The broad stock market is down nearly 20 percent from its January 2022 peak. Worse is likely to come. Whats going on?
The simple explanation is rising inflation and rising interest rates. When interest rates go up, bonds become a more attractive investment than stocks. The Fed is likely to keep raising rates, so stock prices are likely to keep falling.
But there is a lot more to it. Until the recent outbreak of inflation, the Federal Reserve kept short-term interest rates at close to zero for much of the past decade to fight lingering effects of the Great Recession. Markets convinced themselves that this would last indefinitely. Thats why banks would lend mortgage money for 30 years at bargain rates of under 4 percent.
In this climate, financial engineers could borrow money for next to nothing. To prevent dangerous speculation, the Fed and other regulators should have combined cheap money (which is good for the real economy) with tight regulation. But instead, we got loose money and loose regulation, which always sets markets up for a crash.
The past decade was a predators picnicprivate equity doing takeovers on cheap borrowed money; record corporate mergers and profits for merger and acquisition specialists; stock buybacks to further hype share prices; new gimmicks like crypto.
Tightening interest rates abruptly stunned investors. A bear market feeds on itself, as sellers outnumber buyers.
The crypto crash is a leading indicator. Crypto was always a kind of pyramid scheme. As super-investor Warren Buffett says, you never know whos swimming naked until the tide goes out.
The markets current dive has something in common with the epic financial collapse of 2008. Like todays situation, the 2008 crash was driven by the toxic combination of cheap money and financial speculation. But in that era of unfunded credit default swaps and fraudulent subprime securities, the leverage ratios were almost infinite. Today, thanks to the Dodd-Frank Act (which did not go far enough as anti-speculation), banks at least have more of a cushion.
So todays market crisis is more likely to be a slow-motion crash. Even so, the victims will be the vast majority of Americans who work and live in the real economy and not on Wall Street.
Like the supply chain crisis, this financial mess is the result of legacy policies that long antedate the Biden administration, which has embraced good financial regulation more than any since FDRs. But maybe too late.
Just as voters dont like inflation, they dont like a collapsing stock market or its spillover effects. And voters, justly or not, have a habit of punishing incumbents for bad economic news. Unless he becomes even more of a populist, another victim could be Joe Biden.