An Access Advertising EconBrief:
Did China’s Sneeze Give Wall Street a Cold? No, Just the Sniffles
Suppose you kept a chart designed to keep track of your physical condition. Each day, you recorded the number of push-ups, sit-ups, jumping jacks and leg lifts you performed. Over the period of one month, the number of each exercise performed rose every day. You would rightly conclude that your physical condition was improving.
Suppose, though, that you spent the next month in the hospital recovering from a serious operation. You emerged from the hospital twenty pounds below your normal weight. For your first month following the hospital stay, your exercise log recorded much lower numbers of each exercise performed than before your hospitalization. Would you now consider your physical condition “below normal?”
No, you would adjust your expectations for normal physical performance to account for your weight loss and hospital stay. Factors other than exercise affect your physical condition. These constitute the “parameters” of the relationship between your physical condition and the level of exercise you perform. Ceteris paribus (all other things constant), we would expect the ability to perform exercise to vary directly with physical condition; e.g., the more exercise performed, the better the physical condition. When one of the “other things” changes, this change produces a greater or lesser level of physical condition associated with any level of exercise performed.
Economists recognize the importance of distinguishing between functional change and parametric change. Last week, we were handed a golden opportunity to apply this principle when world stock markets collapsed on Monday, August 24 – only to revive again two days later.
The “Black Monday” Stock-Market Collapse of Monday, August 24, 2015
“Markets Reel in Global Selloff,” screamed the headline in the August 25 Wall Street Journal. “Concerns about China’s economy intensified, accelerating the selloff across global markets as investors tried to assess whether the rout was just a short-term pullback or a signal of deeper trouble,” wrote reporter Corrie Dreibusch. “The Dow Jones Industrial Average fell 1,089 points Monday morning – the worst intraday drop in its history – then popped back up like a cork and fell again in a jagged line to finish 588.40 points down, extending a slide that has left the blue-chip index off 11% this year… European and Asian shares suffered even deeper declines, with the Shanghai Composite Index tumbling 8.5%, entering negative territory for 2015, having risen as much as 60% at its peak in June…”. In Japan, the Nikkei Stock Average fell 4.6%, while Australia’s S&P/ASX 200 Index fell 4.1%. “Meltdown was the only word that can be used to describe price action in equities…,”according to ANZ economist Mark Smith. And the carnage occurred amid heavy trading volume – the NYSE saw trading volume of almost 6.6 billion shares, nearly twice the daily average.
To be sure, there were the usual complaints about such computer-activated trades as “automatic selling” tied to stop-loss orders, which apparently contributed to the size of the initial selloff. The flood of sell orders engulfed many brokerage houses, making it difficult for smaller investors to execute their customary exit from the market in the face of price declines. One individual, on the verge of retirement, was quoted as saying, “I felt this was on a roll now and not going to stop for a while, so it’s just time to move” [emphasis added]. The speaker was explaining the reasoning that had induced him to reduce his portfolio’s stock composition from 50% to 5% just at the time when stock prices were plummeting. Ironically, however, it was apparently the much-maligned high-frequency trading firms like Virtu Financial, Inc. and Global Trading Systems LLC that stemmed the tide of the decline and produced the midday price recovery. By day’s end, the Dow Jones Industrial Average finished down 3.6% at 15871.35.
Meanwhile, the Euro and the U.S. dollar benefitted from their status as (relatively) safe havens. The dollar appreciated relative to the currencies of Russia, Indonesia, South Africa and Brazil; that is, relative to countries heavily dependent on commodities (oil, coal, metals and sugar, respectively) whose prices have been battered by a declining Chinese economy. The dollar’s appreciation came on the heels of a rise that has taken it back to the peak it reached at the start of the year, when it was perched at the highest level it has enjoyed in years.
Naturally, the first thing on everybody’s mind when they regained their breach after the market roller-coaster coasted to a stop at day’s end was: What’s going on? Is this the Armageddon that so many of us have secretly feared and expected for the last seven years? Or is it yet one more false alarm in an economic environment that is increasingly coming to resemble a high-crime urban landscape in the wee hours of a weekend, with car alarms going off unheeded and fires smoldering in abandoned buildings?
The Niall Ferguson Explanation: Chimerica at Work
The eminent and popular British historian Niall Ferguson quickly weighed in with an explanation (“‘Chimerica’ and the Rule of Central Bankers,” The Wall Street Journal, 08/28/2015). In order to understand recent events, we must appreciate the combined effects of policies undertaken by the U.S. and China. Ferguson and his collaborator, economist Moritz Schularick, have referred in recent years to “Chimerica” to stress the – often unintended – interrelationships of these policies.
Prior to 2008, the Chinese government’s policy of promoting exports and discouraging household consumption (thus promoting saving) complemented the U.S. tendency to import heavily and save sparingly, financing consumption via portfolio investment from abroad. Ferguson and Schularick claim that Chinese saving was so massive that it held U.S. interest rates unduly low and helped feed our housing bubble.
Subsequently, China “reformed” its economy by encouraging consumption, financing it with budget deficits and overspending by its national government. It reduced its interest rates, came to rely in a “shadow banking” sector similar to ours and created its own investment bubble. At this point, the two countries’ policies were no longer complementary and they created dangers for the world economy. If both nations went into recession simultaneously, it could foster worldwide depression.
Now Ferguson and Schularick see the makings for just such a calamity. The U.S. Federal Reserve has been setting the stage for an increase-rate increase in September 2015 ever since last year. Meanwhile, a Chinese recession is in prospect. Economists have recently expressed doubts about the veracity of official Chinese-government claims of 7% economic growth in the most recent quarter. The Chinese government has instituted frantic attempts at economic stimulus. (These, we observe parenthetically, have ranged from the quixotic [trying to rig higher stock-market prices by encouraging their institutions to buy stocks but threatening potential sellers!] to the depressingly conventional [lowering interest rates in an attempt to increase investment] to the alarmingly provocative [lowering reserve-requirement-ratios on bank reserves].)
Ferguson sees the current problem as the result of both the Chinese and U.S. economies “try[ing] to exit easy money at the same time.” Fortunately, “China took the first step” toward remedying this flaw by reversing its course in a stimulative direction. Now the U.S. must coordinate its monetary policy with China’s by steeling its resolve to raise interest rates and holding fast to its determination to “normalize” its interest rates at last. Only one country can kick the easy-money habit at once, the two believe. That country should be the U.S.; China should return to easy money.
Thus, Ferguson and Schularick feel that the latest Wall Street “Black Monday” was the result of “Chimerica,” the “symbiotic relationship increasingly dominating the world economy.” The unfavorable developments in China threatened recession there at the same time as a U.S. interest-rate hike loomed. “For the first time in financial history,” Ferguson claims, “a sneeze in Shanghai gave Wall Street – and almost every other stock market in the world – a cold.”
Are they correct?
The “Dudley Effect:” How an Interest-Rate Increase Can Affect Economic Events Without Actually Happening
In order to put the impact of Chinese economic dislocations upon Wall Street in their proper perspective, consider the effect of a statement made by William Dudley, late of the New York Federal Reserve and notorious economic and monetary insider. On Wednesday, August 26, Dudley remarked publicly that China’s downturn and its apparent effect on stock markets had made the case for the U.S. Fed’s scheduled September interest-rate increase “seem less compelling.” To a layman, this might see like a casual, off-the-cuff reaction. But the public vernacular of monetary policy consists of subtle hints and vague suggestions. By the standards of the craft, Dudley’s use of the muscular adverb “compelling” practically constituted a thundering declaration. His words landed on the investing world with oracular force. Not surprisingly, they were seconded by a host of pundits and familiar celebrity economists such as Lawrence Summers.
By the end of the week, the U.S. stock market had recovered virtually all the ground it had lost on Monday and Tuesday.
What inferences may we draw from this stunning sequence of events? The beginning of the week seemed to herald the return of 2008 – or worse. By week’s end, financial markets had backtracked completely. Without the benefit of training, experience and context, it would be impossible for even an intelligent layman to make sense of this. But economic logic can do it.
First, we must recall that Dudley formerly held the top policymaking position at the New York Federal Reserve, and that the New York Fed was the action arm of the Fed’s Open Market Committee and the Chairman. Dudley has long been viewed as the eminence grise of America monetary policy, the policy insider who knows all the secrets and the propensities of policymakers. Thus, his words are viewed in the same light as those of Warren Buffett on the topic of value investing. Like Buffett, Dudley is a man who can move markets with a single carefully chosen sentence.
Second, we recall that markets have passed through a long period of adjustment after the Fed’s original announcement of eventual intent to raise interest rates (more precisely, to raise its benchmark rate and cause ripple effects that will affect other short-term rates). Originally, the first increase was to have come in June. Then the date was pushed back to September. The long lag between announcement and execution not only allowed time for the effective date to be pushed back, it also allowed time for the markets to digest the effects of the higher rate in advance of its actual occurrence. The practice of adjusted to an event before it occurs is referred to in financial circles as “discounting” the effects of an event. This is one of countless cases in which economists use a familiar word in an unfamiliar, specialized sense. Here, “discounting” does not mean ignoring or disregarding. It means incorporating the expectation of the event into one’s current behavior. The effect of this is to mute or perhaps even to fully negate the impact of the event once it actually occurs. If (say) Apple were to suddenly declare bankruptcy tomorrow, the surprise announcement would cause consternation and tremendous change and dislocation throughout the world. But if Apple were to announce tomorrow that it would declare bankruptcy on a date exactly three years from tomorrow, by the time the bankruptcy date arrived, very few dislocations would occur. Advance knowledge of the event would allow everybody to adjust their behavior accordingly, so on the actual bankruptcy date, there would be little reaction – all the big reactions would already have happened. That is what “discounting the future” implies.
And that is what markets have been doing ever since the Fed announced their intention to increase interest rates sometime in mid- or late-2015. U.S. interest rates have gradually risen somewhat higher. The U.S. dollar has been appreciating slowly and steadily since 2014. In effect, people began behaving as though interest rates were already slowly rising as the anticipated date of the rate rise drew gradually nearer.
That fact, coupled with the immediate aftermath of the Dudley announcement, puts the issue of the Chinese economy and the U.S. financial markets in a whole new light.
At issue is the effect of developments in China on the U.S. economy – specifically, on the U.S. financial markets. But there are certain givens, certain parameters that must be kept in the background in such an analysis. One of those is the status of U.S. interest rates – which, as we have seen, includes not merely actual interest rates but also interest rates that are expected to hold in the future. And the sledgehammer losses of Black Monday and the following Tuesday occurred before William Dudley’s momentous comment on Wednesday – when the investing world expected U.S. interest rates to rise when the Fed Open Market Committee met in mid-September. Thus, we can label this result “September Rate Hike = Dow down 588 points (3.68%).”
After Dudley’s statement, everybody in the world “knew” that the September rate hike was dead in the water. As Reason Magazine put it, “December is the new September” – December being the next scheduled Open Market Committee meeting. And, wouldn’t you know it, in the following week, more bad economic news came out of China. (The news was that China’s manufacturing sector was showing weakness.) But this time, the background against which that economic news was placed didn’t seem quite so unfavorable to participants in the financial markets. Why? Because they were contemplating an interest-rate rise further in the future, over three months instead of only a couple weeks away. Consequently, the fall in the Dow wasn’t as pronounced as before. The Dow Jones Industrial Average fell 470 points (2.8%) to 1601 instead of falling over 1000 points before settling at down over 588 points as it had on Black Monday. This result is labeled “December Rate Hike = Dow down 470 points (2.8%).”
Deferring the rate hike by a mere three months had the effect of reducing the fall in the Dow by nearly a percentage point (.88%). What this tells us is that, while it is clear that financial markets take developments in China seriously indeed, it is really the background against which those developments occur – specifically, the height of current or expected U.S. interest rates, that governs the strength of that so-called symbiotic relationship linking “Chimerica.”
Experiments in the Social Sciences Compared to the Physical Sciences
Ferguson and Schularick present us with a hypothesis about the relationship between the Chinese and U.S. economies; namely, that the two are so closely intertwined that changes in each have large repercussions in the other. They go even further than that, maintaining that policymakers can and must manipulate economic events to prevent this mutual interdependence from producing adverse outcomes. This implies that both governments have the knowledge, ability and motivation to take the appropriate actions – an implication that economists and political scientists have been taking for granted for most of the 20th century and all of the 21st.
Ferguson tells the story of the recent Black Monday episode using a colorful metaphor: Shanghai sneezed and Wall Street got a cold. We can put this metaphor in quasi-scientific terms, enabling us to view recent events as a kind of laboratory experiment. The Chinese economy (or, more precisely, changes or developments therein) is the independent or causal variable. U.S. financial markets, for which we can use the Dow Jones Industrial Average as a proxy variable to simplify matters, is the dependent variable. And the level of current or expected U.S. interest rates represents a key parameter affecting the dependent variable – a parameter of paramount interest in this case.
The events of recent weeks have allowed us to observe something that happens only rarely – a controlled experiment in which successive changes in the independent variable and a key parameter while the dependent variable was held roughly constant have produced revealing results.
Normally, economists have to hold key variables constant statistically because in real life economists can acquire date only over fixed intervals and the relevant variables refuse to hold still for our benefit – they change because people insist on living normal lives instead of participating in a grand experiment to further the interests of social science. But in this case we saw a combination of two unusual, fortuitous occurrences: successive weeks saw two significant changes in the Chinese economy sandwiched around the remarks by William Dudley (and others) that shifted expectations about when the U.S. Federal Reserve would begin normalization of U.S. interest rates.
When we carefully observed the results of each change, we determined two things. First, Dudley’s suggestion that the September interest-rate hike should not occur was sufficient to virtually reverse the effects of Black Monday and Tuesday. Second, when a Chinese “shock” occurred under a somewhat more favorable interest-rate environment – the expectation that interest rates would rise in December instead of September – this reduced the effect on the Dow by almost one percentage point (specifically, by .88%). Taken together, these results suggest that internal parameters generally and interest rate expectations specifically are more causative of changes in U.S. financial markets than are developments in the Chinese economy.
Seldom does life present us with the opportunity to observe an economic experiment in the laboratory of reality. Here, we were able to observe a change not only in the dependent variable (the Chinese economy), but also a change in a key parameter affecting the dependent variable (U.S. financial markets). And the result warns us that, however, tempting a grand thesis (“Chimerica”) may sound, we should keep our wits about us and subject it to a common-sense test.
As it happens, we can say more about the Ferguson-Schularick hypothesis. These additional comments do not derive from good fortune but from sound theory.
Why Should Central Banks Stop Monkeying Around With Money?
Niall Ferguson was not the only prominent personality to weigh in on the subject of Black Monday. Former Council of Economic Advisors Chairman Martin Feldstein wrote in The Wall Street Journal about “The Fed’s Stock-Price Correction” (8/26/2015). Feldstein believes that the Fed’s easy money policies after the 2009 stimulus were aimed at herding investors into the stock market by depressing yields on fixed-income assets. (This is called a “portfolio substitution” strategy.) When stock prices rose, the resulting effect on real incomes would make households feel wealthier. In turn, this would make them spend more, and this increase in consumer spending would stimulate more production and spending via a multiplier effect.
According to Feldstein, the strategy worked – too well. It produced a bubble in the stock market that is now beginning to burst. He expects the bubble to continue deflating (or “unwinding,” as he puts it) “for several months.” Whereas Ferguson and Schularick regard the interrelation of the Chinese and American economies as the decisive factor posing danger to the world economy, Feldstein sees the “mispricing of assets” caused by easy money policies as “enough to make the downturn inevitable.” A “variety of events” lit the match, but the tinder had already been placed by central banks.
Oddly, while Feldstein holds central banks accountable, Ferguson and Schularick believe that only central banks can prevent disaster. Feldstein does not trust central banks, but he strongly believes that fiscal policy – that is, policies involving government taxation and spending – are necessary to “stimulate the economy without increasing the national debt.”
These commentators call to mind the parable of the blind men who encountered an elephant, each one fondling a different part and each one concluding that he grasped a different animal. They have each grasped a portion of the truth. In particular, Feldstein’s concern for mispricing of assets is well-founded but insufficient. It is not only stocks that are mispriced – investments of all kinds and durations are mispriced by a policy that does not allow interest rates to perform their fundamental function of coordinating the actions of savers and investors through time. Moreover, each of these commentators is blind to the fundamental fact of economic life: government runs the economic show today despite the fact that regulators lack the knowledge, expertise and motivation to do the things that they claim the ability to do.
The worst offender in government today is the central bank. Their worst offense is the control of interest rates. Normalization is the first step on the road back from economic serfdom. It should begin immediately and proceed uninterrupted.