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A Stock Bubble Negates the Benefits of Rate Cuts and Must Be Deflated. [Copy link] 中文

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Post time 2015-5-11 13:58:19 |Display all floors
Whereas stock prices are originally intended to reflect the future profitability of the firms that issued the shares, due to the meddling of the central banks around the world, the stock market has ceased to be a barometer of the health of the economy, but its converse, stocks go up in price when the central bank is expected to lower the interest rate in order to save a faltering economy.  And stocks go down in price when the central bank is expected to raise interest rates in order to avert inflation.  The short to intermediate fluctuations of the stock market as a whole have little to do with productivity and profitabiity of the firms whose stocks are being bought and sold in the market.

Thus, when the central bank tries to prop up the stock market in order to give the impression that the economy is improving, it is actually diluting out the benefit of its lowered interest rate in terms of increasing liquidity in the real economy, because part of that liquidity is being sucked up by the stock market in the form of a speculative bubble, which in turn prompts the central bank to further lower the interest rate to overcome the dilution caused by the stock bubble, and so forth.

The infused liquidity will however sooner or later be released back into the real economy as there is no stock bubble that does not ultimately burst.  This increased liquidity comes in two forms.  First, those who sold near the top would have a stash of cash that they did not have before, and therefore, they can spend it to buy real goods and services, driving up the price of such items, i.e., cause inflation.  Second, those who sold near the bottom would still have some remaining cash, albeit less than what they started out with, which they would want to take out of the stock market altogether, causing the price of whatever they buy with it to go up.  In the end, all the interest rate cuts come home to roost as raging inflation.

All this speculative investment ties up capital in unproductive activities, causing the real economy to slow down further, which then prompts the central bank to lower the interest rate more, causing more capital to move into the stock market and away from bank deposits and bonds, which starves the real economy of working capital, and so on.

Therefore, before the PBOC cuts the interest rate again, it should suspend all stock market activity for a whole week, before and after the interest rate change.  Furthermore if the volume of trade in the stock market exceeds a certain amount per unit time, the stock market must be suspended for another week.  This allows speculative capital to be returned to the real economy, to do the work that the rate cut intended to achieve, but could not because of the stock market reaction.

The correct response of the stock market to a rate cut made by the central bank due to weakness in the real economy is for investors to buy stocks that have a proven track record of issuing dividends which exceed the interest rate being paid by the banks.  All stocks that do not issue dividends and depend entirely on capital gains will have to trade at the last bid and offer price obtaining just before the moratorium is decreed.  Speculative investments should not be given the same access to capital as non-speculative investments if the real economy is to benefit the maximum from any rate cut.

In reality, most rate cuts have the opposite effect of what is intended.  They inflate speculative investments and deflate nonspeculative investments, which can have real consequences of factory closure and mass layoffs.  It is time central banks stop subsidizing the transformation of stock markets into casinos with public money.

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