The wild swings in the North American financial markets this week serve as yet another reminder of the weakness of any linkage between levels and changes in financial asset values and levels and changes in real economic variables. This is apparent for both bonds and equities.
In the case of the U.S. and Canada, the rise in government bond prices is surely excessive. As of today, the Government of Canada's 10-year bond had a yield of 2.4% compared to a near record low of about 3% a month ago, and the U.S. yield is about the same. I certainly buy the argument that their and our economic prospects are not good, but locking in a real return of about 0.5% per year for ten years suggests that investors have panicked. (In Europe they have probably panicked in the opposite direction by demanding excessively high yields for pretty safe debt in the case of the larger economies which have come under attack.)
At the same time, equities are probably under-valued relative to continued high corporate profitability, especially given that (unfortunately) neither real wages nor the wage share are likely to be much of a downward force in the foreseeable future. Dean Baker thinks that the U.S. stock market is significantly under-valued judged by prospective profits -- and he has a record of making good calls on these things.
Volatility driven by fear and greed and the hope of quick, short-term returns results in large day-to- day and week-to-week swings in financial asset prices. While there may -- or may not -- be some underlying forces which bring prices back into line with fundamentals over long (often very long) periods of time, such swings have damaging effects on the real economy.
My bet is that big correction in equity prices over the past little while will increase household and corporate savings, lowering consumption and investment at just the wrong time. Those saving for retirement will see a need to make up for losses, and will also have been sharply reminded just how uncertain is the ability of a certain sum of savings to fund a decent retirement. Pension funds already deep underwater will be forced to weather a downdraft in equities, and, more importantly, the sharp plunge in U.S. and Canadian interest rates will require firms to put much more money into plans to make up for another sharp increase in the present value of liabilities.
Market over-shooting and excessive volatility likely reflect short-term trading for quick, speculative gains by hedge funds and the investment banks. Once again, the excesses of the markets will damage the real economy.
This should remind us that little or nothing has been done to implement the financial re-regulation agenda which was briefly given serious consideration in the aftermath of the 2008 stock market crash.
There is no shortage of tools on hand to limit speculative trading. We should limit the use of leverage, especially by the hedge funds, and introduce transactions taxes to limit returns from very rapid trading. We could also regulate outright gambling through naked shorts (selling stocks one does not own) as some European governments are now doing, and we could impose higher rates of personal and corporate income tax on short-term capital gains.
Market mayhem continues because governments are still in thrall to a financial sector which profits from patently parasitic and damaging speculation.
This article was first posted on The Progressive Economics Forum.
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