The Bull Market’s Flawed Foundation
Tighter money supply ahead?
Increased risk for investors when market growth outpaces economic growth.
Alan Greenspan is correct to be concerned that soaring stock prices will lead to higher spending and prices elsewhere in the economy. He is also correct that the extraordinary increase in the stock prices is being fueled by a wave of optimism. What he does not say is that neither the wave of optimism nor the rising stock prices would be possible without the massive amounts of new money created by the Federal Reserve and the banking system.
Since early 1995, the banking system, under the umbrella of Federal Reserve System and related government intervention, has expanded the money supply measured by currency, checking deposits, and money market funds by over 60%. This is the biggest jump in the money supply since the 1984-87 period, which caused the surge in the stock market before the ’87 plunge.
Greenspan, in an article he wrote in the ’60s, “Gold and Economic Freedom,” (please see footnote) described how this process worked in the late ’20s. He discussed the Fed’s attempt to lower interest rates by pumping excess reserves in the banking system: “The excess credit which the Fed pumped into the economy spilled over into the stock market—triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late….” While the environment in the ’20s was different in some ways from that of today, the Fed stimulated the boom then, just as it is doing now. In attempting to stimulate the economy with easy money, the Fed cannot control where the money will flow; it can only initiate and encourage the flow.
What confuses people about today’s situation is that the rise in prices thus far has been mainly limited to a rise in stock prices, and to a lesser extent, real estate prices. By contrast, if the Fed’s inflation of the money supply were causing grocery prices to skyrocket as they did in the ’70s, people would be alarmed. They would demand an end to the inflation, which is why, in 1979, Paul Volcker was brought in. However, when stock prices soar, people say, “Relax, it’s a bull market.” Nevertheless, when the rise in the stock market far outstrips the growth in the economy for many years, one must look for another explanation.
A major reason the excess money has gone into the market over the past few years as opposed to other areas of the economy, is that the market has been rising, with a few brief exceptions, since the early ’80s. The ruinous inflationary policy of the Fed in the ’70s pushed real rates of return into negative territory and drove the stock market down to a fifteen-year low in real terms. In the 80’s, the Fed reduced the rate of money growth, and positive real rates of return were restored, which enabled the stock market to catch up from its dismal performance in the ’70s. By 1995, the accepted wisdom had become that all one needed to do is buy blue chip stocks no matter what the price, and hold them for the long pull. Any losses would be temporary.
Rising stock prices will inevitably lead to rising prices in the rest of the economy. First, due to their rising stock portfolios, people feel they have enough savings, and therefore, can afford to consume more. This, of course, is known as the wealth effect. Here is a common example: In 1995, approximately 500 shares of Proctor & Gamble were required to purchase a Honda Accord; today, one can purchase three Honda Accords with the same 500 shares.
Also, businesses are taking advantage of the high prices offered for their shares in the stock market by selling equity or borrowing against the rising market value of their existing equity. The frenzied rush by Internet companies to raise money through IPOs and secondary offerings is a very visible example of this process. They use the money to buy computer gear, hire scarce technology workers, buy advertising, rent office space, etc…
Therefore, the stock market is working like a transmission belt by which the newly created money will ultimately push up prices across the economic system. At that point, the Fed will be compelled to act forcefully, sharply tightening the money supply and raising interest rates substantially. Given today’s high valuations, these rate hikes, or the anticipation of rate hikes by investors, will cause the market to fall further. Novice day traders and thousands of other investors, oblivious to the risks they have been taking, will experience substantial losses.
1. Alan Greenspan; Gold and Economic Freedom; Capitalism: The Unknown Ideal; Ayn Rand; New American Library; 1966.