Tag Archives: stockmarkets

Economic Illusions

In my book An Extraordinary Time, I document the hubris of economists who thought they had discovered the key to economic stability during the postwar Golden Age. Esteemed experts such as Walter Heller, chairman of the President’s Council of Economic Advisers under presidents Kennedy and Johnson, and Karl Schiller, West German economy minister and then finance minister as well, believed economists knew enough to tell presidents and prime ministers how to assure strong economic growth and low unemployment. It was a seductive vision. It also proved to be an illusion: when economic crisis arrived at the end of 1973, the experts were unable to deliver the prosperity they had promised, leaving citizens frustrated and angry.

A reader recently asked whether talk of a “Great Moderation” in the late 1990s and early 2000s was a similar display of hubris. As was the case during the boom of the 1960s, those involved in economic policy in the late 1990s seemed to think they had conquered the business cycle. They had many admirers. Journalist Bob Woodward feted Alan Greenspan, then the chairman of the Federal Reserve Board, as “The Maestro” for orchestrating the economy’s smooth performance. Of course, the Great Moderation ended in the deepest economic crisis since World War II — a crisis that is long since over in the United States, but has yet to come to an end in parts of Europe.

While macroeconomists displayed no lack of hubris in boasting of the Great Moderation, I would submit that there was an important difference between the economic policies of the 1960s and early ’70s and those of the Greenspan era. Walter Heller and his contemporaries didn’t pay much attention to monetary policy. Their version of fine tuning involved manipulating instruments under direct government control, mainly taxes and government spending, to achieve a desired economic outcome. The Fed was an afterthought. This approach to fiscal policy was badly discredited by the economic failures of the 1970s and has never come back into fashion.

During Greenspan’s time at the Fed, in contrast, fiscal policy was in disarray. Deep divisions between Democrats and Republicans and between Congress and President Clinton rendered the U.S. government incapable of changing tax rates and federal spending to achieve any particular economic goal; although the federal budget went into surplus at the end of Clinton’s presidency, this was more the result of unexpectedly high tax receipts during the Internet boom than any deliberate purpose. Greenspan himself was no fan of fine tuning. Rather, he was among the very large number of economists who believed the central bank should use its control over short-term interest rates to achieve price stability, and that other important factors affecting employment, the rate of economic growth, and the prices of financial assets were beyond Fed control.

Yet this point of view involved hubris as well. Macroeconomists in the 1990s overwhelmingly believed that the prices that mattered to the economy’s performance were those paid by consumers. The Fed, they said, didn’t need to worry about certain other prices, such as those of stocks and real estate, because these would not have much effect on employment, incomes, and voters’ other economic concerns. As we learned at considerable cost, that conventional wisdom wasn’t right. The sharp drop in asset prices that began in 2008 left millions of households with depleted retirement accounts and upside-down mortgages, forcing them to pull back spending, leading in turn to a sharp rise in unemployment. By and large, economists missed this connection between the financial economy and the real economy.

Of course, saying that the Fed should worry about asset prices as well as consumer prices still leaves the central bankers to determine when stock prices are reasonable and when they are soaring unjustifiably. Either way, economists must pretend to know something that cannot possibly be known until after the fact. In his masterful biography of Greenspan, Sebastian Mallaby wrote that “The delusion that statesmen can perform the impossible—that they really can qualify for the title of ‘maestro’—breeds complacency among citizens and hubris among leaders.” Unfortunately, he’s right. One of the great challenges facing modern democracies is that their citizens expect more than their governments can possibly deliver.


What’s a stock exchange?

As the sixth edition of my book The Economist Guide to Financial Markets is published this week, I’ve been thinking about how financial markets have changed since the first edition was published in 1999. One of the most remarkable changes involves exchanges. Although computerized trading was already quite important at the time, there were three distinct types of  exchanges that traded financial products: stock exchanges, futures exchanges, and options exchanges. To be sure, there was some overlap, but not much; the Chicago Board Options Exchange traded options contracts but not futures contracts, and the Brazilian Mercantile and Futures Exchange traded options and futures but not stocks. The New York Stock Exchange, right there on Wall Street, was indisputably the most powerful of the world’s financial markets.

Today, matters are quite different. Then, most exchanges still had trading floors populated by specialists who kept the market moving; whether you wanted to buy orange juice futures or sell IBM common, someone at the exchange, usually attired in a distinctive vest, would take the other side of your trade if no other customer was at hand. These days, only a handful of exchanges still have trading floors, and the even there most business takes place off the floor. The specialists whose personal interaction made exchanges so fascinating are largely gone. Modern exchanges are essentially computer systems that bring buyers’ and sellers’ orders together, confirm trades, and make sure money and financial assets are credited to the correct accounts. And once the exchange has gone to the trouble of building its technological infrastructure, it can trade almost anything. NASDAQ, the Korea Exchange, and the National Stock Exchange of India all are heavily involved in futures and options trading as well as share dealing. Last year, the venerable New York Stock Exchange, dating to 1792, was gobbled up by IntercontinentalExchange, or ICE, an all-electronic upstart that began by trading energy options in 2000. ICE owns 23 different exchanges, so it can get an awful lot of bang for its technology buck.

Large and sophisticated as they are, these far-flung exchanges face some challenges of their own. Their systems are being overwhelmed by buy and sell orders placed by the computers of high-frequency trading firms; in many cases, those orders are placed to confuse the market and then quickly withdrawn before being executed, so an exchange may collect no revenue from posting them. Meanwhile, a large and growing share of trades, especially in stocks, is being arranged privately, through so-called dark pools owned by investment banks or others, rather than on exchanges subject to public disclosure requirements. I have a hunch that by the next time I revise The Economist Guide to Financial Markets, the world of financial exchanges will have changed a good bit more.