Is the Stock Market Telling Us that We Were Right All Along?

With the stock market one never knows for sure, but this AP story is at least hinting that tight money in 2008 explains the severity of the recession:

NEW YORK (AP) — Stocks are set to extend their gains Wednesday as expectations continue to grow that the Federal Reserve will take steps to stimulate the economy at its meeting next month.

.   .   .

But weak jobs figures could also be enough to get the Federal Reserve to resume buying Treasurys in an effort to try and stimulate borrowing and spending. Japan’s announcement Tuesday that it cut a key interest rate to near zero percent and will buy some of its government bonds is adding to expectations the U.S. Fed will take similar actions to buy bonds.

The U.S. central bank long ago set interest rates at near zero percent, so it’s likely to buy Treasurys in an effort to further drive interest rates lower. The move would also make investing in stocks and riskier assets more enticing because yields on bonds would continue to drop.

If mere expectations of a Fed move that is likely to be cautious and timid are causing a significant rally on Wall Street in recent weeks, then that tells me that monetary policy is still very important at zero rates.  It also tells me that if policy had been much more expansionary in late 2008, the stock market would have done far better, for two reasons:

1. The drop in AD would have been milder if NGDP growth expectations 2 years out were much higher.
2. The financial crisis would have been milder.

One almost never observes severe recessions without stock crashes, so if policy had been expansionary enough to give the stock market hope that the recession would be mild, then I think stocks would have done much better, and the recession most probably would have been much milder.  It would have been a “recalculation recession” of the sort we had during December 2007 to July 2008.

Perhaps an analogy from the Great Depression would help.  During the long contraction of 1929-33 a number of progressive monetary theorists like Hawtrey, Cassel, and Fisher said the root cause of the Great Depression was the increasing value of gold.  That was not a widely held view (otherwise the Great Depression never would have happened.)  Between March and July 1933, FDR provided a decisive test of that theory, by sharply reducing the value of the dollar in terms of gold.  Stocks, commodities and industrial production took off like a rocket, despite a banking system flat on its back, with many banks shut down.  I saw this upsurge as providing retrospective confirmation of the explanation of the Great Contraction provided by the progressive monetary theorists.

The likely monetary easing this time will be far, far milder, and the stock rally is also much less impressive.  So it’s not proof, just a tantalizing piece of evidence that we quasi-monetarists might have been right all along.