Speculative markets are not black holes

Marc Faber is a very knowledgeable guy, but thumbing through a copy of his most recent Gloom, Boom, & Doom Report, I stumbled on a pretty big error. Here is Faber:

"All the liquidity that central banks have created isn't flowing into the real economy but remains in asset markets (mostly financial markets) buying and selling currencies, bonds, stocks, real estate, art, entire companies, etc. For example, most corporations find it advantageous to buy back their own shares (in order to boost their share prices) instead of investing in new plant and equipment... Or take wealthy individuals as another example. Most of them invest in stocks, bonds, funds or real estate; very few of them go out and build businesses. Private equity funds do the same: instead of building new businesses, they tend to buy existing assets." 

and later on:

"I believe that as long as savings and newly created fiat money flow into booming and speculative asset markets, real economic activity will remain depressed."

Faber is repeating a very old fallacy that goes something like this: new money and credit can stay tied up in financial markets indefinitely. This unproductive absorption of capital by speculators in turn prevents the real economy from benefiting. New buildings and factories go unbuilt, consumer goods go unsold, and cutting- edge technology goes undeveloped because the stock market 'sucks up' all the money.

Marc Faber styles himself as an Austrian economist, so he should know that Fritz Machlup, an Austrian 'fellow-traveller', dealt with this particular fallacy in his 1940 book The Stock Market, Credit and Capital Formation (pdf).

In a nutshell, newly-created money (or already existing money) that flows into stock and bond markets does not enter a financial black hole. For every buyer there is a seller. By definition, money will flow away from the market on which it is spent just as quickly as it enters it.

Here is the argument in more depth. Say that Frank (for lack of a better name) invests fresh money in a new issue of corporate shares. These funds don't fall into an abyss. Rather, the issuing company now owns them and uses them to build a factory. Faber would approve since machinery is being created from scratch.

But even if Frank uses the new money to buy already-issued shares rather than newly-issued shares, these funds don't get sucked into a vortex. They are now held by the seller of the used shares, Tom. And the moment Tom uses these funds to buy a car or invest in his home business, they are released into the real economy.

Of course, Tom might simply reinvest the funds earned on the sale in another stock or bond. But this changes nothing since an entirely new seller, Sally, comes into ownership of the funds. Like Tom, Sally might choose to invest it in real capital or on consumption, the real economy enjoying the benefits. Or she might choose to reinvest in the stock market, selling to Harry, and so on and so on. But even if the next ten or twenty recipients of Frank's newly-created money all choose to reinvest those funds in equities, the stock market is nothing akin to a black hole. At some point along the chain the money will inevitably arrive in the account of an investor who chooses to dispatch it to the so-called real economy by either purchasing consumption goods, services, or some sort of industrial good. Though the chain along which this money might travel can include many people along the way, when it finally exits only a few financial heartbeats will have passed.

So in sum, contra Faber money and credit cannot be held up inside speculative markets. It doesn't take long for it to be spent into the real economy.

For those who like to keep track of these things, the 'financial black hole' myth is related to the 'idle cash on the sidelines' myth, dealt with ably by John Hussman many years ago. In the 'sidelines' story, money sniffs its nose at the market and stays at the edge of the dance floor only to have a sudden change of heart, subsequently flooding the stock market. But as Hussman points out, when you put your cash on the sidelines to work in the stock market, it becomes someone else's cash on the sidelines. Both the black hole and sidelines stories are wrong because money doesn't disappear when it is spent. Rather, there is a seller who is left holding the stuff.

Do credit-induced asset price bubbles show up in GDP?

Having read Larry White's book on free banking (pdf) and a number of George Selgin's papers I consider myself to be an advocate of free banking. That being said, I can't help but wonder about a few of George's recent points in his post on Intermediate Spending Booms, the most recent in a series of posts that trains a critical eye on market monetarists. Here is George:

But in seeking to free monetary theory and policy from the Keynesian overemphasis on interest rates, the Market Monetarists tend to downplay the extent to which central banks can cause or aggravate unsustainable asset price movements by means of policies that drive interest rates away from their "natural" values. Such distortions can be significant even when they don’t involve exceptionally rapid growth in nominal income, because measures of nominal income, including nominal GDP, do not measure financial activity or activity at early stages of production.

George is saying that nominal GDP might not properly capture the effects of a central bank setting its rates below the natural rate because it doesn't measure a few key variables, namely financial activity and early-stage investment projects. This sounds somewhat like a rechristening of the classic Austrian complaint against traditional measures of inflation. Here, for instance, is an article by Bob Murphy talking about how relatively tepid changes in CPI might mask credit-induced asset bubbles.

As I pointed out in my comment on George's blog, GDP calculations include investment, presumably much of which is in the early stages of production. GDP also includes inventories. Bill Woolsey describes this better than I can.

As for changes in financial activity due to excess credit, I think GDP should capture it pretty quickly. The next little bit is just a paraphrasing of Fritz Machlup's The Stock Market, Credit, and Capital (pdf). Machlup wrote it to counter claims that the stock market was capable of "tying up capital". It's a great read.

Fritz Machlup

Say artificially low interest rates convince a speculator to borrow from a bank in order to fund the purchase of a stock. When the transaction is completed the speculator owns the stock. On the opposite side of the transaction, the seller of the stock has been freed of her position and owns cash. She in turn can do two  things with this cash. First, she might buy goods. This will immediately show up in GDP. Alternatively, she can buy another stock, in which case a third person now owns the cash. This third person can in turn either buy goods, which registers in GDP, or purchase new stock from a fourth person. This fourth person can.... you get the point. The process proceeds fairly quickly until someone in the chain purchases a good, thereby allowing GDP to capture the effect of excess credit.*

Another factor limiting the ability of long chains of stock transaction to tie up capital is that the longer the chain continues, the more likely stock prices are to be bid up. At higher prices, firms are more willing to finance themselves by issuing new shares since their cost of capital has fallen. This is because they can raise more today than the day before while issuing the same amount of shares. When firms issue new shares they drain the purchasing power originally created by excess credit creation out of the market and invest it in new capital. This allows GDP to ultimately capture the effect.

So a decline in market rates below the natural rate will result in more credit, and this credit could very well be used to purchase stocks, and this will put upward pressure on prices. But just as quickly as credit is used to buy stocks, purchasing power is released from the stock market as the sellers of stocks use the proceeds to buy real goods. GDP measures will capture the effect. I think this process happens fairly quickly given the agileness of financial markets. Maybe George thinks these chains can persist for some time.

One interesting side note. Say that the purchasing power created by excess lending exits the stock market when someone in the chain purchases used goods, say an old couch. Second hand goods transactions are not included in GDP calculations. So in this case, the effects of excess credit might not show up in GDP. It's for this reason that Nick Rowe  prefers the value of total transactions ( P x T) to nominal GDP (P x Y) as his choice indicator. Incidentally, George too invokes the idea that measures of transactions might be better indicators of monetary conditions than income measures:

When interest rates are below their natural levels, spending is re-directed toward those earlier stages of production, causing total nominal spending (Fisher’s P x T) to expand more than measured nominal income (P x y) 

It would seem then that market monetarists like Nick Rowe and Selgin do have some things in common.

*There is a third thing that can be done with the cash. It can be held. But if people do this, then the issuing bank never issued excess credit in the first place. Sufficient demand already existed in the economy for bank liquidity and this is expressed by the fact that people willingly decide to hold those newly created deposits.