August 26, 2015

Quick rethinking of the stock market

Comment on ‘Quick thoughts on the stock market and the economy’


The monetary order, banking, and the stock market are institutions that evolved historically. Like in biological evolution the outcome of this messy process is often suboptimal. Institutions can and must be designed,constructed and maintained. The U.S. is particularly bad at institution building.

Mortgage financing, for example, is a very old and rather simple business. In Germany it was institutionalized in 1900 with the Mortgage Banking Act. This law was so well-crafted that it worked with minor modifications until 2005 when it was abolished in an act of institutional suicide. This was when deregulation was the hype of the day, which lasted until Wall Street's meltdown. This financial mega crash first of all showed one thing: what happens when you do mortgage banking the American way.

Remember that the investment banks literally invented and pushed subprime lending and the derivatives superstructure. No classical mortgage banker, neither in Germany nor in France, would ever have touched this type of business. It is important to realize that after 1900 there has never been a real estate boom-bust cycle in Germany. That is quite remarkable when one considers that Japan, the U.S., Britain, Spain and many other economies have been badly devastated by real estate busts.

Interim results: (i) financial crises are the result of a bad institutional design, (ii) the U.S. is particularly untalented at institution building, (iii) in the international arena, according to a variant of Gresham’s Law, bad institutions crowd good institutions out, (iv) without well-crafted counter-measures the financial superstructure quite naturally deteriorates and becomes a menace to the real economy.

Therefore, the question is not: does the stock market have an effect on the real economy? but: should the stock market be allowed to have such an effect in the first place? Or, even more fundamental, is a stock market needed at all or can its useful functions be taken over by a better designed institution and its negative impacts thereby eliminated?

The stock market wrecked the U.S. economy in the 1930s and in 2008. This is sufficient proof of a dilettantish institutional design of the financial sector including the central bank. For China the fundamental question is whether she needs a stock market at all. It should not be impossible for the Chinese economists to come up with a superior institutional design that shields the real economy from dysfunctional international shifts between liquidity, stocks, and bonds.

With a plan-B in place, China could let equities crash, buy the rest cheap, close the stock market, regain her full financial sovereignty, and live happy thereafter.

Rethinking economic theory is indispensable because neither Walrasians nor Keynesians have found out until this day how the market system works.

Egmont Kakarot-Handtke