“The stock market is filled with individuals who know the price of everything, but the value of nothing.” Phillip Fisher
This quote by one of America’s famous investors is actually an adaptation of Oscar Wilde’s definition of a cynic, spun in economic terms. In economics the simple definition of price is the amount of money people are prepared to pay for goods and services and therefore represents a measure of value. While everyone values things according to what they decide is in their own best interests, the aggregate of those decisions represents the price mechanism in markets.
What Fisher was lamenting in the above quote is that investors had gotten used to artificially low interest rates which in turn caused unsustainable price-to-earnings ratios and were ignoring fundamentals such as value. The principal cause of the recent stock market declines is the now artificially high interest rates. The one positive effect, at least for the moment, is that stock evaluations will more depend on company merit. The truth is that the bull markets of the recent past were dependent more on the Federal Reserve’s generosity than sound fundamental investing.
While price mechanism is simple in concept, it is also sorely misunderstood, not only by many in Wall Street, the Federal Reserve, the US Government and our society in general, but throughout history. One of the principal reasons for the failure of socialist regimes was the absence of the price mechanism. When you substitute the free market with a controlled one, you eliminate the functions created by it. Even tampering and regulating it distorts price mechanism functionality.
It’s price mechanism that determines what goods are to be produced, in what quantities, how they are produced and who gets them; this is an existential economic mechanism by which goods and services are distributed, indicating the strength of demand and enabling producers to respond accordingly. Further, only by allowing prices to move freely will the supply of any given commodity match demand. When supply is excessive, prices will fall and production will be reduced until prices begin to rise. Likewise if supply is inadequate, prices will rise, production will increase until prices begin to fall. This is the price mechanism providing equilibrium in the market.
The problem arises when prices are artificially controlled. The monetary mismanagement by the Federal Reserve, feeding into and coupled with the fiscal mismanagement by the US Government has created artificial and dangerous inflationary pressures on prices. Adding to the problem recently was the government’s pandemic lockdowns coupled with the various stimulus programs. The net results are inadequate supply and excessive demand, but unhinged from the market’s price mechanism. All this produced too much money going after too little goods and services fueling an inflationary spiral.
This problem actually started more than a century ago. Since the creation of the Federal Reserve, the US Dollar has lost about 95% of its purchasing power. There were two primary reasons for this, one being the boom and bust cycle created by the Fed’s interest rate manipulation and money printing, the other the slow death of the dollar itself as it went from commodity money to fiat money. Both fed into an inflationary spiral, all due to failed monetary policies. Despite what Modern Monetary Theory believers tell us, there’s only one thing we need to understand, best expressed by Milton Friedman when he said that “Inflation is always a monetary issue.” The really bad news globally is that the dollar is so strong now compared to other major currencies because they’re in even worse condition.
There are some economists who blame Supply-Side Economic Theory for our current inflation and price dilemma. That theory is a modern but inaccurate interpretation of Say’s Law, which states that the production of a product creates demand for another product by providing something of value which can be exchanged for that or any other product. In the absence of distorting government behavior, Say’s law should hold true. However, if the government causes credit booms and busts through artificially changing interest rates, this can cause disequilibrium.
Interest is that word so much in the news today as the Fed seeks to control inflation by stunting growth with high rates. In economics, the rate of interest is the price of credit, and as Benjamin Franklin famously cautioned “Remember that credit is money.” So we have yet another case of causing disequilibrium by artificially increasing interest rates; it’s artificial because the price mechanism by which the market would determine the time preference for money is substituted with another fiat. Among other negative effects this has an unfortunate impact on bonds, including USTs. As the interest rate on bonds increases, the prices of bonds fall. With USTs, this means not only does the US get less money for the debt issued but at a higher cost of servicing that debt. About a month ago the US national debt went over $31T, the highest of any nation in the history of the world.
In his famous 1949 book “Human Action” Mises presciently stated that “The misinformed observers blame the bust rather than the boom for economic misfortune. The average person does not blame the authorities for having fostered the boom. He reviles them for the necessary collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils that inflation and credit expansion have brought about.”
The price we pay for not allowing the free market function of the price mechanism is that the U.S. national debt is so high that it’s now greater than the annual economic output of the entire country, in effect making the US incapable of ever paying down that debt without a huge increase in economic output. The question is can Americans get informed and motivated to change the viscous cycle that our government created or are we doomed to remain those misinformed that Mises describes?