Is the stock market telling us that we were right all along?

With the stock market one never knows for sure, but this AP story is at least hinting that tight money in 2008 explains the severity of the recession:

NEW YORK (AP) — Stocks are set to extend their gains Wednesday as expectations continue to grow that the Federal Reserve will take steps to stimulate the economy at its meeting next month.

.   .   .

But weak jobs figures could also be enough to get the Federal Reserve to resume buying Treasurys in an effort to try and stimulate borrowing and spending. Japan’s announcement Tuesday that it cut a key interest rate to near zero percent and will buy some of its government bonds is adding to expectations the U.S. Fed will take similar actions to buy bonds.

The U.S. central bank long ago set interest rates at near zero percent, so it’s likely to buy Treasurys in an effort to further drive interest rates lower. The move would also make investing in stocks and riskier assets more enticing because yields on bonds would continue to drop.

[Note: The story was later altered, so the link has changed.]

If mere expectations of a Fed move that is likely to be cautious and timid are causing a significant rally on Wall Street in recent weeks, then that tells me that monetary policy is still very important at zero rates.  It also tells me that if policy had been much more expansionary in late 2008, the stock market would have done far better, for two reasons:

1.  The drop in AD would have been milder if NGDP growth expectations 2 years out were much higher.

2. The financial crisis would have been milder.

One almost never observes severe recessions without stock crashes, so if policy had been expansionary enough to give the stock market hope that the recession would be mild, then I think stocks would have done much better, and the recession most probably would have been much milder.  It would have been a “recalculation recession” of the sort we had during December 2007 to July 2008.

Perhaps an analogy from the Great Depression would help.  During the long contraction of 1929-33 a number of progressive monetary theorists like Hawtrey, Cassel, and Fisher said the root cause of the Great Depression was the increasing value of gold.  That was not a widely held view (otherwise the Great Depression never would have happened.)  Between March and July 1933, FDR provided a decisive test of that theory, by sharply reducing the value of the dollar in terms of gold.  Stocks, commodities and industrial production took off like a rocket, despite a banking system flat on its back, with many banks shut down.  I saw this upsurge as providing retrospective confirmation of the explanation of the Great Contraction provided by the progressive monetary theorists.

The likely monetary easing this time will be far, far milder, and the stock rally is also much less impressive.  So it’s not proof, just a tantalizing piece of evidence that we quasi-monetarists might have been right all along.

PS.  Because of a heavy workload at school and a huge volume of comments, I will fall way behind for a few days.  As usual I hope to eventually get to all my comments.  Thanks for your support.



18 Responses to “Is the stock market telling us that we were right all along?”

  1. Gravatar of Silas Barta Silas Barta
    6. October 2010 at 08:24

    Wait, are you saying that loose money must have accounted for the ~35% stock market gain since Obama took office, too?

  2. Gravatar of JimP JimP
    6. October 2010 at 08:29

    I don’t think there is any doubt. The general “tone” or feel of the market of late has been much better. Bad data is ignored – in a way it would not have been had Plesser and the deflationists been still shouting that we need more deflation and the Fed is going to do their best to deliver it. The market was just freaked when those morons shot off their mouths and there did not seen to be anything that Bernanke was willing or able to do. The last hope just seemed to be entirely gone. It does not feel like that now.

  3. Gravatar of Luis H Arroyo Luis H Arroyo
    6. October 2010 at 10:09

    “If mere expectations of a Fed move that is likely to be cautious and timid are causing a significant rally on Wall Street in recent weeks, then that tells me that monetary policy is still very important at zero rates.”
    Very good observation, Scott

  4. Gravatar of marcus nunes marcus nunes
    6. October 2010 at 10:31

    Jeffrey Miron is “light years” away from being a QM!

  5. Gravatar of marcus nunes marcus nunes
    6. October 2010 at 10:36

    Jimmy Rogers: another “blind man lost in the woods at night” (although this last qualification makes no diffrence)

  6. Gravatar of Gregor Bush Gregor Bush
    6. October 2010 at 11:17

    A key peice of evidence that supports y0our view has been the skyrocketing correlation bewteen S&P 500 returns and the 5-year TIPS spread. Undernormal circumstances the correlation is zero or even slightly negative. Positive demand shocks are roughly offset by expecations of higher future policy rates. But since the Fall of 2008 the correlation has become strongly positive. And since the eurozone crsis of April 2010 the correlation has surged even further with increeases in the TIPS spread becoming almost prefeectly correlated with increases in stock prices. To me, this is clear evidence that the stock market and economy are screaming for easier money.

  7. Gravatar of rob rob
    6. October 2010 at 11:59


    Considering Jim Rogers has his own commodities ETNs and he profits from people investing in them, I think he should be viewed more as a commodities salesman at this point than an objective commentator.

    Which raises a question to me about the EMH: with all the endless ads to buy gold these days including on this very site, should we expect this hype to affect the price of gold? On the one hand it seems intuitive that it would, but on the other: if the market price represents the best wisdom available on where the price of gold should be, it seems the market should be completely immune to hype, in the same way an autistic is immune to framing.

    Or should it? If hype increases real demand then it becomes a material variable in the equation. But that doesn’t seem right either, since by definition hype can’t last long and the current price should discount future expectations. For everyone buying hype someone should be selling it.

  8. Gravatar of marcus nunes marcus nunes
    6. October 2010 at 12:50

    Commodities in general have been trendless for the past 12 months. He should recognize the present moment, where there is the expectation that “the Fed will do something” to “feel grateful”. But he doesn´t. So he is not a QM!

  9. Gravatar of Nick Rowe Nick Rowe
    6. October 2010 at 16:03

    Gregor Bush: That is indeed a very interesting and important piece of evidence. “Well spotted Bruce!” (to borrow the old Monty Python line).

    Got any numbers on that correlation, before and after Fall 2008?

  10. Gravatar of scott sumner scott sumner
    6. October 2010 at 18:07

    Silas, No, just that monetary policy was less bad after March 2009, and hence stocks recovered part of their recession losses, but not all.

    JimP, I think so too, although of course the stock market can always surprise us.

    Luis, Thanks.

    Marcus, Yes, but I like Miron’s views on the war on drugs.

    Jim Rogers? I once read one of his books–something about riding a motorcycle around the world.

    Gregor, That’s a very interesting observation. I think time-varying correlations can tell us a lot, and is an underutilized research technique. I know another economist who is working on this, and found some really interesting results.

    If I had time, I’d work on it.

    Rob, It could be a little of each, but I don’t think ads can sell gold without the underlying “story” to excite investors. For people who only follow money at a superficial level, all the stimulus does make it seem like hyperinflation is just around the corner. I think the ads just play on anxieties that are already there–and maybe inflame them a bit.

    Nick, I don’t have numbers, but I think the correlation got a lot stronger after September 2008.

  11. Gravatar of DanC DanC
    6. October 2010 at 19:23

    Or the market, or a segment of it, is expecting higher inflation and switching out of bonds and fixed instruments and into stocks.

    Or while structural challenges remain in place, the market is well aware that polling data shows sweeping political changes – changes that will be more pro-growth.

    It would appear that the market closely tracks Obama ratings. As candidate Obama gained in the polls the stock market fell. As President Obama saw his popularity decline the stock market gained. Given the Obama agenda that should not be a surprise. I wouldn’t be too quick discounting the changing political climate.

  12. Gravatar of scott sumner scott sumner
    7. October 2010 at 06:09

    DanC, Politics plays a role, but very small. A Republican presidential win is worth 2 percent on the Dow.

  13. Gravatar of JTapp JTapp
    7. October 2010 at 08:46

    I found a couple good blog posts from a former corporate economist illustrating how the bond market is responding vis-a-vis QEII:
    The bond market it bracing for inflation 1
    Quantitative Easing is Working.

  14. Gravatar of DanC DanC
    7. October 2010 at 09:40

    I worry that inflation will not lead to significant growth given structural barriers in the economy.

    I worry that it might lead to a period of stagflation, higher prices without real growth.

    I also worry that a Fed that seeks to manipulate the economy may do long term damage.

    But I worry a lot.

  15. Gravatar of DanC DanC
    7. October 2010 at 09:44

    A Republican President gives us 2%, a Republican Congress gives another 2%, pretty soon we get real growth.

    Plus Republican dog catchers means the idiot children of Republicans get a chance at sinecure jobs.

  16. Gravatar of Lee Kelly Lee Kelly
    7. October 2010 at 14:54

    I wasn’t right all along. Two years ago I discovered the Austrian Business Cycle Theory, and for a while that was how I explained the recession. I even began fearing hyperinflation! But then it didn’t happen, I breathed a sigh of relief, and went about looking for alternative explanations. Then I came across Steven Horwitz and Bill Woolsey over at Coordination Problem discussing monetary equilibrium theory. Somehow I ended up here finally in a position to understand what you were talking about. Since then I have been advocating monetary expansion and something like an NGDP level targeting for monetary policy. (Admission: I once considered you an muddled Keynesian nut.)

    Oh well, live and learn, right? Though you’re still a nut.

  17. Gravatar of Charles R. Williams Charles R. Williams
    8. October 2010 at 02:51

    All that is clear is that the stock market is up. It is reasonable to think that this is partly due to subsiding fears of deflation. This is partly due to the Fed’s announcement and partly due to a slight pickup in the inflation indexes.

    Europe is stabilizing, the dollar is resuming its fall, the Bush tax cuts will get extended for all, a Republican House will constrain the worst policy excesses of the Obama Administration, M2 is starting to rise, the economy continues to heal. It looks like an average year for stocks. There are even some signs that hiring might pick up by year end.

  18. Gravatar of scott sumner scott sumner
    8. October 2010 at 14:27

    JTapp, Yes, the market is already responding. Expectations of QE have almost certainly created at least a trillion dollars in new stock market wealth worldwide in the last month. (When do I get my share?)

    DanC, Since I favor targeting NGDP, even stagflation would be better than what we have now, as long as NGDP is well behaved.

    Lee, Yes, I’m still a nut, but if I’d had a blog in the 1970s every single one of my posts would have been screaming for tight money. I.e., I’m not quite the inflation nut I might seem.

    Charles, I hope you are right.

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