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Spilled Milk

January 9, 2001

Nasdaq: July 2000-Jan 20001Let us consider, for a moment, a complex modern economy in which the price of farm products is declining. Farmers may begin pleading for the government to stop the price drop. "Wealth is being wiped out of the economy," they will complain, "the value of our farms has fallen 50% in the last year. This makes everyone poorer, since we can't spend as much." This reasoning makes their pleas seem to be for the good of the whole nation, not just a matter of self-interest.

Surely, any free-market economist would debunk this wrong-headed thinking. Wealth has not disappeared from the economy at all! The same farms, the same fields, the same tractors are here today as were there last year. If some farms have shut down, it is only because they were economically unnecessary.

All that we definitively can say has occurred is that there has been a change in relative prices. A bushel of wheat buys fewer dollars, but the flip side of this that a dollar buys more wheat. Those holding wheat are hurt, but those holding dollars, or any other good which did not decline along with wheat, are helped. This constant adjustment of prices by market participants, so as to bring supply and demand into balance, is the essence of the market process. Beyond pointing out this most elementary of economic facts, there is little further we can say about whether "everyone" is better off with the new price configuration than they were with the old one. Certainly, though, we can point out that it will not do to try to maintain the old prices by government manipulation in the face of the new data of supply and demand.

Or consider the continuous, thirty-year decline in the price of computers. Economists have (quite correctly!) heralded this as a sign of the wondrous powers of the market. Certainly, computer manufacturers would like to have seen a thirty-year rise in the price of PCs (if they could, in fact, have sold the same amount at the higher prices). We haven't heard any economists worrying about the wealth that was disappearing as the value of one of our old Tandy 1000s headed to $0.

So why do so many "free-marketers" have such difficulties when the fall in prices occurs in the stock market, instead of in the market for agricultural commodities or personal computers? When stock indices fall, we hear repeated worries that "wealth is being wiped out." On the surface, this seems too obvious to argue. With the NASDAQ plunging from 5100 to 2400, the total capitalization of the index has shrunk by over three trillion dollars. It looks as though this wealth has simply vanished into thin air.

However, as we have seen above, this view is the result of confusion between the money prices of goods and the amount of wealth in the economy. The NASDAQ decline has not leveled any buildings or rendered any machines inoperable. America is just as full of farms, warehouses, railroads, and oil wells as it was when the NASDAQ was at its peak. The dot-com wipeout has not sucked the knowledge of Java programming out of anyone's head. Certainly, some companies have shut down. But these were the companies that, in light of the new configuration of market prices, it no longer seemed worthwhile to operate.

The stock market decline represents a shifting of wealth. Those who were holding cash, bonds or gold are now wealthier, as their assets can buy a greater share of various corporations. Those who were short shares of companies they judged to be over-priced are wealthier. The largest group made better off by the decline is the non-stock-holding consumer. The stock-rich have been bidding up the price of various goods. (Try, for instance, hiring a building contractor in Fairfield County, Connecticut, where one of us lives.) Those whose assets have declined will no longer be able to bid as much, making these items more affordable for others.

Cries for the government to stop the market decline are no less special interest group pleading than are attempts by farmers to boost wheat prices. Those holding stocks have come to expect that they have the right to see the prices of their assets at a certain level, and call for the government to intervene when this expectation is disappointed. A campaign pitch designed to appeal to the "investor class" is essentially promising that stock prices will remain high and only go higher. Such a political pitch is, in essence, no different from a campaign that promises farmers higher wheat prices or labor unions higher wages. It is a promise to use political muscle to redistribute wealth to the favored group.

This gives us an insight into the push to "privatize" social security. The real "free market" solution is, of course, to truly privatize retirement savings, by eliminating social security and allowing people to save for retirement on their own. What the pseudo-privatizers are looking for is a way to legally mandate that people invest in the stock market, in an effort to keep stock prices rising.

The price of securities must ultimately rest on their prospective future yield. While American productivity has been increasing, and we would therefore expect higher future yields on stocks, this explains only a small portion of the 85% rise in the NASDAQ in 1999 and the further 20% increase at the beginning of this year. We contend that a good deal of the NASDAQ run-up was due to the Fed flooding the market with liquidity in preparation for Y2K. This liquidity entered the capital market first, creating a classic "market bubble."

In addition, as Auburn University economist Roger Garrison has pointed out, the Fed has attempted to create a "firewall" to protect the "real" economy from the securities markets. But firewalls work both ways. We might reasonably suspect that holders of securities have begun to feel that they would be protected from changes in the rest of the economy, with the government stepping in to bail them out, as during the Mexican and Long Term Capital Management crises.

Freely established market prices are not arbitrary; they serve a definite social function. At any time, the current market price of a share of stock reflects the best estimates of experts—where "experts" are those who have demonstrated the greatest foresight in the past—of the future price of this share (adjusted for interest). Any perceived arbitrage opportunity will be quickly bid out of existence. Thus the critic of the price movement is implicitly asserting that he knows better than those actually risking their own money to support their convictions do.

In any discussion of share prices, we must also keep in mind the social function of the stock market itself. The price of a stock is closely connected with the present value of the expected future revenues of the company. Thus, unlike stamp collectors, those buying stocks are not merely guessing what everyone else thinks the future stock price will be. (In this respect, Keynes’ analogy of a beauty contest in which each judge tries to guess which contestant the other judges will rate highly—rather than which contestant is actually beautiful—may be dangerously misleading.)

A surprisingly poor performance will invariably reduce a company’s share price. This is vitally necessary, in order for the market to accurately price the company itself. In the event that a company’s book value is worth less than the sum of its assets, the company becomes vulnerable to the much-maligned (but socially beneficial) "corporate raider." The corporate raider—epitomized by Danny DeVito in Other People’s Money—may then execute an "unconscionable" leveraged buyout, thereby liberating the underutilized assets (including labor) and transferring them to the highest bidders, i.e. those expecting to use the assets in the most productive way.

Before condemning a fall in a stock index, we must first ask, "Why has the stock market plummeted?" The answer to this question demonstrates why any interference with the process is harmful. Many people seem to think the recent drop is simply a case of an "irrational," self-fulfilling prophecy. But to the extent that this is true, the real wealth of the economy (as argued above) has not changed one iota.

Suppose everyone decided that he or she is holding too much cash. People start spending more, which drives up prices until everyone’s real cash balances have been reduced to the desired level. Far more than the slide in the NASDAQ, this scenario represents, on paper, an unambiguous reduction in wealth. (Everyone possesses the same number of physical items, but now holds smaller real cash balances.) Yet nothing real has changed; the same number of factories and final products still exist.

But what if the stock market plunge is due to something more fundamental than mere speculation? In that case, the euphemism "correction" is accurate. If people realize with dismay that they have been overly optimistic about future corporate earnings, or increase the premium they place on present over future dollars, this must necessarily reduce share prices. This may be indicative of what we might legitimately term a decrease in the society’s wealth.

 However, the decline in prices is merely a symptom of the previous errors, not their cause. If Americans gave up their romantic illusions about the Civil War, the value placed on the Lincoln Monument would fall considerably, perhaps even to the point of its being worth more as rubble. This loss of a patriotic symbol would not be offset by anyone’s gain, but this certainly does not justify any attempts to interfere with the adjustment. People might regret their previous value judgments, but there is no use crying over spilled milk.

Of course, none of the above should be taken to mean that the government should deliberately try to lower security prices, either! Rather, the market should be allowed to price securities in accordance with supply and demand. Furthermore, to the extent that government policies interfere with the smooth operation of the market economy, those policies should be abandoned. High and progressive tax rates, tariffs, subsidies, price controls, and so on act as a drag on the economy as a whole and restrict human liberty. They should be discarded for those reasons. If, in addition, they lead to an increase in stock prices, this is merely a welcome side effect for the owners of those assets.

As Ludwig von Mises said in Human Action:

It is easy to understand why those whose short-run interests are hurt by a change in prices resent such changes, emphasize that the previous prices were not only fairer but also more normal, and maintain that price stability is in conformity with the laws of nature and of morality. But every change in prices furthers the short-run interests of other people. Those favored will certainly not be prompted by the urge to stress the fairness and normalcy of price rigidity.

Supply-siders might feel patronized by the above analysis. These free marketers believe they are speaking out against government intervention in the credit markets, a position that should warm the hearts of the present writers. For instance, conservative columnist Deroy Murdock writes, "[The lives of Americans] have been disrupted as Greenspan and his fellow central planners willingly sacrifice them to the gods of inflation." Yet Murdock’s prescription is not the abolition of the Fed, with a complete removal of politics from the determination of the interest rate. Rather, Murdock fancies himself a better central planner; he knows true inflation when he sees it.

Supply-side economist Larry Kudlow recommends tax cuts and deregulation to forestall the coming recession. This is all fine and good. But he also declares, "The Fed should do its part by relieving excessively tight liquidity conditions." On what basis does Kudlow judge liquidity to be tight? Those supporting hard money might feel that pumping any quantity of artificial credit into the stock market represents excessively loose conditions.

Criticism of the Fed chairman is certainly a welcome change from the fawning that has become too commonplace. (As Murray Rothbard pointed out, when a government official is invested with the power to wreck the economy, it is vitally important to convince the public that the official in question possesses superhuman powers.) Greenspan, as the supply-siders correctly note, often makes mistakes, mistakes with drastic consequences. Rather than suggest our own ideal interest rates, though, we must recognize that such a policy is beyond the powers of any one person.

There is a relevant historical precedent for the strategic danger to free marketers of surrendering to the siren song of "sustained prosperity through credit expansion." Three Republican administrations, under the influence of the intellectual ancestors of today's supply-siders, encouraged the Fed to pump "sufficient credit" to businesses throughout the 1920s.

It was also Rothbard who, in America's Great Depression, convincingly demonstrated how this continual credit expansion paved the way for the collapse of 1929. Since this occurred under GOP, "pro-market" administrations, the doctrine of laissez-faire was discredited, in the mind of the "man on the street," for decades afterward.

Only by returning the credit and stock markets to the truly private sector can we eliminate the boom-and-bust cycle which, no matter how many times government experts declare it to be extinct, somehow always rears its ugly head.

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Robert Murphy (ofur1984@hotmail.com) is a graduate student in economics at New York University. Gene Callahan, who writes frequently for Mises.org, is working on a book called Economics for Real People. See his Archive or send him MAIL


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