Thursday, July 16, 2009

Scott Sumner's Stock Market Theory

Scott Sumner, who's "Nominal GDP (NGDP) target"-theory I analyzed here have a post with a misleading and (presumably deliberately) provocative title "The Fed should create the mother of all stock market bubbles, permanently".

It is misleading because the first impression you get is that he wants the Fed to target the stock market. But as he points out, you can't really target more than one thing at once, so that would conflict with his NGDP target.

No, if you read through the post you can see that what he is really saying is that his NGDP target will create a permanent high plateau for stock prices.

As empirical evidence for his theory, he cites how stock markets crashed right in 1929 and 2008, right before there was a dramatic drop in NGDP growth. What he overlooks is that stock market crashed (particularly in real terms) in the 1970s and in 2000-02, despite the fact that NGDP growth increased or were relatively stable.

Perhaps Sumner would protest that he focuses on "expected" NGDP growth and not actual, but since there is no way to measure these expectations, that would make empirical references completely meaningless.

Analyzing instead this from a purely theoretical point, Sumner's theory makes little sense. It is true that under certain conditions with for example nominal wage rigidity that a sudden sharp drop in NGDP growth will reduce profits, and therefore also likely stock prices. However, even under constant NGDP growth, profits can be under big pressure, if there is a sharp increase in cost pressures. In that case, businesses would be forced to either reduce gross margins (bad for profits) by not raising prices or reduce volumes and therefore also reduce capacity utilization (also bad for profits as it increases fixed costs per unit). Either way, profits will be squeezed-something which in turn will depress stock prices. This scenario is a pretty good description of the 1970s bear market.

Another way in which a bear market can arise under constant NGDP growth is if over investments causes so much overcapacity that businesses will have to cut prices given the increased volumes, something which will reduce gross margins (bad for profits), or they will have to restrict volumes and therefore also reduce capacity utilization (again bad for profits).Either way, profits will be squeezed-something which in turn will depress stock prices. This scenario is a pretty good description of the 1970s bear market.

So no, NGDP targeting will not create the permanent high plateau from Irving Fisher's wishful thinking.


Blogger Scott Sumner said...

Thanks for the mention. I should clarify that I am strongly opposed to high inflation, as is the stock market. The market did poorly from 1966-1982 because high inflation makes the effective tax rate on capital much higher (due to the fact that taxes on capital in the US are not indexed.) When I say 5% NGDP, I don't mean at least 5%, I mean as close to 5% as possible (to keep inflation around 2%.) Indeed I would be happy with a 3% NGDP target if the Fed ever learned how to operate in a liquidity trap. The poor stock performance of the 1970s actually supports my thesis, as it occurred during a period of very bad monetary policy--NGDP growth was far too high.
The 2002 case is a bit trickier. I think the market fell for two reasons. One was the tech bubble bursting, and the other was the recession of 2001. My plan would not prevent tech bubbles, but it would moderate recessions. Thus the drop in stock prices in 2001-02 would have been smaller (although still very significant.) I did not mean to suggest stocks would never fluctuate, but rather that the trend P/E ratio would be in what is now considered bubble territory.

2:42 AM  
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