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Warren Buffett is quoted in the book "The Snowball" written by Alice Schroeder as saying in a presentation given in 1999 in Sun Valley, Idaho that "Ultimately, the value of the stock market could only reflect the output of the economy." (Page 34)

But, Buffett is very clear, not only in this presentation, but also in many of his other writings that inflation is not a part of this equation. Inflation only builds inflated asset prices, asset prices that cannot be sustained over time. Therefore, credit inflation is not the way to build up long-term value because debt, although useful in small amounts, does not result in sustainable real value.

Yet, in the policy discussions going on in Washington, D. C., the ever-present solution to the current debate is whether or not there should be more credit created.

Fed Chair Ben Bernanke has been very prominent in this debate. He is a great believer in the wealth effect on consumer spending. A large part of the argument he has given us concerning his approach to monetary policy is that excessive credit growth will inflate the stock market and this increase in consumer wealth will result in people buying more houses and more cars and more consumer goods and thereby spur the economy along.

But, in my reading of Warren Buffett this is backwards. If, "ultimately", the value of the stock market reflects the output of the economy, inflating the stock market puts the cart before the horse and this…I would call…a bubble…or, more precisely, a credit bubble.

Another type of argument that reverses the thinking of Mr. Buffett is something the Federal Reserve relied on for years, the Phillips curve argument. Those drawing on the Phillips curve approach argued that there is a trade-off between inflation and unemployment. That stimulating the economy will achieve a lower level of unemployment at the cost of a little more inflation.

The economist Milton Friedman argued that this was just a short-term phenomenon and that as people's expectation of inflation caught up with actual inflation that the tradeoff would go away. But, this did not stop some policy makers who believed that the "short-run" gains were worth the added inflation. The result of relying on such "short-run" solutions was a credit inflation that grew and became built into the expectations of the culture.

And, when expectations get built into the economy it changes the whole structure of the economy. Two examples here: first that of housing prices in the last half of the twentieth century where the purchase of housing became the "piggy bank" of the middle class. Housing prices, it was believed, could never decline…until housing prices began to decline.

Second, those that either had the resources or had the advice to take advantage of the constantly rising prices use the persistent expectation of credit inflation to their own benefit. I believe that this is a major reason for the tremendous shift in the income/wealth distribution in the United States over the past fifty years or so.

Now, we have a more subtle argument than that presented in the Phillips curve analysis. This comes from Larry Summers, formerly the leading candidate to follow Ben Bernanke as the next Chairman of the Board of Governors of the Federal Reserve System. In today's Financial Times, Mr. Summers argues for efforts on the part of the federal government to "spur growth" in the economy. The trade off this time is between a higher deficit and faster economic growth, a growth that would actually lower the ratio of government debt to GDP over time.

Mr. Summers writes "The latest Congressional Budget Office projection is that the federal deficit will fall to 2 per cent of GDP by 2015 and that a decade from now the debt-to-GDP ratio will be below its current level of 75 per cent. While the CBO projects that under current law the debt-to-GDP ratio will rise over the longer term, the rise is not large relative to the scale of the US economy. It would be offset by an increase in revenues or a decrease in spending of 0.8 per cent of GDP for the next 25 years and 1.7 per cent of GDP for the next 75 years. That is, there would be a short-term negative impact of higher deficits, but in the long run….

Two immediate problems with this: first, this argument carries with it the assumption that nothing else will change. But, things do change, there will be the 2014 elections followed by the 2016 election. There may be a war in the Middle East. There may be many other things arise that need "fixing" in the short-run. This is how politicians work.

Second, what if efforts to "spur growth" are not that effective at this time. The efforts to "spur growth" in the first Obama administration have not done much in terms of spurring growth. And, the constant argument of Krugman and others of his persuasion that we didn't get more growth because we didn't provide enough stimulus is just circular argumentation.

What if the real reason we could not spur on more growth at this time is that because the nature of the problem is structural and not cyclical? Mr. Summers even gets to this in his opinion piece where he argues "We need more public infrastructure investment but we also need to reduce regulatory barriers that hold back private infrastructure. We need more investment in education but also increases in accountability for those who provide it. We need more investment in the basic science behind renewable energy technologies, but in the medium term we need to take advantage of the remarkable natural gas resources that have recently become available to the US. We need to assure that government has the tools to work effectively in the information age but also to assure that public policy promotes entrepreneurship."

These structural needs are vitally needed in the United States. But, as we have seen over the past decade, if we continually "goose up" the budget deficits in order to serve short-term political needs, we never find ourselves in a budget situation to address these longer standing problems that are really affecting us in the world today.

We never get to attack these long-run problems because, as Mr. Keynes said, "In the long run we are all dead."

Maybe this is the reason why Mr. Buffett doesn't invest based upon the expected performance of the stock market. If the value of the stock market depends upon the output of the economy and economic policy only attempts to "blow up" the bubble of asset prices in an attempt to "spur economic growth", the value of the stock market is just a short-run illusion that must eventually adjust back to reality.

This is a reason why the Nobel prize-winning economist Robert Shiller's measure of stock market value, the cyclically adjusted price earnings ratio, CAPE, might be so high over its long-term average for such a long time. The high value of CAPE reflects how much credit inflation is distorting stock prices relative to the earning power of the economy given the lagging performance of economic growth.

If the fundamental economic policy of the federal government, espoused by both Republicans and Democrats, results in an almost constant injection of credit inflation into the economy, one cannot expect the value of the stock market to reflect the output of the economy. It will only be a matter of coincidence if the value of the stock market and the output of the economy coincide.

If this is true, maybe one should look at the current difference between the value of the stock market and the output of the economy as the artificial creation of the federal government's attempt to spur on economic growth, a policy that, over time, will only result in the fall of stock market prices to reflect the state of the economy. I believe that Mr. Buffett would believe this.

Source: The Stock Market And The Economy: Warren Buffett