Supporters of President Donald Trump and many independent economists have rejoiced over the stock market’s record highs, as indicators of a strong economy and high investor confidence. Although historical experience has shown that the stock market can be volatile and even worse — disconnected from the trends in economic fundamentals — little has swayed the lofty optimism.
There are multiple reasons for this, but at the core is a widespread misconception perpetrated by the field of economic science itself.
The belief is that inflation, which is bad, should be measured exclusively through the index of consumer prices. The corollary of this is that the only way money and credit creation can mess up the real economy is by inflating consumer prices. If this does not happen, everything is fine. Further, asset price inflation is not really inflation: annual doubling of the price of oil, bread, or cars would be very bad, but a doubling of the stock and bond prices is a sign of “investor confidence.”
This misconception is so widespread that many eminent economists have fallen victim of it through history in a spectacular and embarrassing fashion. Just a few weeks before the Wall Street crash in 1929, Irving Fisher argued that the US stock market reached a “permanently high plateau.” Three months before the September 2008 financial panic, Arthur Laffer praised Greenspan’s monetary policy on live TV as “spectacular.”
The main reason why they believed these foolish things was that monetary policy in both cases achieved or almost achieved the famed ideal of “price stability.” Many economic models say that in this case everything else should be fine as well.
This fateful dogma that “consumer price stability” equals “macroeconomic stability” became deeply entrenched after an imprimatur from Milton Friedman, arguably the most influential and respected free-market economist of the 20th century. Friedman’s stabilizationist dogma fell into line with Irving Fisher, often cited as the “greatest economist who ever lived.” What are the chances then that free-market economists of our era would question the most fundamental desideratum of both Friedman’s and Fisher’s theories?
The irony of the situation is that the discovery of asymmetric effects of credit creation on financial assets and consumer goods is very old: it belongs to French 18th-century economist Cantillon, and it was revived by Ludwig von Mises, Friedrich Hayek, and other “Austrians” in the 20th century. It dovetails with a long-established empirical fact that during peaks in business cycles asset prices and prices of “higher order” producer goods typically go up much more than the prices of consumer goods, and then decline much further during a recession.
Hence asset-price bubbles are eminently possible, even in the absence of regular inflation (although many varieties of the Chicago school deny this), and record stock-market highs are not particularly good news. Au contraire, they are more like a warning sign that a disaster or at least a painful correction is not far away.
One of Mises’s students, Fritz Machlup, wrote a book titled The Stock Market, Credit and Capital Formation, which is the most comprehensive treatment of the issue to date. Machlup concludes that the stock market prices are a proxy for “easy” monetary policy rather than for general economic conditions. Credit creation by central banks — the main driving force of asset price bubbles — does not lead to new capital formation and new real investment. It just “ties up” the new credit into the endless rounds of stock exchange transactions, in the “canyons of Wall Street,” as Reagan’s Budget director David Stockman has memorably put it.
The current orgy of almost weekly records of asset prices has much more to do with this inflationary boom brought about by endless quantitative easing and the Federal Reserve’s bloated $2 trillion balance sheet than with any endogenous factors in the economy itself. US policy makers and economists would do well to qualify their unquestioning loyalty to the Fisher-Friedman “stabilizationist” dogma by reading Machlup and his teacher Mises. Because this latest bubble will not last forever either…