Stock Market Bailout

At some point, and nobody knows when, the stock market is going to reverse its climb. It may even collapse. It is interesting to speculate on what kind of political response that would generate. Given the politics of entitlement and the propensity of the Fed to intervene, the picture looks pretty grim.

Ideally, of course, the government and the Federal Reserve would do nothing. A virtue of the free market is that its prices reflect underlying realities when they are permitted to do so. When they are distorted by a credit-fueled "irrational exuberance," a correction restores rationality. For that reason, falling stock prices would be welcome.

But because stock-ownership is so widespread, the financial socialists in DC will attempt to use the public fear generated by a bear market to enhance their power. That's what they did after the 1987 crash, when the regulators imposed strict new controls. And in arguing for the Mexican bailout in 1995, the demagogues openly invoked fears of falling stocks as an excuse.

Jim Grant of Grant's Interest Rate Observer reminds us that neither investors nor the public is prepared for the consequences of a bear market. Speaking at the Mises Institute's conference on 'Austrian Economics and the Financial Markets" at the Toronto Stock Exchange, he argued that many people have come to think that a 20 percent compounded return is some sort of natural right. Certainly mutual fund dealers will not be adverse to lobbying for a bailout.

Grant points out that Fed-fueled bull markets are characterized by a loss of fear. Every stock is believed to be a winner over time – and indeed this bet pans out so long as the boom continues. But when it stops, fear is restored to an even greater degree than before it was lost. There will be a tendency for people to look towards political leaders instead of market forces for safety-and these leaders will be glad to oblige.

Gene Epstein of Barron's has an interesting (if ominous) theory about the Fed's likely behavior in a bear market. At the same conference, he said he can imagine that the central bank will jump into both the stock and stock futures market in a futile attempt to change market psychology. And where will they get the money? They could sell bonds-to the public or to themselves.

Selling bonds means nothing more than going into debt, which must be paid at some point in the future, either through taxes or inflation. If the Fed buys bonds itself, it does so with newly created money, which is then injected into the economy. Both strategies create problems down the line because they bring even more market distortions. If the Fed pumped in enough money, the result could be hyperinflation.

In the same way, the Department of Treasury might go stock shopping too. It could use whatever fictional dollars are resting in the Social Security "surplus" to buy up sinking mutual funds. It's financial socialism, to be sure, but the Treasury has become its leading practitioner.

How could the Fed and the Treasury get away with this politically? Simple, says Epstein. Our leaders will point out that the stock market is the best deal out there if looked at historically. By strategically selecting base years, you can show that even in real terms, there is no better place for your money. Also, they might point out, the best investment advice is to buy low and sell high. Hence, the Fed and the Treasury are merely acting the way smart investors would act if they weren't so overcome with fear.

The fallacy here is that government is deigning to know something about markets that market participants themselves deem to be incorrect. From the point of view of the investor, past earnings indicate nothing about the future. That stocks eventually made money between 1925 and 1965 means nothing for the person invested only in downtimes.

Moreover, stock prices do not fall because of mysterious fears floating in the air. A bear market simply means that market players are unwilling to hold stocks at their old prices. For the Fed to intervene in this judgment is to impose a form of price control – an action that is always and everywhere counterproductive.

There is an additional danger associated with government intervention in the stock market. Once the feds become actual and potential holders of stock, they will exercise inordinate control over the companies themselves. As owners, they can influence management. The potential for corruption and eventual nationalization is extremely high.