Could the Fed's asset purchasing programmes have changed the way people save, and thereby made market drops like the one in Q1 2020 more likely?
One of the big headlines this past week has been about the US stock market having its best quarter since 1998 (1), while millions of jobs are lost and some US states are re-imposing lockdowns to combat Covid-19. A reminder that financial markets don’t mirror the real economy, and to the cynic strong evidence of the power of Quantitative Easing (QE). I typically discuss monetary policy from a macro perspective, arguing that QE and other central bank asset purchasing programmes exacerbate inequality between classes and generations, which you can read more about here, but this week I will argue that the current monetary policy climate distorts incentives for individuals which can make large market drops more common.
The Economist ran a story in their latest issue about how American banks are more robust now than before the Great Recession according to their stress-testing (2). American banks are far less likely to suffer a bank run now that they hold more capital, but with practically non-existent returns on deposits it seems likely that people would try to hold as little cash as possible in the bank, instead investing their means to get a return. Statistics from the Federal Deposit Insurance Company (FDIC) (3) show that the amount of dollars insured by the FDIC has decreased steadily since 2000, and that the equity to assets ratio for American banks have decreased in the first quarter of 2020. Just as financial institutions have to go from governments bonds to more risky assets to get the same returns as before QE as bond yields have declined, individuals also has to migrate to more risky assets to get the same return as they previously got in their savings accounts. With the headlines that good years like 2019 produce, and the incredible quarter American stocks have had it might seem as though putting money in stocks is a no-brainer.
In this scenario financial markets, mainly the stock market, fill the same role as banks did previously which exposes financial markets to the perils banks faces, namely bank runs. A ‘stock run’ as I will dub this phenomenon, functions a lot like a bank run with some key differences. For one, a financial market cannot be insolvent as a bank can; if one invests in a stock one is never guaranteed a price for that stock, instead the stock is valued based on the price it is trading at. If there’s a sudden downturn in the economy, people will both want to sell their stock to protect their money, and many might be forced to sell to withdraw their savings they need to cover expenses which creates an intense downward pressure on the price of stocks.
Admittedly, this is only a thesis, I haven’t spent the time to adequately research whether private individuals really are shifting their savings from bank accounts to equities, but the ‘stock run’ theory would explain the early pandemic stock market drops and would create fascinating new challenges for policymakers. It could also be a sort of ‘Black Swan’ rationalisation of an episode of irrationality, and it’s dubious to propose a theory based on a single anecdote, especially given that said anecdote took place mere weeks or months ago. Nevertheless, I find it to be a plausible and intriguing theory. Time will tell if it’s a useful way to understand how central bank assets purchases have affected the way people save or just wrong.
If you liked this post you can read another recent post here, and read everything I've written on QE here. I'd be grateful if you shared this post with a friend or coworker who might find it interesting, and consider coming back next week for a new post!
Written by Karl Johansson
Sources:
1: 'U.S. Stocks Finish Best Quarter in More Than 20 Years', Wursthorn, M. Wall Street Journal, 2020-06-30, [Accessed Online 2020-07-06] https://www.wsj.com/articles/global-stock-markets-dow-update-6-30-2020-11593508397
2: 'How resilient are the banks?', The Economist, The Economist, 2020-07-04, [Accessed Online 2020-07-06] https://www.economist.com/finance-and-economics/2020/07/04/how-resilient-are-the-banks
3: 'Statistics at a glance' FDIC, FDIC 2020-06-16, [Accessed Online 2020-07-06] https://www.fdic.gov/bank/statistical/stats/
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