The Wisdom of the Market
Forget politics and ideology. It's the Dow that should guide America's path to renewed prosperity.
In an era of bubbles, crashes, tarnished reputations, and outrage over the gulf between the wealthy and the struggling classes, it may seem like the height of insolence to suggest that stock markets hold the key to economic recovery in the United States and Europe. Wasn't it market misbehavior that got us into this mess in the first place? But, in fact, policymakers would still do well to look to the stock market as an essential indicator of the likely impact of their reforms.
In an era of bubbles, crashes, tarnished reputations, and outrage over the gulf between the wealthy and the struggling classes, it may seem like the height of insolence to suggest that stock markets hold the key to economic recovery in the United States and Europe. Wasn’t it market misbehavior that got us into this mess in the first place? But, in fact, policymakers would still do well to look to the stock market as an essential indicator of the likely impact of their reforms.
Stock market reactions to economic reforms provide powerful forecasts of policy effectiveness because changes in stock prices reflect the average opinion of thousands of shareholders who care little for ideological debates and simply consider whether a given change will create or destroy value. This predictive ability makes market movements an important complement to the traditional backward-looking measures Washington is fond of, including growth, inflation, and unemployment.
In particular, policymakers in the United States and Europe need to study the movements of markets over the last few decades in what we used to call the "Third World." With Europe back in recession and the United States offering temporary solutions to its problems that inspire little confidence, advanced countries sorely need a new direction. By enacting large, unprecedented policy changes over the last three decades, developing countries turned around their economies and became the "emerging markets" that now drive global growth. Historical analysis of stock price reactions to policy-reform announcements made by governments in emerging economies across the globe demonstrates repeatedly that decisive, clearly communicated plans to implement market-friendly policies are what drive growth and create value — not just for shareholders but for all.
When it comes to the debate in Western countries over the merits of austerity versus stimulus, for example, emerging economies’ stock markets show us that one size does not fit all. In countries where large, persistent deficits have seduced governments into monetizing their debts and have spawned runaway increases in the cost of goods and services, the stock market tells us that austerity or "cold-turkey" policies designed to stop spiraling inflation dead in its tracks are both necessary and desirable. In contrast, equity markets react extremely negatively to government policies that doggedly pursue fiscal austerity when inflation is not out of control.
Take Brazil. In 1994, then-Finance Minister Fernando Henrique Cardoso enacted a radical stabilization program to eliminate inflation. The government introduced a new currency and abruptly stopped printing money to pay its bills. In the course of just one year, the country’s Bovespa stock market index jumped 75 percent as a result of the policy change. The market anticipated the program’s success and was ultimately proved correct. In just three years, Brazil’s inflation rate dropped from 3,000 percent to the single digits. As a result of the fall in inflation, lower deficits, and greater openness to flows of goods and capital, the economy took off by the first decade of the new millennium. Between 2001 and 2011, growth and the implementation of anti-poverty measures lifted 20 million Brazilians out of poverty and into the country’s growing middle class.
In contrast to the situation in Brazil, the stock market tanked in Chile when the government decided to implement austerity measures under three successive agreements with the IMF between 1983 and 1989. Because inflation was not the major economic issue facing the country at that time — Chile needed to rebuild its financial system, reduce import tariffs, and make its exchange rate more competitive — the announcement of cold-turkey approaches to macroeconomic stabilization triggered an average 87 percent drop in the stock market in each of the 12-month periods preceding these IMF agreements. Consistent with the market’s gloomy forecast, real GDP fell sharply with the onset of austerity and did not return to its pre-recession level until 1986.
Moving beyond Brazil and Chile, between 1973 and 1994, the stock market indices of 21 emerging countries jumped an average of 44 percent in response to announcements of austerity programs implemented in the midst of high inflation. In countries with only moderate inflation, however, markets fell an average of 24 percent when governments pursued austerity.
Given that the inflation rate for the United States, the eurozone, and other advanced economies in 2012 was less than 2 percent, the implications of these stabilization lessons for First World fiscal policy seem straightforward. Attempting to balance budgets in the eurozone by 2014, as called for by the European fiscal compact that came into force this Jan. 1, would require a drastic swing in investment and consumption that would exacerbate the region’s economic woes. Instead, European countries should adopt a long-term target for fiscal deficits along with clear and credible measures to drive a process of gradual deficit reduction. The United States, having avoided a free-fall off the fiscal cliff at the start of 2013, also needs to resist radical attempts to eliminate its deficit overnight.
Stock market responses in emerging markets also suggest the best way to resolve the problem of debt overhang that plagues European countries like Greece, Italy, and Spain. People familiar with the bleak economic landscape of heavily indebted developing countries in the late 1980s should recognize the problem — and the solution. After a decade of lost growth and insistence that debt relief had no place in a solution to the Third World debt crisis, the U.S. Treasury changed tack in 1989. Treasury Secretary Nicholas Brady designed a plan under which 16 countries would receive roughly $65 billion in debt forgiveness from the banks to which they owed money.
In anticipation of debt relief, stock markets in these countries rose 60 percent during the 12 months prior to the official announcement. Importantly, the stock prices of major U.S. commercial banks with large developing-country loan exposure also jumped — 35 percent over the same pre-announcement window. Since the Brady plan led to higher valuations in both debtor and creditor countries, debt relief was not a zero-sum game: The reduction of debt did not simply transfer wealth from the international commercial banks to the developing countries.
Debt relief under the Brady plan was not free, nor should it have been. When the government of a country accumulates liabilities beyond a manageable threshold, both lenders and borrowers must acknowledge their mistakes and share the burden of adjustment. Debt relief was given to the 16 Brady countries on the condition that they adopt additional economic reforms to drive growth: labor market reform, greater commitment to free trade, and privatization of inefficiently run state-owned firms. The countries that implemented and sustained these reforms began to flourish. The three countries that failed to sustain reforms under the Brady plan — Jordan, Nigeria, and the Philippines — experienced a much smaller initial rise in the value of their stock markets than the other Brady countries: 30 percent versus 60 percent. And those increases completely evaporated within a year as their lack of commitment to reform became clear.
So while the stock market tells us that debt relief must be part of the plan for growth in European countries that suffer from debt overhang, real reforms are also needed — primarily changes that reduce the cost of hiring and firing workers. Debt relief will restore market confidence, investment, and economic growth only when accompanied by structural adjustments that increase productivity and encourage firms to invest. Yet European economies continue to flounder because governments have yet to act decisively on the need for debt relief and reforms that serious leaders know must happen.
Viewed in the aggregate, the experience of emerging equity markets gives us a sense of the kind of value governments can create when they demonstrate clear commitment to market-friendly policies. Shareholders in Latin America predicted that reforms — free trade in Mexico, stability in Chile, and greater openness to foreign investment in Colombia, to name a few — would improve economic performance, and they were correct. The impact was striking, both on stock valuations, which rose fourfold over a period of roughly three decades, and on traditional measures of economic progress. Stock markets rose throughout Latin America because economic reforms, difficult as they were to implement, would eventually make these countries — and the companies within them — more profitable places to do business.
Of course, it’s worth asking just who benefited from these profits. Did stocks in the developing world rise simply because the reforms signaled a political triumph of rich over poor and the anticipation of further redistribution of income from workers to shareholders? The rise in valuations did create more wealth for owners of shares. But higher stock prices also reduced the cost of capital for firms, making it cheaper for them to invest in factories, equipment, and new technologies. With more and better machines to do their jobs, workers became more productive. Higher productivity, in turn, boosted the wages and material well-being of workers in the manufacturing sector of countries all over Latin America. In other words, the stock market serves both as a useful predictor of whether policy changes will have positive effects on the lives of people at all levels of society and as a conduit through which those effects are actually transmitted. Income inequality is still an issue in Latin America, but economic stability has generated a burgeoning middle class in places such as Brazil and Mexico.
Reviewing the history of developing countries’ struggle with economic reform through the lens of their stock exchanges leaves little doubt about the change of direction needed to restore growth and jobs in advanced countries. The United States needs legislation to place the country on a sustainable fiscal path. Troubled European countries need to embrace structural reforms to raise productivity and improve competitiveness, even as their creditors agree to write down substantial amounts of their outstanding debt.
While the recipe for turnaround is clear, at present the United States and Europe appear unwilling to take the stabilization and structural-adjustment medicine they’ve been prescribing to developing countries for years with the help of the IMF and the World Bank. As a result of this aversion, stock markets on both sides of the Atlantic are left guessing what comes next. And as long as the uncertainty continues, so will the volatility in stock market indices from the DAX to the Dow. But don’t blame market mood swings on behavioral economics. Pin them instead on the bad behavior of First World governments neglecting their duties.
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