No, the Stock Market Isn't a "Leading Indicator" of Economic Prosperity
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“STOCK MARKET UP ANOTHER 300 POINTS,” Donald Trump tweeted on October 12, with characteristic overcapitalization. “GREATEST LEADING INDICATOR OF THEM ALL!!!”
President Trump’s use of the stock market as an economic indicator is hardly unusual. Democrats like to tout the stock market performance under Obama as a counterpoint to Trump’s boasting. This type of thinking, which equates stock market performance with economic health, is widespread. It’s also somewhat understandable; by the twentieth century, middle-class stock ownership had become the standard strategy for saving and investing, giving most citizens a personal interest in market activity. When the market goes up, investors benefit, and this makes market activity a powerful political issue.
However, as a metric of the overall health of the economy, stock market performance is, at best, a misleading and unreliable indicator. Strictly speaking, stock prices indicate nothing more than the price people are willing to pay for partial ownership claims in businesses. With a stable money supply—a fantasy scenario in the modern world—stock market gains would reflect increased levels of savings and productivity and would indeed be indicative of economic growth.
Why Stock Prices in an Inflationary Economy Are Different
But for inflationary economies, which have become the global norm, newly created money bids up these prices, without—or in excess of—actual savings. In one sense, this is not unlike the effect money supply inflation has on every other marketable good, and the fallacy of viewing inflation-driven price hikes as economically desirable is not as absurd as it might immediately appear. In the 1930s, it was precisely this line of thinking that drove New Deal policymakers. Thinking price increases could somehow spur the economy to new heights, New Dealers curtailed production, burned crops, and slaughtered livestock to prop up farm prices as a solution to the Great Depression, even while millions of Americans struggled to feed their families.
Nowadays, federal officials don’t seek price increases by curtailing production, but instead increase the money supply through central bank efforts in the open market (among other strategies). The Fed is now engaging a wide variety of asset purchases that require the creation of new money. And it is likely to expand these efforts in the future. For the time being, at least, the Federal Reserve does not purchase stocks directly, though the Fed has recently started buying company bonds for the first time, suggesting that direct stock purchases are likely on the horizon.
But how does this relate to stock prices? The primary issue linking credit expansion and the stock market is the misallocation of resources driven by an artificially low interest rate.
Understanding the consequences of inflationary policy is one of the many reasons the study of Austrian economics, and the Austrian business cycle theory in particular, is so important. As central banks pump new money into the economy—ostensibly for the purpose of stimulating consumption, though in reality to finance government deficits through the purchase of Treasury securities—the supply of loanable funds expands, producing lower interest rates for borrowers.
With a nonfiat money supply (e.g., precious metals or cryptocurrencies) interest rates reflect the general rate of savings, and savings require delayed consumption. But credit expansion (i.e., creating money out of "thin air") distorts this signal and facilitates borrowing even as people consume more in the present. Companies invest in expanded lines of production, competing against consumers for resources. In the short run, the economy enjoys low unemployment rates, indulgent consumption, and, of course, a rising stock market.
Negative Long-Term Consequences
Eventually, though, prices adjust to the new money supply, leaving businesses with higher production costs than they originally anticipated, and the produced goods find limited markets; without delayed consumption, there is less future consumption, but the interest rate failed to reflect this. The stock market crash that follows is not the cause of a bad economy, in other words, but rather the consequence of artificial growth and misallocated resources.
The relationship between the stock market and consumption habits is easily relatable through common financial decisions that most people face at some point in their lives. Consider the decision to purchase a house, which for most people represents the most significant consumer decision of their lives. When the Federal Reserve sets a low target interest rate—meaning that they intend to increase the money supply in pursuit of that interest rate—people applying for mortgages enjoy lower rates as well. Home buyers with savings held in mutual funds or something similar often compare the annualized rate of return to the low mortgage rates and decide that it makes more sense to borrow, rather than pulling their savings out of the stock market to pay off part or all of their home.
Easy Money Leads to More Money in Stocks
This, in fact, is a standard recommendation from professional financial advisors. And individually, the recommendation is sound—at least on paper, which doesn’t reflect the security of outright ownership in weathering economic downturns. In the aggregate, however, decisions such as this reflect the way artificially low interest rates facilitate the simultaneous increase in consumption and stock market investment. With people choosing to borrow money instead of cashing out stocks, businesses essentially expand consumption as if these home buyers did not have a monthly mortgage. The distorted interest rate, therefore, leads to financial decisions that set false expectations about future discretionary income. Considered in the aggregate, this individual logic—along with the array of similar personal and business decisions that weigh borrowing against projected returns on investment—makes clear the relationship between inflationary fiscal policy, stock market growth, and economic crashes.
Returning to the president’s boastful tweet, it is important to remember that credit expansion to lower interest rates has been the standard Fed policy since long before Trump took office. This does not mean that he is devoid of blame for the economic consequences that inevitably follow inflationary booms. As recently as May, the president called for negative interest rate targeting, indicating an even more expansionary fiscal policy than his predecessor. With a need to finance the record-setting deficits Trump has supported, instead of the balanced budget he promised during his 2016 campaign, his call for loose money is no surprise. Although this means that Trump does deserve at least some credit for the rising stock market, the only gains that can come from his fiscal policies are the unhealthy, temporary gains that accompany the misallocation of resources prior to the corrective bust. To the degree that the stock market reflects this artificial growth—and it certainly does—it cannot serve as an accurate metric of economic health.