future capital expenditures and people saving for retirement learn to prepare for inexplicable and inconveniently timed falls.

Unfortunately, for more than two decades, the Fed has apparently tried to sustain the illusion that it can use low interest rates and happy talk to keep stock prices on a smoothly increasing trajectory and the economy eternally recession-free. It has failed on both fronts while jeopardizing the allocation of capital to productive enterprise.

Former Fed Chairman Paul Volcker, who was unconcerned about “surprising markets,” once asked: “What’s wrong with making traders lose money from time to time?” Mr. Powell faces different problems than Mr. Volcker did. But asserting the Fed’s independence from stock-market hostage takers would serve the nation well.

 

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