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Monday, June 26, 2006

Ahmadinejad is a Destabilizing Influence; Bernanke is Not

What is the explanation for the recent large stock market losses in the U.S. and around the world generally? Was it U.S. monetary policy as many claim, or something else?

What News Is Moving the Markets?, by Robert J. Shiller, Commentary, Project Syndicate:  Stock markets in much of the world have shown sharp cumulative declines since around May 10, with most of the drop occurring in the two-week period to around May 23, but with prices continuing to fall on average since then. Does trouble in the world’s stock markets mean trouble for the world economy? ...

Many commentators try to tie such events to developments the United States. But US stock prices fell only 5.2% between May 9 and May 24. Nor does China appear to be behind the global decline, since stock prices there actually rose during this period.

Economists’ standard explanation revolves around monetary policy. In the wake of the great deflation scare of 2003, central banks around the world cut interest rates, setting off speculative booms in both stock and housing markets. But now, according to this view, rising interest rates are beginning to bite, which portends further declines in asset prices.

There is certainly an important element of truth in this argument. The US Federal Reserve did indeed raise rates on May 10, and its chairman, Ben Bernanke, indicated then that there may be further rate increases in the future. Worsening US inflation data were reported on May 17, suggesting that further monetary tightening is in store.

Economists like to view the world as logical and manageable, which implies that they understand what is happening. But, in doing so, they often exaggerate central banks’ role. Indeed, the US rate increase was just one in a series of rate hikes – the 16th in a row. No other major central bank raised rates after the stock market drops began in May ...

Another factor is the price of oil, which rose 24% from March 22 to May 2, setting all-time records along the way. Surely, this was a major event that would plausibly affect stock markets all over the world. Oil price increases have been a culprit in virtually every economic recession since World War II.

Still, the oil price increases do not correspond to the time interval in mid-May when stock market indexes fell most sharply. To argue that oil price increases caused the stock market declines presupposes a time lag of several weeks.

But stock markets are not very logical, and there could be a lagged response to the oil price shocks. ... When oil prices rise quickly, people watch the news related to oil prices and talk to each other more about oil prices, hence creating heightened sensitivity to this news.

The crisis in the Middle East is tied to oil prices, and it dominated the news in May. Ominous signs and strong language used by various political figures were possibly amplified in investors’ minds by the oil price increases. On May 8, Israeli Vice Premier Shimon Peres, reacting to hostile statements by Iranian President Mahmoud Ahmadinejad, said that “the president of Iran should remember that Iran can also be wiped off the map.”

Similarly, near the beginning of the May stock market tumble, Ahmadinejad visited Indonesia, ... and newspapers reported on May 13 that he had received a standing ovation from students at two of the country’s top universities. This story might have been interpreted as evidence that Ahmadinejad’s brinkmanship on the nuclear issue was paying off for him politically, fueling a perception that the tense situation in the Middle East might lead to even higher oil prices.

These news stories may seem far more remote from the stock market than is monetary policy. But public reaction to them, together with recent oil price increases, may well account in good measure for the change in market psychology. Attitudes toward risks change over time... So, while these things happen in ways that are hard to quantify, maybe analysts should pay attention to the words of Ahmadinejad just as carefully as they do to those of Bernanke in trying to understand ... the world’s stock markets.

Economists might not like to focus on the public mindset and how it interacts with price changes, world news stories, and speculative dynamics. After all, doing so implies that economic events are less predictable (and economists less omniscient) than they like to imagine. But such a focus makes intuitive sense. What is really on investors’ minds? Ahmadinejad is a charismatic figure; Bernanke is not. Ahmadinejad is embarking on an adventure; Bernanke is not. And, perhaps most importantly, Ahmadinejad is a destabilizing influence; Bernanke is not.

Indeed, whatever their ultimate cause, the mid-May drops in stock prices throughout the world are indicative of unstable market psychology. It is difficult to believe that they were related only to opinions about likely monetary policy, and not to larger and deeper issues...

I'm not sure why Shiller thinks economists are resistant to such explanations, I'm not. It doesn't surprise me at all that news about, e.g., potential conflict with Iran might move oil prices and stock markets. He says "doing so implies that economic events are less predictable," but why does adding relevant explanatory variables make things less rather than more predictable?  If Shiller's right, it allows me to explain (ex-post) more of the variation in stock prices than before when spurious correlations between, say, stock market movements and monetary policy which do not hold up over time are used instead.

    Posted by on Monday, June 26, 2006 at 09:24 AM in Economics, Oil | Permalink  TrackBack (0)  Comments (3)

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