By Alexander Apostolides on December 02, 2011

Why do we listen to the market? Sound Macroeconomic policy means much more.

I have been discussing with students recently in how odd the reporting of the financial crisis has been since 2007. Most news publications that claim to have some authority / influence in the global economy seemed to change their stories going through three stages during the last 4 years:
1) 2007 - 2008: The problem was how to save the banks. Governments Should step in and help banks because they are "too big to fail". This is intensified after the collapse of Lehman Brothers in 2008, since media reported that even a smallish banking collapse created panic in the markets.
2) 2009 - 2010: The focus was on the rallying stock markets and how governments are endangering such growth through excessive borrowing. They are removing liquidity from the market and destabilising currencies --> the Euro. The answer was very strict budget retrenchments.
3) 2010-2011: Unsurprisingly the reigning in of government budgets made the possibility of a "Double dip" recession very real as output growth faltered. Stock markets that were rising due to the injected liquidity by governments in 2007/8 ignoring that the real economy underperformed re-adjusted downward very rapidly when government sponsored liquidity dried up and the real economy felt the effect of reduced government expenditure. This caused another scare and placing the emphasis on the printed press to the need of governments to focus on economic growth as the only way out of the economic crisis.

[I am aware that the above is an oversimplification, but I think the emphasis on the three different strands is fair if one looks at the aggregate picture]

What disturbs me with this is that such analysis has proven not only short sighted, but also ruinous as it assumes that the financial markets always know what is best for their long run future.

Now I am not against the existence of global financial markets, far from it, but I do think that sound Macroeconomic policy means that market considerations is only one of the many factors that need to be taken into account. In short, the real economy is always more important than the market!

Back in 2007 growth should have been the only consideration: when you have growth you can fix all the other issues brought up by this crisis (excessive deficits, borrowing, financial weakness of banks, competitiveness)much easier than when you are in recession and all the above issues create vicious pro-cyclical loops that make solving any of them very difficult. I owe this understanding to an MSc class with Dr. Tim Leunig, who thankfully now he seems to be able to be the voice of reason in the UK through his work with the Centreforum.

When one assumes that the financial markets know best, they forget that the profit motive might lead to results that are sub-optimal to the society. It has been recently been discovered that the Federal reserve of US has pledged 7.7$ Trillion dollars, with very little of that being injected in the real economy, with the possibility of some even being re-invested in treasury bonds rather then invested in the real economy in order to increase income and hence promote growth.

Its is clear that what was best globally, including for the global financial markets, would be a return to growth in the US economy through the investment of part of such injections to the real world, but the safe bet won out in the period where bears (conservative investors) as more than the bulls (risk takers) by investing them instead in treasury bonds. Hence market decisions can lead to below optimal results .

If the Fed gave support only on the condition that a share of the liquidity would be given to the real economy as loans, then growth would have enabled the global economy to tackle the issues of excessive government debt much more simply, thus calming the markets and enabling government to support any banks that were still in trouble.

Sadly we once again seems to have forgot our goal, which has to be growth. The press and financial markets seems to be caught in the dream of austerity again, but only a long term goal of growth (followed by reform) will make make the US and EU economies healthy again.

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