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Financial market drops and volatility fit into debate about Trump and Fed policies

I wrote on Monday about last week’s drop in the U.S. markets, only to find news later in the day of another big market drop. Further volatility has been occurring this week with another big drop the day of my post. The New York Times summarizes the market events through Tuesday or so at this link, for those in need of a summary of all the excitement. As I pointed out, valuations have appeared lofty for some time. The immediate impetus for the panicky investor behavior in recent days is news about monetary policy and debates about the impacts of various policies on growth and wage growth. Recent employment and growth data have provided evidence of an accelerated pickup in growth around the world and in U.S. wage growth. On top of worldwide growth, the year-on-year wage number in the official U.S. employer survey was the highest in years.

The strong numbers helped to increase Fed-pessimism and bring about the sell-off: Since wages are the biggest item in business costs in the average industry, wage increases lead one to expect price increases. Hence, the probability has increased of more-rapid interest rate increases on the part of the Fed. The financial markets tend to respond strongly to news that changes expectation of the path of Fed policy. Higher interest rates on new bonds lead investors to sell existing bonds and other investments until their expected returns are higher. Also, investors are less eager to take “leveraged” market positions, by paying only a portion of the price in cash. For the New York Times’s account of the factors leading to the recent market turmoil–more or less the same as the above—see this link.

I have argued that characteristics of the situation suggest likely overvaluation in certain markets. One is increasing leverage (use of debt) in our “financialized” economy; in the stock market, borrowed money underlies gains in recent years to such an great extent that realistic assessments of future profitability and soundness may have little to do with “rich” valuations. Floyd Norris in this 2013 Times column pointed to rising margin borrowing as a basis for high share prices relative to earnings–a Minskyan explanation that goes beyond pure Keynesian market psychology.

Tallying policy effects a bit, the Trump tax law passed earlier this year is regarded as unlikely to raise revenues any more than other big tax cuts for business and people with large amounts of wealth. The supply-side theory postulates an effect that works through increased investment that makes workers more productive. More investment and higher productivity increase productivity, which lead to higher growth and real wages. Such effects are likely to be modest and even far-fetched or preposterous when the mechanism is stated fully–especially as justification for a tax cut for a particular group.

Any analysis consistent with the economics of Keynes asks instead about impacts of higher after-tax business revenues and household incomes (“aggregate demand impacts”). Larger streams of cash may help businesses that lack the ability to borrow and may stimulate demand from households, as even the wealthy probably increase consumption when their incomes rise.

Heterodox economists see investment as dependent on profits and output variables such as capacity utilization. They argue that nothing will spur investment if demand for the final product is weak. Hence, unconditional gifts of money that fail to affect the profit rate or output may not change investment. As spurs to consumption, they are weak relative to new money for households that spend every free dollar of their income or feel constrained in their consumption by the need to save. These Keynesian-expected effects of business-oriented tax cuts are expected to be relatively low and certainly not sufficient to increase tax revenues. Nor are they likely to increase real wages for any reason.

The mainstream expects supply-side effects (through investment and worker productivity rather than increased aggregate demand) to be relatively small but tends to accept such this causal analysis of tax cut effects as theoretically valid and relevant, especially over the long run. Often, they see aggregate demand effects as irrelevant in the long run because they average out to zero in some sense.

In part, a Minskyan perspective blames up-and-down Fed stimulus for financial instability and favors an always-low and stable federal funds rate. Consumption-centered fiscal policy or direct job guarantees would be the foundation for any Minskyan alternative in macro policy. On the (modest) effectiveness of Fed stimulus, see this Roosevelt Institute post by Josh Mason–a heterodox blogger and erstwhile Eastern Economic Association political economy presenter. Mainstream Keynesian and Times columnist Paul Krugman’s take on market turmoil refers to stock overvaluation, downplays it as an economic outcome, and concurs that it could significantly impact the economy.

A distinctly post-Keynesian analysis then offers a distinct alternative with some value for those who see the alarming role of debt and worry about the possibility of another crisis. (An absolutely constant policy interest rate is not an essential part of this alternative.) Minsky’s theory was billed as “financial Keynesianism” and complements the policy views of Keynesians such as Abba Lerner, which favored the use of fiscal (taxation and spending) tools as means to achieve full employment and price stability.


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