Friday, August 05, 2011

Bond market and stock market go their different ways

As Paul Krugman has pointed out the stock market and the bond market can be viewed as acting in contradictory ways since the Washington debt ceiling deal -- though he says that's not all there is to it (and he factors in European events). My brilliant partner who has written here before on matters financial, explains in this guest post just what those differing markets are and why they might have different paths. Just maybe, their divergence may enable those of us who aren't playing games with money to find some traction for demands that our rulers pay attention to the economy's real problems: failure to create jobs and to divide the nation's wealth fairly.

It's been said recently that, on the national level, the Republicans have become the party of Big Oil and the Democrats of Big Finance. Don't know whether I quite buy this, but there's something to it. What I do know is that there is a real division within Big Finance - between the stock market and the bond market.

As we've seen since the "deal" was sealed, the stock market has tanked, while the bond market is perfectly happy. I think this is because the stock market reflects the capacity of capital to earn a return on some kind of actual activity (though not necessarily making things) - while the bond market cares only whether or not there is inflation.

When you invest in bonds, you know at the outset what your return is going to be; what you care about is whether or not inflation will make the same number of dollars less valuable when your bond matures. For example: Say you buy a one-year bond for $100,000. When it matures, you know you will get $103,000 back, earning $3,000 in interest. That's great - unless - during that same year there's been 5% inflation. Then, not only did you not make a profit, but while your money was sitting in the bond, it actually lost value. So "investing" in bonds is basically gambling on which is going to be higher - the interest you get paid, or inflation. (In real life, it's a little more complicated than this, because sometimes bonds kick off their interest during the life of the bond, rather than waiting until maturity, but this is the basic mechanism.)

That's why the bond market is desperate about controlling inflation at all costs (including the human costs of unemployment, loss of services, deferred maintenance on infrastructure). They don't care if the rest of the economy tanks, as long as it doesn't tank so badly that the companies and governments that sold them the bonds don't actually go belly up and default.

So the bond market really cares about reducing the federal deficit, because when the government spends more than it takes in, it does this literally by printing more money (or creating more digital dollars). This increase in the supply of money decreases the buying power of each dollar. Inflation doesn't hurt ordinary workers that much - as long as it's within reasonable limits - because wages usually rise to keep up with inflation. But it freaks out the people whose income and wealth depends on bonds.

By the way, the Clinton administration was deeply connected to the bond market. Part of the impetus for "welfare reform" was an attempt to find a place to cut government spending that would cater to class and race prejudices, and thereby reduce the deficit and keep inflation low.

The stock market, on the other hand, used to be interested in long-term investments in the materials it takes to make actual products. In theory, you buy stock (a tiny bit of ownership) in a company; the company uses the money it raises by selling stock to invest in factories and equipment, or computers and software, in order to make more money by profiting on the stuff it sells. The stockholders get a part of that profit in the form of dividends.* As the company grows and reinvests some of its profits, the stock itself becomes more valuable. Eventually, the stockholders may decide to sell the stock itself, and make a profit on that "investment." Clearly, if there's been inflation over the same period, that profit is smaller than it would have been otherwise, but usually the value of stocks that are a good gamble goes up much faster than inflation.

In the last 30 years, however, there's been a change in how people gamble on the stock market. Instead of investing in order to earn regular dividends, and to make sure the principal doesn't lose value, people are now investing in order to make a profit on a rise in the price of the stock itself over a very short period of time. (In fact, some people even engage in a form of gambling called "day trading," in which they gamble on the changes in a stock's price over the course of a single day.) This means that instead of investing for the long term, both stockholders and company managements are thinking in terms of the reports that come out every quarter. If the price of a stock goes up during that short period, you can sell it and make a profit. And the managers who think they're responsible for that rise get huge bonuses.

This is why even though the U.S. economy is in the toilet, until the last few days, the stock market has been going up; it's completely recovered from the losses of the 2008-09 crash.

Why does any of this matter? I think because it gives us a little insight into one division within the class of folks who own stuff; it's a little more complicated because wealthy people tend to own both stocks and bonds, but what the two markets want from the economy is often very contradictory. There might be a place for a wedge somewhere in there for ordinary people who mostly don't own much of either kind of financial product to use to demand change and find a few allies.

*Of course, if you're a marxist [or a thoughtful wage worker], you know that the actual profit comes from the fact that the workers weren't paid for all the labor they put into making the stuff, but that's a different issue. Right now we're thinking about how things work from the point of view of the people who own the stock. This is why when unemployment goes up, so does the stock market; higher unemployment means people who have jobs have less leverage on their wages, because the company knows that there are people without jobs who will work for the existing wage.

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