Obama's Stock Market Mini-Bubble

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Since the end
of February when the S&P 500 closed at 735.09, the index has
been pushing strongly ahead, closing on Friday, May 8, at 929.23
– an increase of 26.4%. We suggest that the key driving force
behind this strong bounce is a massive increase in liquidity. What
is it all about, and how do changes in liquidity drive the stock
market?

In a market
economy, a major service that money provides is that of the medium
of exchange. Producers exchange their goods for money and then exchange
money for other goods.

The increase
of production of goods and services results in a greater demand
for the services of the medium of exchange (the service that money
provides). Conversely, as economic activity slows down, the demand
for the services of money follows suit.

The demand
for the services of the medium of exchange is also affected by changes
in prices. An increase in the prices of goods and services leads
to an increase in the demand for the medium of exchange. People
now demand more money to facilitate more expensive goods and services.

A fall in the
prices of goods and services results in a decline in the demand
for the medium of exchange.

Now, take the
example where an increase in the supply of money for a given state
of economic activity has taken place. Since there wasn’t any change
in the demand for the services of the medium of exchange, this means
that people now have a surplus of money or an increase in monetary
liquidity.

Obviously,
no individual wants to hold more money than is required. An individual
can get rid of surplus cash by exchanging the money for goods.

All the individuals
as a group, however, cannot get rid of the surplus of money just
like that. They can only shift money from one individual to another
individual.

The mechanism
that generates the elimination of the surplus of cash is the increase
in the prices of goods. Once individuals start to employ the surplus
cash in acquiring goods, this pushes prices higher.

As a result,
the demand for the services of money increases. All this in turn
works towards the elimination of the monetary surplus.

Once money
enters a particular market, more money is now paid for a product
in that market. Or we can say that the price of a good in this market
has now gone up. (Remember a price is the number of dollars per
unit of something.)

Note that what
has triggered increases in the prices of goods in various markets
is the increase in the monetary surplus or monetary liquidity in
response to the increase in the money supply.

While increases
in the money supply result in a monetary surplus, a fall in the
money supply for a given level of economic activity leads to a monetary
deficit. Individuals still demand the same amount of the services
of the medium of exchange. To accommodate this, they will start
selling goods, thus pushing their prices down.

At the lower
prices the demand for the services of the medium of exchange declines
and this in turn works toward the elimination of the monetary deficit.

A change in
liquidity or the monetary surplus can also take place in response
to changes in economic activity and changes in prices. For instance,
an increase in liquidity can emerge for a given stock of money and
a decline in economic activity.

A fall in economic
activity means that fewer goods are now produced. This means that
fewer goods are going to be exchanged, implying a decline in the
demand for the services of money – the services of the medium
of exchange.

Once,
however, a surplus of money emerges, it produces exactly the same
outcome with respect to the prices of goods and services as the
increase in money supply does, i.e., it pushes prices higher. An
increase in prices in turn works towards the elimination of the
surplus of money – the elimination of monetary liquidity.

Conversely
an increase in economic activity while the stock of money stays
unchanged produces a monetary deficit. This in turn sets in motion
the selling of goods thereby depressing their prices. The fall in
prices in turn works towards the elimination of the monetary deficit.

There is a
time lag between changes in liquidity, i.e., a monetary surplus
and changes in asset prices, such as the prices of stocks.

For instance,
there could be a long time lag between the peak in liquidity and
the peak in the stock market. The effect of previously rising liquidity
could continue to dominate the effect of currently falling liquidity
for some period of time. Hence the peak in the stock market emerges
once the declining liquidity is starting to dominate the scene.

(The reason
for the lag is because when money is injected it doesn’t affect
all the individuals and hence all the markets instantly. There are
earlier and later recipients of money.)

Exploring
how changes in liquidity had historically been driving the stock
market.

For instance,
the yearly rate of growth of our monetary measure AMS stood at 4.1%
in March 1974 and 4.5% in May the following year. Despite the relative
stable money-supply rate of growth, the yearly rate of growth of
monetary surplus had a large increase from negative 7.7% in March
1974 to a positive figure of 7.6% in May 1975.

Read
the rest of the article

May
13, 2009

Frank
Shostak [send him
mail
] is an adjunct scholar of the Mises Institute and a frequent
contributor to Mises.org. He is chief
economist of M.F. Global.

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