The Stock Market and MMT: The Dow Is Not Your Friend

July 14, 2020

It is standard for economic reporters to treat higher stock prices as good news. A rising stock market is often touted in the same way that job gains or GDP growth are touted, as evidence of a stronger economy.

This can be true. When the economy is growing at a healthy pace, the stock market is usually rising also. But the link is far more tenuous than is generally recognized. The market is in principle a measure of expected future profits. Policies that redistribute income from workers or taxpayers, such as anti-union laws or a corporate tax cut, would be expected to lead to a rising stock market, even if they did not spur economic growth.

But even beyond this direct redistributive issue, there is another sense in which a rising stock market can be bad for the 90 percent of the population that doesn’t own much stock (this includes 401(k)s). Higher stock prices encourage rich people to spend more money.

To see why this is an issue we need to pull out our MMT or Keynesian handbook. (MMT is essentially Keynes. That is not an insult; the term “modern monetary theory” is taken from the Keynes’ Treatise on Money.) To my view, the main takeaway from MMT is that the limit on the government’s ability to spend is inflation. This goes against the line pushed by the deficit hawks, that we have to worry about the government borrowing too much, because at some point lenders will be unwilling to lend us money.

As those of us who are not part of the deficit hawk cult point out, the government can print money if no one is willing to lend to it. Of course, in reality, investors have been very happy to lend the government money. The current interest rate on long-term government bonds is less than 0.7 percent. That compares to interest rates in the 4.0-5.0 percent range back when the government was running a budget surplus at the end of the 1990s.

But suppose this changed and investors suddenly soured on U.S.  government debt? Well, the Fed could just buy the debt that investors wanted to dump. It would pay for it the old-fashioned way, by printing money.

This is certainly a logical possibility, after all the Fed can print as much money as it wants. (It’s actually all electronic transactions, with bank credits, but that is beside the point.) The real problem that we could run into is that printing money keeps interest rates lower than they otherwise would be. As a result, demand from public and private investment, housing, and other forms of consumption will be higher than in the case where the Fed is not buying bonds. In an economy that is operating near its capacity (definitely not the current economy), higher levels of demand can lead to inflation. If the Fed keeps printing large amounts of money, causing interest rates to stay low and demand to remain excessive, we could see spiraling inflation, or in an extreme case, hyperinflation.

In this story, the constraint on government spending is the risk of inflation, which in turn is the result of too much demand in the economy. This is the story of why we have taxes. If there is excessive demand and we don’t want to cut spending, then we can raise taxes to reduce consumption spending by the people we tax. The tax revenue is not needed to pay for the spending in the way that stores need sales to pay wages, the tax revenue is a way to reduce demand in the economy to provide the room needed for the government to spend.

With this story in mind, let’s get back to the stock market. Suppose the market rises by 10 percent, not because of expectations of greater future profits, but simply as a result of irrational exuberance. Investors are just excited about holding stock, as was the case in the 1990s stock bubble and may well be the case with certain stocks now.

If we round up somewhat, the current capitalization of the U.S. stock market is $40 trillion, which means that a 10 percent increase would imply an addition of $4 trillion. There is a well-known stock wealth effect on consumption, which is usually estimated as between 3-4 percent.[1] This means that if the value of households’ stock holdings rise by $100, they will increase their annual consumption spending by between $3-$4. If we apply this wealth effect calculation to the $4 trillion increase in market capitalization, it would imply an increase in annual consumption of between $120 billion and $160 billion, or 0.6 to 0.8 percent of GDP.

This increase in consumption generates more demand in the economy. It has roughly the same impact in employing labor and other resources as an increase in government spending of the same amount. This means that if the economy was more or less at its capacity, so that additional demand would lead to inflation, and the stock market jumped by 10 percent, we would suddenly be facing a problem with inflation.

In that case, in order to prevent inflation, the government would have to do something to reduce demand to offset the jump in consumption from stockholders.[2] This could mean that the Federal Reserve Board would raise interest rates to reduce investment spending, housing construction, and other consumption. Alternatively, the government could raise taxes to reduce consumption. However, going either route means that someone has to spend less because stockholders are spending more. In other words, higher stock prices mean that people who are not stockholders have to spend less money.

This conclusion is pretty much an inevitable implication of the wealth effect, regardless of whether or not someone accepts MMT or Keynesian economics. If stockholders are consuming more, then there is less for everyone else, at least when the economy is near full employment.

For this reason, most people have little cause to celebrate when stock prices rise. Not only do higher stock prices not benefit the typical worker, they can actually harm them by forcing government cutbacks or tax increases, or higher interest rates from the Fed. The stock market may be the home team for the people who own and run major news outlets, but not for most of the country. When the market goes up, most people should not be cheering.

[1] While people often talk about issuing stock as being a mechanism for financing investment, in reality it is rare for companies to finance investment by issuing shares. The one notable exception to this rule was in the 1990s stock bubble when many new companies found they could raise hundreds of millions or even billions by issuing shares, in some cases without even knowing how they could hope to make a profit from their business. More typically, companies issue shares to allow early investors to cash out their holdings.

[2] In reality, any increase in consumption takes time. Stockholders are not changing their consumption based on day to day movements in the stock market, rather this wealth effect on consumption would be phased in over 1 to 2 years.


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