The first page of today's (February 26, 2000) New York
Times reports an analysis of the effects of rising interest rates on stock
prices that is apparently widely accepted by investors and at the same time is
so grossly deficient as to be potentially disastrous for those who accept it.
The erroneous analysis is reported, without in any way being identified as
erroneous, in an article by Gretchen Morgenson titled "Stocks in Turmoil As
Worries Grow on Higher Rates."
The analysis is described in the following three
paragraphs:
The Dow finished the week down 3.5 percent. It is off 14.22 percent for the
year, while the broader Standard & Poor's 500 stock index has lost 9.25
percent of its value. The Nasdaq composite index, which has been impervious to
the selling pressures seen in the Dow and is dominated by shares of technology
and other so-called new-economy companies, fell yesterday, but is up 12.81
percent this year.
This extraordinary divergence in the market reflects two views held by
investors: that Alan Greenspan, the chairman of the Federal Reserve, continues
to be deadly serious about raising interest rates to curb the economy's growth
and that these rate increases will hurt some industry groups far more than
others.
The older, more established companies that make up the broader market indexes
will be hurt by rising interest rates, investors believe, because these
companies' borrowing costs may rise substantially. But because the fledgling
technology companies found in the Nasdaq composite do not rely as heavily on
banks for capital, these concerns will not face rising costs as a result of a
few interest rate increases.
What is wrong with this analysis is that it
is ignorant of the actual connection between rising interest rates and stock
market activity, or economic activity in general. The main connection is not
the extent to which rising interest rates affect the costs of doing business.
The main connection is that rising interest rates engineered by the Federal
Reserve System signify a slowing down in the creation of new and additional
monetary reserves for the banking system and thus the slowing down of the
creation of new and additional money by the banking system. That, in turn, as
I have explained in "When Will the Bubble Burst?," represents pulling the rug
from under the whole financial bubble on which most of the last few years'
rise in the stock market rests.
If the Federal Reserve really is serious about raising
interest rates and thus about cutting back on the increase in the quantity of
money (which, unfortunately, one cannot yet say with certainty), then Nasdaq
and its high tech stocks will be pulled down along with the rest of the stock
market. Indeed, they will fall much further, for it is they, even more than
the older, more familiar stocks, that have been driven up by the pouring of
new and additional money into the stock market. Their values are in the
clouds, resting on the vapor of hope that in turn has been supported and
fanned by the transitory passage of ever more new and additional money from
buyers to sellers. Once the manufacture of sufficient new and additional money
ceases, that will be the end of the tech-stock bubble.
The rise in Federal Reserve interest rates,
i.e., the rise in the Federal Funds Rate, is a rise precisely in the rate of
interest banks charge and pay to one another in the lending and borrowing of
reserve funds. These are funds that banks are obliged, either by law or by the
circumstances of their business to have available either in the form of
actual currency or in the form of checking deposits of their own with the
Federal Reserve System. A rise in the Federal Funds Rate signifies that the
Federal Reserve is feeding new and additional reserves into the banking system
more slowly. That is why more banks find themselves in need of borrowing
reserves, or borrowing greater amounts of reserves, and fewer banks find
themselves in possession of excess reserves or excess reserves of the
magnitude they previously possessed. It is this change in the conditions of
the demand for and supply of bank reserves that then serves to bring about the
rise in the Federal Funds Rate that the Federal Reserve targets. At the same
time, this tightening of availability of reserve funds chokes off the ability
of the banking system to create new and additional checking deposits, which it
can do only to the extent that it possesses excess reserves. Without large
quantities of such new and additional money pouring into the stock market, a
significant part of the demand for stocks falls away. And if and when that
happens, as it appears to be happening now, or is expected to happen in the
near future, it will be followed by the unloading of stocks by those who have
bought them for no other reason than the anticipation of their going on
rapidly rising for ever.
Nothing in this update should be taken as a
prediction, still less a prediction with respect to timing. As I have
indicated, the actual policy of the Federal Reserve is a major uncertainty. So
too is the extent to which there may still be people out there with
substantial funds already in their possession and waiting to go into the stock
market. What is certain is that once the great majority of those who are
capable of going in have gone in, there will be nothing to make the market go
on rising if the Federal Reserve does not continue to supply the reserves
needed to support the creation of substantial quantities of new and additional
money. At that point, those who have bought in anticipation of endless rapid
rises will have no new buyers sell to. At that point, there is no way for the
market to go but down, and, it may well be, go down as though the bottom had
fallen out.
*Copyright
© 2000 by George Reisman. All rights reserved.
**George
Reisman, Ph.D., is professor of Economics at Pepperdine University’s
Graziadio School of Business and Management and is the author of
Capitalism: A Treatise
on Economics
(Ottawa, Illinois: Jameson Books,
1996).
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