Are The Distortions In The Stock Market And The Economy Catching Up With Us?

by: John M. Mason


Economist Martin Feldstein has written an opinion piece in the Wall Street Journal discussing the stock market movement as a correction to earlier Federal Reserve monetary policy.

The argument goes that, over the past years, a lot of distortions have been created in the economy and distortions always must be removed.

The problem is exacerbated by the distortions that exist all over the world, and the stock market weakness might just be part of the many corrections that are taking place.

Over the past six years or so, the United States economy has experienced some of the largest distortions that it has ever faced.

Martin Feldstein discusses some of these distortions in an opinion piece in the Wall Street Journal that I believe should be read by everyone.

The point of his argument is that distortions will always be corrected and at least some of the major movements we are seeing now in US stock markets… as well as global stock markets… are the results of distortions created in the past.

The particular distortions that Mr. Feldstein is talking about are those created by the Federal Reserve and the "unusual" monetary policy that has been in place over the past six or seven years.

One thing about distortions, however, is that one never knows when distortions will be eliminated, and what exactly will cause the market to change so as to remove the distortion.

The particular distortion Mr. Feldstein discusses is the high stock market prices that were the result of the very unusual monetary policy of the Federal Reserve.

We all know what monetary policy we are talking about… the three rounds of quantitative easing that has resulted in interest rates staying at historically low levels for a historically long period of time.

We are talking about a Federal Reserve balance sheet that bloomed from a little over $900 billion in asset size to one that is over $4.5 trillion. We are talking about the reserve balances of member banks, a proxy for excess reserves, rising from about $10 billion in August 2007 to over $2.5 trillion now.

The Federal Reserve, under the leadership of Chairman Ben Bernanke, seemed to focus primarily on two things throughout this time.

The first came from Bernanke's own economic research on the Great Depression while a professor at Princeton University. His research supported the earlier results of Milton Friedman that the Federal Reserve did nowhere near enough during the early years of the downturn to minimize the depth of the depression. Friedman's research indicated that the broad measure of the money stock declined by one third during this time period.

As a consequence, the Bernanke-led Fed was not going to err on the side of doing too little. The policy at the time was described as the Fed "throwing enough 'stuff' against the wall to see what would stick."

The result was that the US economy had a Great Recession, but not a second Great Depression.

The second goal, as Mr. Feldstein describes, was to stimulate consumer expenditures to get the economy growing faster.

"When the Obama administration's poorly designed 2009 stimulus legislation failed to produce a strong economic turnaround, then-Fed chairman Ben Bernanke announced that the central bank would pursue an 'unconventional monetary policy'…."

This policy was, of course, the policy of quantitative easing.

The whole purpose of quantitative easing was to create a "wealth effect" in the stock market so that consumers, having more wealth now, would go out and buy more and this would stimulate the rest of the economy, producing more business investment and higher levels of employment.

"The Fed's strategy worked, causing household net worth to increase by $10 trillion in 2013."

"The increase in share prices took the price-earnings ratio of the S&P index to about 30 percent above its historic average before the market downturn began last week."

And, as I have been highlighting, Robert Shiller's cyclically adjusted price-earnings ratio, CAPE, has been way above historical averages, which, in the past has indicated that stock prices must adjust downward at some time. Of course, CAPE says nothing about when such an adjustment might occur.

Mr. Shiller has made note of this during the summer months.

Kenneth Rogoff, who with Carmen Reinhart wrote the book, "This Time is Different," which studied eight centuries of financial crises, has also pointed out another distortion of a financial nature. Mr. Rogoff has warned in the past that there was a real potential in China for a debt crisis.

"China is the classic 'This time is different' story," Mr. Rogoff said.

"It's very vulnerable," Mr. Rogoff added. "There is a lot of debt."

Mr. Feldstein, in his opinion piece, goes on to say:

"The excess price of equities was not the only mispricing caused by the Fed's unconventional monetary policy. As investors reached for yield in a very low-yield environment, they depressed the spreads between Treasury rates and the yields on high-risk bonds and emerging market debt. The prices of commercial real estate have also been pushed to extremely high levels, driving down yields to unsustainably low levels. Banks and other lenders have boosted their short-term earnings by lending to lower-quality buyers and making loans with fewer conditions."

Note that I have been writing about how large regional and community banks have been aggressively lending on commercial real estate for the past several years.

Some economists and analysts have been wondering for some time how the distortions created over the past six years are going to work themselves out.

Earlier in the economic recovery, many of these economists and analysts saw the distortions resulting in a very rapid acceleration of inflation due to all the excess reserves the Fed had pumped into the banking system.

This explosion of prices has not occurred yet… and, it doesn't look like it will.

The question now, however, is the reaction to the distortions going to be worked out through a major decline in stock market prices, which will lower the wealth of consumers, and therefore result in even slower economic growth?

And what about the distortions that have arisen in the rest of the world? Rogoff has mentioned the debt distortions in China. But there are the distortions in Europe where an excessive amount of debt is still outstanding… not only just in Greece… and the European Central Bank is now conducting its own version of quantitative easing. What about a world that has been created on the basis of oil that was selling above $100 per barrel? The morning papers are wringing their hands over the fate of Russia, Iraq, and Venezuela. And then there are others with economic and political problems like Argentina and Brazil.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.