Ashland University Professor Looks at Reasons for Stock Market Drop

Thomas W. Harvey, associate professor of finance at Ashland University and director of Ashland University’s Gordon E. Heffern Institute for Contemporary Financial Studies, takes a look at the reasons for the recent stock market drop in the United States.

It Isn’t the Raising of the Debt Ceiling…It’s a Lot More Than That!
My family was in Europe last week on vacation where we heard that there had been a deal struck in Congress to raise the government’s debt ceiling by $2.4 trillion and to lower its spending by $900 billion over ten (10) years. While this should have been done several months ago with the public no wiser, I didn’t think much of it except that $900 billion in governmental budget cuts over ten (10) years really isn’t that much. But, then, as I was looking at the financial news on Friday morning, August 5, I saw on Bloomberg that the Dow Jones Industrial Average lost 512 points the previous day. We hadn’t seen a drop like that since 2007 – 2008 and that started me thinking…why?

On Saturday morning, I picked up a copy of the International Herald Tribune (August 6 – 7, 2011) where Liz Alderman’s column caught my eye (1). In it, she said that many analysts are coming to the conclusion that Europe and the United State may be dealing with fundamental economic and financial problems and will be facing the fallout from the global financial crisis for years to come. “Politicians have done everything to demonstrate they are not ahead of the curve,” said Stefan Schneider, the chief international economist at Deutsche Bank in Frankfurt. “That is hitting market confidence and creating a self-fulfilling feedback loop.”

Now, that started some additional thought. If the policymakers in Washington, Frankfurt, and London are not “ahead of the curve,” the markets know it so a little data was in order. Looking at the results of the Dow Jones from the beginning of 2010 through the first few days of 2011, it is evident that there has been no sustained growth in stock prices as its averages have “waffled” between 10,000 and 12,800 but nothing more than that. With no growth in the stock averages, it is apparent that the market was not impressed with the current economic policy of the United States, even though the country had come out of the great recession of 2008 very quickly and corporate earnings have been strong. Yes, the unemployment rate is still high, but generally, it had seemed like things were good, financially, but the market didn’t think so. And, on Thursday, August 4, the Dow Jones lost 512 points. Was it the debt ceiling deal that caused it or was it something more? I continued thinking about the existence of “fundamental economic and financial problems.”

If it had been the debt ceiling deal itself, the markets would have shown weakness on the
Monday after the deal was announced. That didn’t happen. So, there had to be more to it. But, there was something about the debt ceiling fight that was a concern. The bitterness of the Boehner – Obama stalemate was over their own political agendas, and it did not seem that they had the good of the country in the forefront of their thinking. Didn’t they realize that the world’s financial markets were looking for strong, coordinated leadership from the policymakers of the world’s strongest country, and the last thing they wanted was political bickering which was put ahead of the importance of market stability. So, maybe the debt ceiling argument was not the cause of the market reaction, but maybe it was signal of something bigger that triggered the significant sell-off.

Predictably, the first vote on the debt ceiling package passed the House and failed the Senate right along political party lines, again taking direction from their leadership: Mr. Obama and Mr. Boehner. That suggested that rather than thinking about what was best for the people of the United States, and also the world, they were more concerned about their party line agenda. And, now we were two days away from default. Then, Sen. Mitch McConnell (R, KY) comes out and says that things can happen very fast on Capitol Hill. They had to have known about this issue for months and could have resolved it very quietly, but they waited until the last minute for an ideological statement on their own political purposes which the financial markets definitely did not like, losing 512 points, or 4% on August 4, 2011. And, then, Standard and Poor’s downgrades U.S. debt two days later from AAA to AA+, the first time since 1917 that the U.S. was not AAA. Serious losses were expected on Monday on Monday, August 8 which were confirmed as the Dow was down 635, or 5.55%. That evening, the headline on Fox news was “Fear and Panic.” Millions of people see that and immediately believe it.

Last weekend, Paul Krugman had written in the same edition of the International Herald Tribune (7) that the U.S. economy was not recovering and Washington was worried about the wrong things. He went on to say that Federal Reserve policymakers and members of the Obama administration had been insisting the economy was recovering as they suggested that every setback was attributable due to temporary factors – “It’s the Greeks” or “the tsunami” – that would soon fade. That, he concluded, turned the focus of American economic policy from growth to deficit reduction. Growth was supposed to come from consumers, but millions are still burdened by the debt that they assumed during the housing bubble of 2003 – 2007. So, they aren’t ready to spend, and neither is business due to the lack of consumer demand.

Hold on…the Fed and the Obama administration had told the American people that the financial crisis of 2008 was over as was the great recession of 2008. But, if millions of Americans are still overburdened by debt, maybe it isn’t. But, if it isn’t, and we had TARP, QE1, and QE2, and we have another crisis on our hands right now, what can policymakers do now that they didn’t already try in 2008 and 2009. Maybe the “waffling” stock market of 2010 and 2011 was a better predictor of the economic and financial situation than was the rhetoric coming out of Washington.

Clearly, there is something else going on here over and above the debt ceiling deal. It had to be related to it, but as our vacation was ending, it wasn’t a concern until the next day. Sitting in the airport in Frankfurt on Sunday morning, I was reading the Financial Times – Saturday August 6 / Sunday August 7 and was a bit surprised to read the headline: Grim week echoes depth of 2008 crisis.

The article that followed by Richard Miller; Robin Harding; and Guy Dinmore (1) provided some insight from the European perspective. In it, they wrote: “Europe’s crisis represents systemic risk, and, in that there are analogies to [the financial crisis] of 2008,” said Eric Fine, portfolio manager and Van Eyk Capital. “It’s better than 2008 because at least the U.S. has a policy framework, but the diminishing returns of those policy responses are also now known. The lender of last resort, the rich uncle, is not so rich any more. He’s tapped out.” There is a red flag: If the U.S. is “tapped out,” and TARP and the other economic actions of 2007 – 2009 didn’t work, what can be done now?

Now, I wondered how many Americans had ever thought about that. I continued reading an article by Robin Harding (2) in which she wrote that the policymakers at the Fed expect economic growth to return later this year as supply chains that were interrupted by the earthquake and tsunami in Japan get back to normal and lower oil prices allow consumers to start spending again. Paul Krugman was right: policymakers are still making excuses. And, then, she said something that struck an historical chord with an ominous sound: If there were to be a sustained financial panic like we saw in 2008 after the bankruptcy of Lehman Brothers, the Fed would have to act but only after it had more evidence that its econometric scenarios are wrong. But, Fed tried everything imaginable in 2008 and the country is in the midst of another crisis so what would it do this time? That might have the markets a little nervous. More important, companies like Long Term Capital Management and Lehman failed because their management believed their economic models, disregarding what the market was saying. Is Fed doing the same thing?

In the same issue of the Financial Times, Gavyn Davies closed the loop (7). In his article, he wrote that the debt ceiling fights in Congress were a political act, not one aimed at really solving the problem. Of course, that was it. The markets looked at what was going on in Washington, knowing that the increase in the debt ceiling should have been done quietly and efficiently earlier this year. The political side of it could have been handled with a long term plan to balance the federal budget (and, no, we do not need a Constitutional amendment to accomplish that). And, to stimulate growth, we need tax breaks for small business, the real engine of economic growth in this country.

So, here’s the problem that the world sees, Watching Mr. Boehner, Mr. Obama, and the rest of Congress bicker and fight publicly for their own political agenda has shaken the confidence of the world’s financial markets in the U.S. Instead of worrying about economic welfare of the country, it appears that they are concerned about their own agendas. The bottom line…they would default on the debt of the strongest country in the world for political reasons. That shook the world’s confidence in the ability of Washington to lead the global economy, raised questions about its ability to solve the problems of 2011 since it hasn’t solved the ones from 2008, and posed ethical questions about the policymakers who would rather put their own agendas before those of the good of the country.

It wasn’t the debt ceiling crisis that started this financial concern, but the debt ceiling pointed out the shortcomings of American economic and financial policy. The world looks to America for financial leadership which is based on confidence and trust. It doesn’t look like the financial markets believe that they have either one. The question becomes systemic: how to restore that confidence and trust? The answer is easy to say, but apparently difficult to achieve. Only true bipartisan cooperation and compromise of political leaders, in conjunction with the Fed and the Treasury, will enable it. However, that will take a long time, and I sincerely hope we have it.

We were glad to get back to the States on Sunday night after a very restful vacation in Europe. 24 hours later with the financial markets in turmoil, Europe seemed very close again, financially, but, at the same time very far away.