Success is Vulnerability

Thwarted globalisation undermines good policy

“Our society is dependent on some precarious mechanisms...”Doris Lessing

US stocks have not taken kindly to a possible return of ‘higher for longer’ at the Fed. We await the outcome of the May 1st FOMC with some trepidation. Of course, the outcome may be cause for relief, especially if PCE suggests inflation is ‘beat’. But putting aside recent blips, I’d like to pose a wider question: does the evident and outstanding long-term success of US equity markets pose difficulties for decision makers, rather than the other way around? It is said, often, that the West is woefully short-sighted. Focus on immediate returns distracts decision-makers from strategic considerations. The stock market may be understood as a cumulative assessment of returns with emphasis on the relatively short-term. This has been a complaint by Warren Buffett and many others. It has not obviously affected stock performance adversely in the long-term. But could the very success of the US stock market eventually constrain good decisions and encourage bad decisions? And does that aid foreign powers opposing American influence? Is it happening already?

One of the messages I brought to the Financial Stability conference at the Cleveland Fed last November was all concentration is a vulnerability at some point. I noted the wildly different returns from European stock markets compared to US markets. This may be a cause for financial stability concerns, not in Europe, but in the United States. In the case of stock market valuation, bigger is deemed, invariably, to equal better. But can you have too much of a good thing? Wealth and investment in the United States has become highly reliant on capital market stability. Does such concentration also raise the potential for outside interference? And does protection of that success increase the propensity for government support?

The short answer to the first question is ‘yes, of course’. The entire aim of globalisation is inclusion of foreign financial and economic factors for material gain. The financial locus of globalisation is in US markets. If the S&P 500 reflect the profitable incorporation of global producers of goods and services, as it does, then clearly the influence of those foreign factors has increased. And with that increased influence we can assume a growing unwillingness to accept anything that may disturb the arrangements. Good Vibes Only indeed.

Photo by MARK ADRIANE on Unsplash

The answer to the second question is more subtle. The increase in globalisation also concentrated domestic beneficiaries whose interests are served by maintaining that arrangement. The financial complex has evolved in the last forty years to support and promote large-scale market-based capital allocation. This has changed socio-economic relations, especially in financial intermediation. US banking has oriented its collective balance sheet towards this new model. Central bank policy has aided this shift - as I describe in my recent piece Quantity Theory of Reserves - often to the relative detriment of traditional bank customers including the general public and small business. So monetary authorities appear to have acceded and encouraged the change in arrangements.

If the US stock market has become the focal barometer of globalised finance and innovation, it can also be shown empirically, that a threat to the stock market will elicit a known response from policy makers. We have multiple examples of policy sensitivity since the late 1980s. Stock market stability is synonymous with financial stability as far as US policy makers are concerned.

A credible threat of divorce between the ‘Workshop of the World’ (China) and the Stockmarket of the World (United States) will be treated very seriously indeed by investors and policy makers, not just in the US, but globally.

What is in question here is not the possibility of a stock market correction based on a schism between China and the United States. That is given. A more pressing concern is the expectation of such damaging wealth effects of a schism may encourage either a) pre-emptive opposition to policies that may bring about that outcome or b) government intervention to maintain ‘stability’ and encourage replacement industry. Wealth confers influence, including influence on policy to protect that wealth. And even without a schism the ‘weight’ of stock market capitalization is influential.

It is true that other countries have a greater market capitalization to GDP ratio than the United States. Here is the list of the Top Ten Market Cap / GDP from the last full set of figures from the World Bank, 2022. Notice that only the United States has an economy of any global significance on the list. By my calculations Market Capitalization/ GDP has risen to circa 200% of GDP in the United States as at mid-April 2024.

Source: World Bank

The bigger they come, the more they ask for government support, and the more they ask the boat to stop rocking, or for it to rock in the ‘right’ direction. We have multiple examples of increasing business sensitivity to Chinese sensibility. US corporates cheerfully demur to China’s demands in relation to its domestic policies. The Trump administration created loud, and unsuccessful, opposition to its restrictions on trade - with good reason. Is there a case for such opposition to shift focus towards opposing robust macro-economic stability policy? Or to ask for more macro-economic support? A very high market Cap/GDP ratio based on assumptions of global arrangements may suggest it is possible. Recent disquiet about interest rate policy is traditional. It does not indicate any outside influence. But the concentration of stock market value relative to GDP means no overt public tampering with opinion is needed. ‘It’s the stock market, stupid!’

The move to re-shore strategic industries may be one reason why US stock markets have performed well since late 2022. And this may reflect on any answer to the second quesion: does past success increase the urgency of government intervention? Greater geopolitical disagreement pushes for accommodation of the adversary on the one hand and federal assistance on the other.

The re-shoring policies enacted by the Biden administration have reduced the current account deficit, which all else equal, boosts domestic profits. In addition, there is evidence that fiscal incentives have fed directly through to improved profits, and especially expectations of future profits. So far, the path towards schism has helped increase stock wealth rather than undermine it - though at the cost of fiscal incontinence. It may be that market stability demands that fiscal incontinence continue and maybe even increase.

The United States attracted large amounts of foreign capital as the capital account counterpart to the trade deficit. This enhanced the class of influential supporters of global status quo. While the prospects for expanding globalisation persist, opposition to restrictive policy is relatively quiescent. In good times, good policy is equated with necessary stability measures. However, when the prospects for globalisation retreat, influences previously at ease with Washington policy, including monetary stability, may increase their opposition if such policies threaten wealth. It may also encourage support for fiscal intervention either to prevent any adjustment, or to help with adjustment. Money illusion is real enough if you become wealthy from a strong stock market. A sensible reply may be that rates above 5% does not imply an untoward influence, and that would be right. But the dance is far from over. And while monetary policy has tightened, fiscal policy has gone the other direction.

There is increasing demand by foreign policymakers, including presumably from the Chinese, for lower global interest rates. If fear of schism, or the problems that arise from non-appeasement, become endemic among policy makers then the chances of bringing forward rate cuts increase. Even the Bundesbank now talks about the need for interest rate cuts. By turning on the export taps, the Chinese simultaneously threaten the productive capacity of the West (including Germany), exert deflationary pressure and encourage further US fiscal expansion. This is not benign globalisation any more. Aggressive mercantilism is likely met by more state intervention, or the promise of intervention. The deflationary pressure has not yet shown much influence on the Fed, which seems mildly alarmed at the resumption of domestic economic growth. But it has not stopped the fiscal shift towards supporting American business.

One aim of an adversary may be to debauch the enemy’s currency. It is probably not the only aim, but it may be part of a wider strategy of economic attrition. If that adversary can align a good part of the financial community to equate monetary and fiscal stability with a threat to the stock market, it would certainly aid their cause. It has done the same in many other spheres. It is worth considering. At the very least it may encourage investors on both sides of the geopolitcal fence to promote the benefits of further ‘special support’ from government and accommodation from monetary authorities.