Stock Market is where ownerships of major businesses are exchanged, at a price set by underlying business value. If a business is promising and profitable, its price goes up and vice versa. So the value of Dow Jones Index, representing major 30 businesses, should go up or down based on their performance. And the US economic growth should closely reflect the performance of its 30 leading players. Speculations could influence it but the intrinsic business values should largely determine the Dow Index.
But the events of last five years have corrupted this simple relationship. As President Obama's stimulus measures failed to revive the economy at the desired level, the Federal Reserve became, surprisingly, too eager to help. This meant breaking away with many age-old traditional roles. One such break resulted in the expansion of Fed's portfolio through bond purchases. In simple English it means printing money. Fed increased its balance sheet by four times from 800 billion to over 3000 billion in five years. This increased the reserves of the banks. Although banks are not allowed to invest in the stock market a portion of this new money nevertheless found its way into stock market through shadow financial sectors.
So, effectively the steady increase of US stock prices since last economic crisis owes its origin to the nonstop life support administered by the Fed. Fed, the country's economic guardian, did not consider that similar surge through "irrational exuberance" resulted in the economic crisis of 2007.
It is possible that Fed believed the increased consumer spending will increase economic activities and create sustainable recovery. Unemployment went down to some extent. But a major part of that is because a large number of workers quit labour force. According to BLS (Bureau of Labour Statistics), while 63.3 per cent of the population was employed in 2007, the number dropped and never rose above 58.6 since 2009. The U-6 unemployment, which counts the drop-out workers, was 8.4 in January 2007 and is now 13.7 up by 5.2. [The U6 unemployment rate counts not only people without work seeking full-time employment, but also counts "marginally attached workers and those working part-time for economic reasons."]
Alternatively, it is possible that Fed was insincere. It knew that expansion of money cannot help the real sector of the economy: a fundamental teaching of classical economics. After all, if printing money could truly help economic growth and remove unemployment, Bangladesh and all other countries of the world could benefit from such policy. Sometimes, it can create some jobs temporarily but eventually price level will increase and unemployment will return. So it is plausible that Fed wanted temporary show of success. A trick each administration in Washington adopted in recent decades.
The trouble is that this time even a temporary show of success was hard to get. Today's economy is less sensitive to fiscal stimulus compared to the economy of 80's or 90's. So, the Fed and the government are finding it very difficult to create an "artificial" recovery to sustain for a few years. The recovery is "artificial" because any economic recovery dependent on debt cannot be real. Every year since 1980 the US economy performed only by increasing national debt. Stated in another way, if national debt was kept unchanged in any year (not to speak of a lowering it) the economy would have it unraveled.
Besides monetary expansion, Fed adopted the strategy of near-zero interest rate. The rationale is very similar. Low interest will promote borrowing and spending, and will boost home buying. Economy will get the reward and will bounce up.
There are several problems with the "expand money and lower interest" policy. First, it has failed to work. Even after five years there is little sign of real sustainable growth. Second, whatever growth happened, it owes to life support. That is why, both the Fed and the government are so scared even to slow down their support. Third, it shifts the real problem to the future, otherwise known as kicking the can. Fourth, while economics textbooks extol the virtues of savings, these artificial growth strategies totally downplay saving. Fifth, people who save or depend on interest income are paying a heavy price to support such programme. Finally, another serious flaw of the current policy is that instead of the entire economy, only 12 people in Fed are determining the direction of stock market.
This leads to another serious consequence. The link between stock market and economic progress has become perverse. Any sign of economic recovery creates a scare that those 12 people will decide to slow down their support and the stock index tumbles. This is what happened in the last week of June when the Fed signalled that they are considering a slowdown.
The entire US economy is now trapped in a cycle. Poor economy leads to budget deficit and Fed support, economy improves (temporarily), supports are removed, economy falters (because improvement was not self-sustaining), and stimulus reemerges.
During the 60's through the 80's, budget deficit created temporary economic respites. When that failed to work, monetary stimulus did the job. But it appears that this arsenal has lost its power faster than the budget deficit. In this world of artificial solutions, real solutions to our economic problems remain illusive and people are making investment decisions betting on what Fed will do next.
