New Global Economic Worries Affect Equities

Business and economic news of the past week has sent the US equity market tumbling- again.

In an editorial in the Wall Street Journal on August 16th entitled The Fed Can't Solve Our Economic Woes, Gerald O'Driscoll, Jr., contended exactly that. Which would seem to be germane right now, as many are looking for more Fed quantitative easing to magically rescue the equity markets.

O'Driscoll wrote,

"First, our lingering crisis and economic weakness was brought on not by a Keynesian failure of effective demand, but by a Hayekian asset boom and bust. Second, the textbook case for low interest rates treats the policy as one of benefits without costs. No such policy exists.

In these scenarios, the collapse of demand is a consequence- not the cause- of the bust. Policies to address the crisis must get the cause and effect right.

The financial panic and ensuing great recession was a classic balance-sheet recession. As balance sheets shrank in value, demand collapsed. There was a liquidity crisis as well, centered around Lehman's collapse, but the driving force was collapsing balance sheets, impaired capital values and, for many, insolvencies.

Until balance sheets (corporate and household) are restored, increased spending cannot be sustained.

What is in short supply is not liquidity, but savings. The Fed can supply the former but not the latter. Now there is little further it can do that is beneficial."

If O'Driscoll is correct, then the widespread hope that the Fed will save the markets again is in vain.

As I write this, Jeffrey Sachs, currently a professor at Columbia, is explaining, in an appearance on CNBC, that we are experiencing the result of decades of negative savings by US consumers. He agrees with O'Driscoll.

Whether by the Fed's quantitative easing, or its monetizing of more Treasury borrowing, or the latter's printing of money, it's difficult to see how more liquidity will do anything to alleviate the longer term economic issues. Sure, such measures may give a short term shot to equities, if the money finds its way there.

But, lately, investors have been fleeing to Treasuries, driving rates down. A classic Keynesian liquidity trap. O'Driscoll notes,

"Low interest rates slow the process of restoring balance sheets by keeping asset prices artificially inflated. They also penalize saving, thus prolonging the process of rebuilding balance sheets."

Higher long term US economic growth is dependent upon hiring, which isn't happening in this economic environment. O'Driscoll favors tax cuts and, generally, whatever allows consumers to keep more of their own money to save and invest.

But judging from the Fed's and federal government's recent and expected actions, that's not on the agenda of either entity. Which, if you believe O'Driscoll, bodes ill for near and longer term US economic recovery.