{"id":117032,"date":"2025-08-28T22:23:17","date_gmt":"2025-08-28T22:23:17","guid":{"rendered":"https:\/\/www.newsbeep.com\/us\/117032\/"},"modified":"2025-08-28T22:23:17","modified_gmt":"2025-08-28T22:23:17","slug":"why-arent-markets-freaking-out","status":"publish","type":"post","link":"https:\/\/www.newsbeep.com\/us\/117032\/","title":{"rendered":"Why Aren\u2019t Markets Freaking Out?"},"content":{"rendered":"

\"Cartoon<\/a><\/p>\n

For those of us who follow economic policy in general and the Federal Reserve in particular, the past week has been shocking and terrifying. Donald Trump\u2019s ongoing attempts to bully the Fed into large interest rate cuts have escalated into an attempt to fire Lisa Cook, a member of the Fed\u2019s Board of Governors, over unsubstantiated claims that she committed financial fraud while still a college professor. Indeed, Trump claims that he has already fired her, although he has no legal right to do so.<\/p>\n

Whatever happens, Trump\u2019s campaign to take over monetary policy has shifted from a public pressure to personal intimidation of Fed officials: the attack on Cook signals that Trump and his people will try to ruin the life of anyone who stands in his way. There is now a substantial chance that the Fed\u2019s independence, its ability to manage the nation\u2019s monetary policy on an objective, technocratic basis rather than as an instrument of the president\u2019s political interests and personal whims, will soon be gone.<\/p>\n

So why aren\u2019t markets freaking out? Nations in which central banks lose their independence sooner or later suffer high inflation, especially when they are taken over by autocrats who buy into crackpot economic doctrines. And Trump, who has been demanding large rate cuts because, he claims, the economy is running hot \u2014 which almost every economist would say is a reason to raise rates, not cut them \u2014 certainly fits that pattern. Yet although there have been small tremors in the bond and currency markets, there have been no significant upheavals in financial markets that reflect the severity of the situation we are in. Throughout this episode, the stock market has remained fairly flat and bond yields haven\u2019t spiked.<\/p>\n

Why not? Do financial markets doubt that Trump will get his way? Or do they reject mainstream economics and the clear examples of countries like Turkey and Argentina?<\/p>\n

Neither. My read of economic and financial history is that market pricing almost never takes into account the possibility of huge, disruptive events, even when the strong possibility of such events should be obvious. The usual pattern, instead, is one of market complacency until the last possible moment. That is, markets act as if everything is normal until it\u2019s blindingly obvious that it isn\u2019t.<\/p>\n

The inimitable Nathan Tankus summarizes this by saying that the market is not, as stylized economic models would have us believe, a mechanism that pools the knowledge and informed judgment of millions of investors. It is, instead, a \u201cconventional wisdom processor<\/a>.\u201d That is, it reflects views that seem safe to hold because many other people hold them \u2014 and the crowd only abandons those views when they become blatantly unsustainable.<\/p>\n

John Maynard Keynes said something similar in Chapter 12<\/a> of his General Theory of Employment, Interest and Money. Market investors, he argued, pay little attention to the question of what assets are truly worth. Instead, they worry mostly about the market value of those assets a few months in the future. In a memorable albeit sexist passage (it was 1936), he declared that<\/p>\n

professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view \u2026 we devote our intelligences to anticipating what average opinion expects the average opinion to be.<\/p>\n

So if the conventional wisdom is that economic conditions will remain more or less normal despite highly abnormal policy, markets will remain calm until the illusion of normality becomes unsustainable. At that point market prices may \u201cchange violently.\u201d The current technical term for this phenomenon is a \u201cWile E. Coyote moment\u201d \u2014 the moment when the cartoon character, having run several steps off the edge of a cliff, looks down and realizes that there\u2019s nothing supporting him. Only then, according to the laws of cartoon physics, does he fall.<\/p>\n

You might ask why smart investors with long time horizons don\u2019t foresee Wile E. Coyote moments and get very rich in the process. Some do. But for reasons that would take another long post to explain \u2014 maybe a primer one of these days \u2014 there never seem to be enough such investors to shake market complacency, no matter how unwarranted. It\u2019s one thing to short a stock, but to short the entire market is a completely different beast.<\/p>\n

Can I document these assertions? Let\u2019s look at a couple of relatively recent examples of market complacency and myopia in the midst of clear signals of an oncoming crisis.<\/p>\n

First, the subprime crisis of the 2000s. By 2005, at the latest, there were very good reasons to suspect that we were in the midst of a major housing bubble<\/a>. Here\u2019s a graph of one measure of housing overvaluation, the ratio of home prices to average rents:<\/p>\n

\"A<\/a><\/p>\n

When home prices are very high compared with average rents, that indicates the likelihood of a bubble because, ultimately, the value of the house lies in its use as a place to live.<\/p>\n

The shaded area starting in late 2007 is the Great Recession. Now, one could try to rationalize the extremely high prices of houses relative to rents in 2006. But an honest assessment would at least have reflected the serious possibility \u2014 not the certainty \u2014 that there was a bubble in house prices during this period. It would also reflect the possibility of a flood of mortgage defaults when the bubble popped.<\/p>\n

Yet ABX indices<\/a>, a measure of perceived default risk on securities backed by subprime mortgages, didn\u2019t show any serious decline until well into 2007, when the housing bubble had already been deflating for more than a year:<\/p>\n

\"A<\/a><\/p>\n

Source: Bank for International Settlements<\/a><\/p>\n

Another example of market complacency is the euro area crisis that began in 2009. By the mid 2000s it was already obvious that huge sums of money were flowing into southern European nations like Spain, where they were being used largely to finance highly speculative real estate investment \u2014 very much like the US sub-prime bubble.<\/p>\n

Even if it was unclear that the flood of money would abruptly end — a nasty \u201csudden stop\u201d \u2013 the possibility of such a stop should have been reflected in bond yields.<\/p>\n

Yet the spread between interest rates on Spanish and German bonds \u2014 a measure of the risk markets perceived that Spain would experience a crisis \u2014 stayed very low until the crisis was already underway:<\/p>\n

\"A<\/a><\/p>\n

So if you want to know why markets aren\u2019t reacting to the risk of very bad policy if Trump takes over the Fed, you should know that major market reactions to that kind of risk are rare. In fact, I can\u2019t come up with a single example.<\/p>\n

All of which says, in turn, that the absence of a strong reaction to Trump\u2019s assault on the Fed isn\u2019t a sign that everything is OK. We are, in fact, looking at a policy disaster in the making. But markets probably won\u2019t react strongly until the disaster is already upon us.<\/p>\n

MUSICAL CODA<\/p><\/p>\n","protected":false},"excerpt":{"rendered":"For those of us who follow economic policy in general and the Federal Reserve in particular, the past…\n","protected":false},"author":2,"featured_media":117033,"comment_status":"","ping_status":"","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[37],"tags":[28,112],"class_list":["post-117032","post","type-post","status-publish","format-standard","has-post-thumbnail","category-markets","tag-business","tag-markets"],"_links":{"self":[{"href":"https:\/\/www.newsbeep.com\/us\/wp-json\/wp\/v2\/posts\/117032","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.newsbeep.com\/us\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.newsbeep.com\/us\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/us\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/us\/wp-json\/wp\/v2\/comments?post=117032"}],"version-history":[{"count":0,"href":"https:\/\/www.newsbeep.com\/us\/wp-json\/wp\/v2\/posts\/117032\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/us\/wp-json\/wp\/v2\/media\/117033"}],"wp:attachment":[{"href":"https:\/\/www.newsbeep.com\/us\/wp-json\/wp\/v2\/media?parent=117032"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.newsbeep.com\/us\/wp-json\/wp\/v2\/categories?post=117032"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.newsbeep.com\/us\/wp-json\/wp\/v2\/tags?post=117032"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}