Irrational Exuberance (?)

irrational exuberance 1
An attempt to explain the present stock market bearish behavior...

In his book Irrational Exuberance, Robert Shiller, a professor of Economics at Yale, attributed the latest observed stock market mania to investors psychology.

Shiller believed that “stock market players” were driven by impulse and herd behavior.

An attempt to explain the present stock market bearish behavior by means of the above factors, can similarly present investors as automatons who react mechanically!

In my opinion this view, today, is completely misguided!

Today, investor’s actions, are conscious and purposeful.

It is not some mysterious impulse or herd behaviour that causes investors to generate massive falls in prices that are out of touch with equilibrium, or fundamentals, but rather investor’s conscious actions!

In a free, unhampered market economy, errors generate incentives for their corrections. All other things being equal, the effect of an over-investment in the i.e. production of a product is to depress its profits, because its excessive quantity can only be sold at a price that is low in relation to costs.

The effect of under-investment in the i.e. production of another product, on the other hand, will lift its price in relation to costs, and thus will raise its profits.

Obviously, this will lead to withdrawing of capital from the first product and a channelling of it toward the other, implying that if investment goes too far in one direction, and not far enough in another direction, this will set in motion counteracting forces of correction!

Similarly, for large deviation of stock prices from their fundamentals to occur, there must be a mechanism that undermines the functioning of the market economy.

According to Ludwig von Mises (1881 – 1973), this mechanism is set in motion by the central bank’s monetary policies.

Trouble erupts whenever central bank officials try to improve on the working of the free market economy!

In a free, unhampered market, errors generate incentives for their corrections. These incentives are removed once the central bank begins to inject money, thereby artificially lowering interest rates below the level dictated by i.e. demand and supply.

In a free economy, interest rates in financial markets will mirror consumer’s preferences.

By responding to interest rates, entrepreneurs are, in fact, abiding by consumer’s instructions.

Once interest rates in financial markets are lowered artificially, they cease however, to reflect consumer’s preferences.

This, in turn, means that entrepreneurs, once they are reacting to interest rates in financial markets, are committing errors, i.e., doing things against consumer’s wishes!

As long as the artificially low interest-rate policy remains in force, there are no ways or means for entrepreneurs to know that they are committing errors.

On the contrary, as the policy of the monetary pumping and hence artificial lowering of interest rates intensifies, it generates apparent profits and a sense of prosperity!

The longer the period of artificial lowering of interest rates is, the more widespread will be the errors, i.e., the disobedience of entrepreneurs regarding the will of consumers!

The discovery that entrepreneurs didn’t abide by consumers’ instructions occurs once the central bank tightens its monetary stance!

On this Mises wrote, “As soon as the credit expansion comes to an end, these faults become manifest.

The attitudes of the consumers force the businessmen to adjust their activities anew to the best possible want-satisfaction.

It is this process of liquidation of the faults committed in the boom and readjustment to the wishes of the consumers which is called depression”.

If the lowering of interest rates is a one-time-only event, and is not supported further by the central bank, then the market interest rate will rise. In response to this, stock prices will weaken.

If, however, the central bank clings to its loose monetary stance, this will reinforce the rise in stock prices.

Whenever the central bank reverses its monetary stance, a stock market bust is set in motion.

The severity of the bust is dictated by the magnitude of the preceding boom, i.e., the preceding bull market and by the state of the real pool of funding!

Thus, the longer the bull market, the more widespread the errors were, and therefore the more severe and longer the bear market will be.

We can thus conclude that, contrary to Shiller, the present sharp deviation of stock prices from their fundamentals is the result of monetary policies of the central banks, not a failure of human psychology!