Crisis On Infinite Markets: What the bleep is going on in the economy?

Crisis On Infinite Markets: What the bleep is going on in the economy?

By Dr. Jerry Hionis

The famed Keynesian economist Sir John Hicks once quipped, “Investment is a flighty bird”. What Hicks meant by this statement is that stock markets, bond markets and the investors involved wherein are almost impossible to truly predict. Further, investors are a particularly finicky bunch; suffering from a self-protective heard mentality that Keynes himself labeled animal spirits. Many stock markets boom and bust merely from the collective “feeling” of investors and rarely from data driven analyses.

After what is now being labeled the Great Recession of 2007/2008, the U.S. economy has been heading back into an expansionary period where all economic indicators (baring the growing wealth and income gaps) are looking quite positive. Yet the stock market took a couple of big dives at the end of August, causing a wide range of panic levels from the academically astute to the economic laity. And while I may spend my days roaming the halls of the preverbal ivory tower of academia (my office building does have a castle-like tower design), the average Joe’s questions about the economy have yet to subside: What is the state of the economy? What is the deal with China lately? Did the stock market collapse? Should I be worried about by savings account? What about my 401K and IRA?

Therefore, in my (never ending) quest to help service the economic queries of the community, I want to present a bit of background as to, as one acquaintance put it, “what the bleep is going on in the economy”?!

 

The Federal Reserve Bank

Beyond the “4 M’s” — meat, music, marriage and moon sightings — no topic seems to still up controversy within the community like the Federal Reserve Bank (I’ll be referring to it simply as the Fed from here on out). Whatever your views might or might not be about the Fed, let us step back and discuss what it is they do.

Simply put, the Fed manages monetary policy by issuing out government bonds, in the form of Treasury Bonds (or “T-Bills”), and controlling the supply of printed notes and coins. No, they do not actually print the money, that is done by the Bureau of Printing and Engraving and is part of the Department of the Treasury; and no, the Fed is technically not “part” of the government, although it has federal government oversight.  One should think of the Fed as a commercial bank’s bank. When a commercial bank — like TD or PNC — need a loan, they can borrow from other commercial banks or from the Fed itself. In fact, the original charter of the Fed was for it to be the “lender of last resort”; that is, if your bank is about to fail and depositors are going to lose all their money, as had happened during the Great Depression in the U.S., then they could get a loan through the Fed and pay a special rate on the loan called the “discount rate”. Given the many problems with free banking (where individual banks print their own versions of official U.S. notes and coins), the U.S. eventually gave the Fed the duty of controlling the supply of money after the effects of the Great Depression.

But how does monetary policy work? This is a complex question that maybe beyond the scope of this short article, but we can discuss it in a more abridged fashion. Let us suppose that we are in a recession: consumer spending is low à producers/investors to produce less à unemployment rises and wages shrink àconsumers have less income and, hence, spend less à repeat the cycle.

The Fed has two general methods of offsetting such a cycle . . . but the two are so interrelated that its basically one system. That being said, we will look at them separately for maximum clarity. The first is to increase the money supply; that is, print more notes and coins (mostly notes) and lend them to commercial banks with extremely low interest/discount rates. The goal is that if commercial banks have more in their vaults, they will increase the amount of loans they are willing to lend and will do so at lower interest rates. Therefore, investment and spending will increases causing more jobs, more income, more consumer spending, more investment and so on.

Second, the Fed can set (implicitly) interest rates for the economy as a whole. No, they do not explicitly restrict and require each bank to set their interest rates according to some kind of Fed mandate. Instead, they use (some would say manipulate . . . but that is a bit hyperbolic for my tastes) market forces to augment the direct of the economy. So, how does it work? As I mentioned above, the Fed issues out Treasury bonds that yield a specific interest rate depending on the “time stamp” on them. The key here is that in a developed nation like the U.S., a government bond is considered the safest and most risk-adverse investment one can make; they do not pay very well, but they are a safe place to put your money in. Hence, government bonds set the official market rate as a whole because it is the benchmark in which all other banks and lenders (even loan sharks) base their rates upon. If for example, the Fed is willing to pay 2% on a T-Bill, then all other banks have to offer at least 2% to remain competitive.

In a recession, the Fed aims to increase consumer spending by decreasing the incentive to put their money away into a bank. Therefore, the Fed will increase the money supply (increasing commercial banks’ lending resources) and decrease the implicit interest rate in the hopes that banks will begin to lend and consumers will spend. This mechanism is commonly known as quantitative easy (QE) and is, to some, akin to devil worship. Beyond some of the more arcane arguments against QE policies, the most common (and legitimate) criticism is the risk of future inflation. Since all indicates have shown more threats of deflation than inflation, the Fed has been engaged in a series of QE policies since the Great Recession began back in 2008. The question that many have been asking ever since the economy has started to stabilize and grow is: when will the Fed begin to increase interest rates?

The Fed has been pretty mum about the issue until the spring of 2015 when rumors began to circulate that interest rates would increase any day now. Eventually, all the insiders had confirmed that September 2015 was the time that QE would be relaxed, signaling the official end of the Great Recession. The Fed would be back to “business as usual”.

Yet, a number of events occurred causing speculation that this would NOT be happening.

 

The Labor Market

 The health of the labor market has always been one of the most important indicators of where the economy is heading. Our aim in the U.S. is to have an unemployment rate of 5%, known as the Natural Rate of Unemployment, where the 5% allows for normal labor mobility from firm-to-firm and industry-to-industry (economic growth cannot happen if there is 0% unemployment). As of the latest job numbers, the U.S. is at an unemployment rate of 5.1% mark with employers demanding close to, on average, 200,000 new jobs per month, most in the professional sector (that’s a good sign).

Yet, again, there is a problem. Increasing wage rates normally follows decreasing unemployment: as the demand for labor increases, firms have to compete over a shrinking pool of unemployed laborers and will, hence, increase wages to increase attraction. Unfortunately, this has not happened. Wages have remained stagnant; in fact, I have been hearing the terms “sticky” and “anemic” more often then not. This tells us two things that are happening:

  • While unemployment is decreasing, we still have a large number of “long-term” unemployed — those unemployed for so long that they have stopped searching for employment; known as “discouraged workers” in economic jargon — and are now coming out of the woodwork looking for employment. Marx often referred to the labor reserve army of unemployed and desperate workers that were always willing to work and, hence, bust any unionize effort to strike. In a sense, this is true today: the number of truly unemployed workers is so large that while they are now getting hired, there is no incentive for firms to offer higher wages and benefits since the supply of skilled labor (remember, the unemployment rate of those with college degrees is depressingly high) is so large.
  • Many may have taken jobs they were over qualified for but still needed gainful employment. Now with the jobs market opening up, they workers are starting to find jobs that are more matched with their skill set.

In addition, one must know that the official unemployment rate is only a month-to-month indicator of the labor market and does not represent the true percentage of the working population who are without work. Once again, the technicalities of the unemployment rate calculation are beyond the scope of this article. One major worry amongst economists is that while the unemployment rate is falling, there may still be many who are employed in jobs that do not truly match their skill set; for example, a certified medical doctor flipping burgers at a (halal) fast food truck. Not to say that the former is an undesirable occupation, only that the medical doctor would be more productive and valuable within the field he/she has spent so long investing time and money into learning. When the economy is working on a more functional basis, workers tend to remain unemployed until they find the job which best utilizes their skillset. Since the economy had been malfunctioning for such a long period of time, many could wait no longer and chose jobs which mismatched with their skillset.

Either way, the stagnant wage rate is causing the Fed to be very, very (VERY) cautious about declaring the “Everything Is Okay” signal to the economy. Investors like stability and confidence in the state of the economy. If there is uncertainty over what the Fed will be doing with interest rates (which will change the whole dynamic of the economy itself), then most investors will limit their decisions until events become better defined. Hence, a slow down, or even a dramatic dip, in the stock market will be expected.

 

China

 Of course, we would be remised if our economically symbiotic relationship with China (or, as Donald Trump would say, “Chyn *breath retention* nah”) were not mentioned.

To give some background, the Chinese has been running at a 10% economic growth rate for a number of years now. To give some comparison, a developed nation like the U.S. aims for a 2-3% growth rate where a 4% rate is considered a boom. It should also be noticed that most economists view the numbers coming from China to be a bit skewed due to the lack of transparency in their statistical process. Regardless, they have been growing at an extraordinary rate. Why? Since the Cultural Revolution, the Chinese economy has been employing a state capitalism model that had aimed at increasing production in all areas of the economy. This has, generally, worked quite well for China in that it has increased employment, income, investment, production possibilities and all other manners of economic necessities for high-density consumption akin to most developed economies.

The problem now is that the Chinese economy has hit a wall and their growth rates have slowed to around 7%. The numbers are still good, but the decline has indicated that the Chinese economy is now in transition. The old-school model of mass expansion in production has reached its limit; hence, the number of infamous “ghosts cities” that have emerged throughout the Chinese landscape. In addition, the Chinese government had slowly created a bubble by endorsing, through state media, a coming “bull market”. Basically, the Chinese government was attempting to increase the perception that demand in the Chinese economy was increasing with the hopes that citizen investment, being spurred by its reporting, would increase the actual demand to predicted levels. Sometimes this works; sometimes it doesn’t. In this case, it didn’t work. While much of the world was concerned over the European Union’s troubles with Greece, the Chinese stock market was crashing. The bubble had burst. The Chinese government attempted to flex its power to help quell the crash but came up unsuccessful.

In a mildly desperate move, the Chinese government employed a policy of deflating their currency with the direct purpose of increasing the attractiveness of their exports (unscrupulous, but not illegal necessarily; besides, most economies do it from time to time). To explain, one has to realize that the value of any currency, whether backed by gold or not, is relative to what you are comparing it against. Devaluing one’s currency causes inflation in prices but also increases the purchasing power of foreign investors. Yes, devaluing currency looks “weak” from a political standpoint, but it is quite an effective way of increasing sales of exports.

 

How Does All This Affect Me?

With trouble in China and uncertainty of the labor markets stability, many economists are predicting that the Fed will choose to delay interest rate increases (and I would personally agree with this decision). Due to this uncertainty of both domestic monetary policy and the overall state of the global economy, investors will remain erratic and skittish. Therefore, sudden spikes and lulls are to be expected.

Are your retirement accounts safe? Depends. If you are planning on cashing in your 401K in the next month or so (do not forget to pay your zakat on it!), then you might take a hit. If you are planning on retiring in the next ten, twenty or thirty years, then there is absolutely nothing to worry about. In fact, you might even benefit from this drop. With some stocks bottoming out, investment firms will be able to grab some lucrative shares at cheap prices. When the market bounces back, your portfolio will now be worth even more!

Is our country’s economy safe? The U.S. has been growing steadily at 2% for sometime now but many indicators give us “mixed bag” results. For a number of reasons, our economy is growing but the Great Recession has laid down some pretty substantial poisonous roots into the economy. Frankly, the question depends on what your occupation is and where you are located. The most hit sectors are those that either focus in exporting to China and, interestingly, those in the petroleum field — such as petroleum engineering — due to: (a) falling crude oil prices; (b) increased focus on natural gas extraction; and, (c) a surplus of unemployed college graduates with a degree in the field. Due to its location, western states near the Pacific Ocean are expected to take significant blows due to China’s economic problems; Oregon and Washington are mention often.

The consensus then is that the latest shake up in the stock market is not a sign of a coming systemic economic downfall. The optimal strategy is to bear through the next couple of months until certainty within the market comes back – probably after the Fed’s policy meeting later this month.  Of course, Allah knows best.

 

About Jerry Hionis

About Jerry Hionis

Jerry holds a PhD from Temple University. His primary research is in conflict theory with an emphasis on civil conflicts and Warlord-like competition. Other research interests include game theory, economic development, Islamic economic theory and history, political theory and African economics.

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