To borrow a phrase from the Vietnam era, the financial markets are “in a dynamic state.” In other words, no one knows what the hell is going on.
The whole world, but especially the United States and European Union, faces enormous uncertainty, a situation in which we not only do not know what the future holds, but we cannot even list the possible outcomes, much less the likelihoods of any of them occurring.
Such uncertainty undermines efficient use of resources, especially for long-term investment in productive facilities and infrastructure, and it undermines economic growth at a time when it is most needed.
The volatility of the past few days raises questions about the “efficient markets hypothesis.” Once widely accepted by financial economists, this is the belief that at any time, the price of an asset fully reflects all of the information available about all the factors that may affect its current and anticipated value. It depends heavily on assumptions that humans are rational and motivated by self-interest.
This does not mean that markets have perfect information about the future or never get things wrong. Nor does it mean that some individuals’ ideas of what something is worth cannot be better or worse than the market as a whole at any given point.
It does mean, however, that no one can outdo the markets systematically. Some person may be smarter than the collective sentiment of the market at times but cannot be consistently so.
People not conversant in finance theory may wonder why this is important. And they certainly may question why, if markets are so good at digesting new information, stock markets can plunge 5 percent one day and soar an equal amount the next, supposedly in response to news that, on reflection, had been largely available for days or even months.
That is the Achilles heel of this much-vaunted theory. It may be correct in many situations, but it is also of exceedingly little relevance when uncertainty is great and people acting in financial markets are driven primarily by fear and greed, two of the most irrational factors possible in human decision-making.
The more volatility there is in markets, the more wary individuals are about saving and investing their money and the more cautious businesses are about investing in new machines, software or training for employees. They hesitate to initiate new ventures, to take any risks. This all results in slower economic growth and more persistent unemployment.
This week has also pointed up the limited power of central banks like the Federal Reserve. A central bank can act as a lender of last resort and try to keep a nation’s financial sector from collapsing.
But success is not guaranteed and the short-run actions deemed necessary in the heat of an emergency may work against longer-term interests.
That is why there is a highly unusual and visible division of opinion on the part of policy makers. The Fed’s Open-Market Committee met Tuesday in the immediate aftermath of Monday’s 5 percent drop in stock prices. The Fed cannot lower nominal interest rates any further, and its efforts to increase the money supply via unprecedented purchases of government bonds have run aground on the shoals of commercial banks’ hesitancy in lending to businesses and individuals.
All the Fed can do is to try to change public and market sentiment. It chose to do so by committing to keeping short-term interest rates low for another two years. But three of the committee’s10 voting members publicly dissented from this gesture. One dissent is common and two not unknown. But having three dissenters is extremely rare.
This is not because the committee usually thinks alike, but rather that a wise Fed chairman does not push any initiative that does not have the support of all but one, or in exigent circumstances two, of its members. Any visible lack of consensus carries the danger of frightening markets more than reassuring them.
The fact that Chairman Ben Bernanke chose to put Tuesday’s commitment up to a vote illustrates how dire he considers the situation. The U.S. economy still could slide into a worse situation than we have seen in the past four years.
This does not mean that the three dissenters, including Minneapolis Fed President Narayana Kocherlakota, are out in left field. Their concerns about the dangers of making policy commitments that the Fed may not be able to carry out or of unleashing inflation are valid ones. The split is a judgment call about which knowledgeable and well-motivated experts can differ.
Eventually all this uncertainty will be resolved. The outcome may well be painful for many, however.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.