Dow Jones Index in Longest Slump Since 2002: What Gives?

Bloomberg News reports that the previous six weeks of continual stock market declines constitutes the longest slump since 2002. Longer even then anything in 2008. How is this possible? If Keynes, Bush, Obama, Romer, Paulson, Geithner and Bernkanke were right, this should not be happening. Over the past four years, the U.S. Government and its sponsored agencies have undertaken unprecidented fiscal and monetary stimulus. The media championed their moves as bold leadership made by people who were not going to sit on their laissez-faire hands while the financial system imploded. They said that government deficit spending would get the economy moving again by putting cash into hands of consumers, boosting consumer spending which supposedly makes up 70 percent of the economy. When GDP numbers increased, it was taken as a sign that the government experts were right, having saved us from financial Armageddon.

It turns out it just is not so. As I have written before, money cannot buy prosperity. Savings and investment and wise entrepreneurship? Yes. Inflation and government spending? No. We should not confuse GDP growth with economic prosperity.

Monetary inflation via credit expansion, which is the Federal Reserve's bread and butter, was able to prop up the financial system for a couple extra years. Doug French reports, however, that there is still trouble with a capital T which rhymes with B and that stands for Banking System. Increasing statistical evidence is mounting indicating that, even according to official numbers, the economy is not functioning well enough to put people back to work.

This is because credit expansion funded by monetary inflation instead of voluntary savings does not contribute to capital accumulation, but capital consumption through malinvestment. It funds an inflationary boom which makes it look like things are better than they are. As soon as the flow of new money slows, however, economic reality reasserts itself and several projects that looked profitable are revealed to be unsustainable and must be liquidated, ushering in another recession.

Thus it appears that the stock market may be running out of steam because of perceptions that the QE2 money has run out and Bernanke is not yet willing to commit to QE3. Without the artificial stimulus, the market may be correcting itself to expectations more in line with economic reality.

In his book, Money, Bank Credit, and Economic Cycles, Jesus Heurta de Soto explains how government intervention in the money market can manipulate the stock market. He writes:

Only when the banking sector initiates a policy of credit expansion unbacked by a prior increase in voluntary saving do stock market indexes show dramatic and sustained overall growth. In fact newly-created money in the form of bank loans reaches the stock market at once, starting a purely speculative upward trend in market prices which generally affects most securities to some extent. Prices may continue to mount as long as credit expansion is maintained at an accelerated rate. Credit expansion not only causes a sharp, artificial relative drop in interest rates, along with the upward movement in market prices which inevitably follows. It also allows securities with continuously rising prices to be used as collateral for new loan requests in a vicious circle which feeds on continual, speculative stock market booms, and which does not come to an end as long as credit expansion lasts. As Fritz Machlup explains:

If it were not for the elasticity of bank credit, which has often been regarded as such a good thing, the boom in security values could not last for any length of time. In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted.

Therefore (and this is perhaps one of the most important conclusions we can reach at this point) uninterrupted stock market growth never indicates favorable economic conditions. Quite the contrary: all such growth provides the most unmistakable sign of credit expansion unbacked by real savings, expansion which feeds an artificial boom that will invariably culminate in a severe stock market crisis (pp. 461-62).

These words of Heurta de Soto are, as they say, as timely as today's headlines.