Glenn and Donald Kohn on the Report of the Task Force on Financial Stability

   Glenn co-chairs the Task Force on Financial Stability with Donald Kohn, now a fellow at the Brookings Institution and formerly vice-chair of the Board of Governors of the Federal Reserve. The Task Force on Financial Stability was formed by the Initiative on Global Markets at the University of Chicago and the Hutchins Center on Fiscal & Monetary Policy at the Brookings Institution to make recommendations intended to increase the stability of the U.S. financial system.

On June 29, 2021, the Task Force issued a report, which can be found HERE. Glenn and Donald Kohn discuss the reports findings in an opinion column published on bloomberg. com.

The Federal Reserve building in Washington, D.C.

Our Financial Early Warning System Is Broken

The U.S. financial system emerged from the reforms that followed the 2008 global crisis stronger than it had been going in. But the onset of the pandemic in March 2020 demonstrated how much was left undone: Although banks weathered the storm well, financial disruptions elsewhere — in money market funds, in the Treasury market — necessitated extraordinary measures to prevent an even greater economic disaster.

A group that we co-chair, the Task Force on Financial Stability, has just released a report on how to make the system more resilient. Among other things, we see the need for a structural change: Overhaul the agencies tasked with identifying and addressing threats outside traditional banks.

The Dodd-Frank financial reform of 2010 created two new entities focused on systemic risk. The Financial Stability Oversight Council, which included the Treasury Secretary and the heads of all the major financial regulatory agencies, was supposed to foster collaboration in finding and fixing dangerous buildups, wherever they might arise. And the Office of Financial Research, formed within Treasury and equipped with subpoena power, was supposed to provide the FSOC with the data and analysis needed to do the job well.

This financial early warning system didn’t operate as intended. The FSOC’s efforts to impose special scrutiny on certain systemically important non-bank institutions, such as insurance companies, ran into legal and political headwinds. Its member agencies often proved reluctant to encroach on one another’s turf, and the FSOC lacked the power to compel action. The OFR never subpoenaed anything, for fear of making enemies. Ultimately, the Trump administration deemphasized and defunded the whole apparatus.

As a result, the U.S. was much less prepared for the shock of the pandemic than it could have been. A rush to cash triggered runs on certain money-market mutual funds, threatened the flow of credit to everyone from homebuyers to municipalities, and — in a troubling departure from the usual “flight to quality” — caused the prices of Treasury securities to fall sharply. The Treasury and the Federal Reserve had to go to extreme lengths and pledge trillions of dollars to restore stability.

Regulators’ objective should not be merely to put out fires once they see smoke, but to prevent the dangerous accumulation of combustible material. New threats will emerge in unexpected ways; solutions will prompt unanticipated responses. So regulation must be dynamic, requiring an ongoing assessment process, not just periodic changes. To meet that challenge, we urge a restructuring of the FSOC and the OFR.

  1. Congress should give each FSOC member agency an explicit financial stability mandate, and require each to establish a similarly focused office to inform its rule making. This would force agencies such as the Securities and Exchange Commission, the Commodities Futures Trading Commission, and the Consumer Financial Protection Bureau to consider systemic-risk issues that they can otherwise too often neglect.
  2. Only the Treasury Secretary should issue the FSOC’s annual report, avoiding the consensus-building process among member agencies that can weaken identification of risks and accountability for dealing with them. While each agency would write a separate appendix, the Secretary would bear ultimate responsibility. The report should include a look back at what risks were missed, why, and how they will be addressed. To ensure the subject gets adequate attention, a new under-secretary for financial stability should act as the secretary’s point person.
  3. The OFR should receive a clear new mandate to gather the data that policymakers need (and, today, often lack). To underscore its importance, it should be renamed the Comptroller for Data and Resilience — echoing the stature of the Comptroller of the Currency — and its head should have a voting seat at the FSOC, a level of authority that would help the government recruit talent and experience to the post.

As the pandemic begins to recede, concern over financial stability should not. We don’t know what major shock will next hit the economy and financial system. But a process to scan for risks and adapt to them should be front and center.

Glenn’s Take on the Proposal at the G7 Meeting to Impose a Minimum Tax on Corporate Profits

   The G7 (or Group of 7) is an organization of seven large economies: Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States. Only democratic countries are included, so China is not a member. At a recent meeting attended by U.S. Treasury Secretary Janet Yellen, the group agreed to adopt a uniform corporate tax rate of at least 15 percent.

Glenn discusses this decision in the following opinion column published in the Financial Times.

U.S. Treasury Secretary Janet Yellen and Paolo Gentiloni, European Commissioner for Economy, at a recent meeting of the G7.

Governments Should Tax Cash Flow, Not Global Corporate Income

From the Biden administration’s inception, US Treasury Secretary Janet Yellen has championed a global minimum tax for corporations. While the US walked back from a request for a 21 per cent rate (which was linked to an objective of raising the current US corporate tax of 21 per cent to between 25 and 28 per cent), it did lock in with G7 finance ministers a rate of at least 15 per cent. Secretary Yellen praised the move: “That global minimum tax would end the race to the bottom in corporate taxation, and ensure fairness for the middle class and working people in the US and around the world.”

It is tough to argue that corporate income shouldn’t pay its “fair share”. But the global minimum tax raises both political and economic questions.

Politics first. Approval in the US is likely to be tough. The minimum tax is estimated by the OECD to raise as much as $50bn-$80bn per year, much of it from successful American firms. Revenue to the US Treasury would be part of this amount, but small relative to the substantial expansion in spending proposed by the Biden administration. Will other governments engage their own political costs to achieve a deal that may be ephemeral if it fails to get US legislative approval? Even if the deal succeeds, might it hand a competitive victory to China? As a non-party to G7 or OECD proposals, could it not use both tax rates and subsidies to draw more investment to China?

But it is on economics that the global minimum tax draws more sensitive questions in two areas. The first is the design of the tax base. The second addresses the foundational question of the problem policymakers are trying to solve and whether the new minimum tax is the best way to do so.

A 15 per cent rate is not particularly useful without an agreement on what the tax base is. Particularly for the US, home to many very profitable technology companies, the concern should arise that countries will use special taxes and subsidies that effectively target certain industries. The US has had a version of a minimum tax of foreign earnings since the Tax Cuts and Jobs Act of 2017 enshrined GILTI (Global Intangible Low-Taxed Income) provision into law. The Biden administration wants to use the new global minimum tax to raise the GILTI rate and expand the tax base by eliminating a GILTI deduction for overseas plant and equipment investments.

For a 15 per cent minimum rate to make sense, countries would need a uniform tax base. Presumably, the goal of the new minimum tax is to limit the benefits to companies of shifting profits to low-tax jurisdictions, not to distort where those firms invest. The combination of a global minimum tax with the broad base advocated by the Biden administration could reduce cross-border investments and reduce the profitability of large multinational firms.

A still deeper economic issue is that of who bears the tax burden. I noted above that projected revenue increases are small compared to G7 government spending levels. It is not corporations who would pay more, but capital owners generally and workers, according to contemporary economic views of who bears the burden of the tax.

There is a better way to achieve what Yellen and her finance minister colleagues are trying to accomplish. To begin with, countries could allow full expensing of investment. That approach would move the tax system away from a corporate income tax toward a cash flow tax, long favoured by economists. In this revision, the minimum tax would not distort new investment decisions. It would also push the tax burden on to economic rents—profits in excess of the normal return to capital—better satisfying the apparent G7 goal of garnering more revenue from the most profitable large companies. And such a system would be simpler to administer, as multinationals would not need to set up different ways to track deductible investment costs over time in different countries.

In the debate leading up to the 2017 US tax law changes, Congress considered a version of this idea in a destination-based cash flow tax. Like a value added tax, this would tax corporate profits based on cash flows in a given country. The reform, which foundered on the political desirability of border adjustments, limits tax biases against investment and boosts tax fairness.

Returning to the numbers: countries with large levels of public spending relative to gross domestic product, as the Biden administration proposes, fund it mainly with value added taxes, not traditional corporate income taxes. A better global tax system is possible, but it starts with a verdict of “not GILTI.”

Glenn on Keynes, Hayek, and What It Will Take to Return to Full Employment

   Glenn wrote the following opinion column for the New York Times.

How to Keep the Economy Booming — And Meet the Demand for Workers

In recent economic news, optimists and pessimists could both find evidence to support their outlooks.

The May jobs report showed a gain of 559,000 jobs in May and a decline in the unemployment rate to 5.8 percent. It also showed a marked improvement from last month’s weaker showing across a number of sectors, and average hourly earnings continued to rise. Ahead of the monthly report, the unemployment insurance weekly claims report on Thursday showed the number of new unemployment insurance claims fell from 405,000 the week before to 385,000 — lower than levels typically indicative of a recession (400,000). This is the first time this has happened since the pandemic-induced closures began. Further wage growth should help draw more workers back to the labor force.

Yet at the same time, the recent jobs report showed a big miss relative to the expected gain of 650,000 jobs. Constraints in supply chains and business reopenings still complicate the return to work. And workers still aren’t out of the woods: Thursday’s report indicated the total number of already unemployed individuals claiming benefits hasn’t dropped since mid-March. If job creation is robust, that contrast between falling new claims and those still on the jobless rolls is odd.

What explains these confounding tensions? To unpack them, consider the legacies of the economists John Maynard Keynes and Friedrich Hayek.

In his day, Keynes argued for boosting aggregate demand during a recession to keep workers afloat — a prescription that has clearly shaped the ultra-stimulative fiscal and monetary policies from both the Trump and the Biden administrations. His influence also resonates in the recent jobs reports: The coming rebound in the consumption of services — restaurant meals, entertainment and travel — will lift demand above its prepandemic level, and reopening and abundant consumer cash, bolstered by policy, will increase the demand for workers.

While Keynes may have lit the path to recovery after last spring’s cataclysmic job loss, he offers little to guide us through the coming labor-supply crunch. If policy actively disincentivizes the unemployed from returning to the fold, as recent reports suggest, there will be no one in place to meet the coming surge in demand, imperiling our economic rehabilitation.

To preserve the still-shaky recovery, we must now turn to Hayek, the godfather of free-market thinking. He argued that policy should allow workers to adjust to changes in the economy. Looking ahead, policymakers must consider curbing elevated unemployment benefits and a focus on old, prepandemic jobs in order to let workers and the economy adjust to new activities and new jobs that are more promising in the postpandemic world. We don’t want unemployed workers to find the postpandemic economy has passed them by.

As demand revives, supply will need to keep pace. Those in some industries, like carmakers, can simply sell off excess inventories, something that is already happening. Tool and machinery makers can increase imports to keep up. But eventually, demand must be met by higher domestic production from workers. Once businesses are freed from pandemic restrictions, we can expect to see some improvements in supply.

But holding back a faster improvement in employment and output are the very challenges Hayek identifies, including slowing down the process of matching dislocated workers to new, postpandemic jobs. That is to say, demand growth with supply constraints won’t produce the sustainable jobs recovery we need.

Many workers are taking their time to find a new job or are choosing to work less, thanks to their generous pandemic unemployment insurance benefits. These benefits provided extra income for those who lost their jobs early in the crisis. As a result, the economy’s adjustment to a postpandemic paradigm will be slow. These benefits also slow future gains in the form of higher wages workers might earn from a new and better job. But as Hayek tells us, the longer it takes for these workers to rejoin the work force, the longer it will take for them to gain these benefits.

In the coming months, we will be able to assess the potency of dealing with these forces of supply and demand by comparing employment gains in the 25 states choosing to end federal pandemic benefit supplements with the 25 states retaining them. While employment is likely to rise quickly as the pandemic fades and extra unemployment insurance benefits fall away, unemployment rates are still likely to remain high relative to prepandemic levels for another year.

If we look ahead, wage gains should be robust for those employed, particularly for lower-skilled service-sector workers — especially if some employees delay returning to work. Those higher real wages are good news for recipients.

A less welcome wild card would be inflationary pressures, fueled by demand outstripping supply. Those pressures could be a brief blip in an adjusting economy. Or they could suggest a reduction in purchasing power from higher inflation for an extended period. Higher recent inflation readings in consumer prices are a cause for concern.

Whether this happens hinges on whether the federal government and the Federal Reserve dial back their extra Keynesian demand support in time to avoid increases in expected inflation. Inflation risks robbing them of purchasing power gains from their higher wages.

The latest jobs report, then, favors a more Hayekian solution — with a nudge: Policy should support returning to work and matching workers to jobs by supporting re-employment and training for new skills, not just boosting demand. That shift offers the best chance for a sustained lift in jobs as well as demand as the pandemic recedes. In the matter Keynes v. Hayek, then: Let Hayek now prevail.

The Debate over Macro Policy

   The current debate over monetary and fiscal policy has been particularly wide-ranging, touching on many of the issues we discuss in the policy chapters of the principles textbook.

Here are links to recent contributions to the debate.

Glenn and Tony discuss fiscal policy in a podcast HERE.

And monetary policy in a podcast HERE.

We discuss the Fed’s new monetary policy strategy HERE.

We discuss the current state of the labor market HERE.

The President’s Council of Economic Advisers discusses the need for additional fiscal policy measures in this POST on their blog.

An article on politico.com summarizes the debate HERE.

Harvard economist and former Treasury secretary Larry Summers has argued that fiscal and monetary policy have been too expansionary. A recent op-ed by Summers appears in the Washington Post HERE (subscription may be required).

Jason Furman, who was chair of the Council of Economic Advisers under President Obama gives his take on the division of opinion among academic economists in this Twitter THREAD.

Is the Natural Rate of Unemployment the Best Guide to Monetary Policy? The Fed’s New Monetary Policy Strategy

In response to the 2007-2009 financial crisis, in December 2008, the Federal Open Market Committee effectively cut its target for the federal funds to zero where it remained during the first six years of the recovery. In December 2015, Fed Chair Janet Yellen and the FOMC began the process of normalizing monetary policy by raising the target for the federal funds rate to 0.25 to 0.50 percent.

The FOMC raised the target several more times during the following years (Jerome Powell succeeded Janet Yellen as Fed Chair in February 2018) until it reached 2.25 to 2.50 percent in December 2018. In Chapter 27 of the textbook we discuss the fact that the experience of the Great Inlfation that had lasted from the late 1960s to the early 1980s had convinced many economists inside and outside of the Fed that if the unemployment rate declined below the natural rate of unemployment (also referred to as the nonaccelerating inflation rate of unemployment, or NAIRU), the inflation rate was likely to accelerate unless the FOMC increased its target for the federal funds rate. The actions the FOMC took starting in December 2015 were consistent with this view.

At the December 2015 meeting, the FOMC members gave their estimates of several key economic variables, including the natural rate of unemployment. At the time of the meeting, the unemployment rate was 5.0 percent. The average of the FOMC members’ estimates of the natural rate of unemployment was 4.9 percent. The inflation rate in December 2015 was 1.2 percent—well below the Fed’s target inflation rate of 2 percent. Although it might seem that with such a low inflation rate, the FOMC should not have been increasing the federal funds rate target, doing so was consistent with one of the lessons from the Great Inflation: Because monetary policy affects the economy with a lag, it’s important for the Fed to react before inflation begins to increase and a higher inflation rate becomes embedded in the economy. With many FOMC members believing that the NAIRU had been reached in December 2015, raising the federal funds rate from effectively zero seemed like an appropriate policy.

At least until the end of 2018, some members of the FOMC indicated publicly that they still believed that the Fed should pay close attention to the relationship between the natural rate of unemployment and the actual rate of unemployment. For example, in a speech delivered in December 2018, Raphael Bostic, president of the Federal Reserve Bank of Atlanta, who was serving that year on the FOMC, made the following points:

“[P]eriods of time when the actual unemployment rate fell below what the U.S. Congressional Budget Office now estimates as the so-called natural rate of unemployment … I refer to … as “high-pressure” periods. … Dating back to 1960, every high-pressure period ended in a recession. And all but one recession was preceded by a high-pressure period….

One potential consequence of overheating is that inflationary pressures inevitably build up, leading the central bank to take a much more “muscular” stance of policy at the end of these high-pressure periods to combat rising nominal pressures. Economic weakness follows. You might argue that the simple answer is to not respond so aggressively to building signs of inflation, but that would entail risks that few responsible central bankers would accept. It is true that the Fed and most other advanced-economy central banks have the luxury of solid credibility for achieving and maintaining their price stability goals. But we shouldn’t forget that such credibility was hard won. Inflation expectations are reasonably stable for now, but we know little about how far the scales can tip before it is no longer so.”

Bostic also noted in the speech that “it is very difficult to determine when the economy is actually overheating.” One indication of that difficulty is given by the following table, which shows how the average estimate by FOMC members of the natural rate of unemployment declined each year during the period in which they were raising the target for the federal funds rate. 

December 20154.9%
December 20164.8%
December 20174.7%
December 20184.4%
December 20194.1%
Federal Open Market Committee Forecasts of the Natural Rate of Unemployment, 2015-2019

As we discuss in Chapter 19, Section 19.1 of the textbook, because of problems in measuring the actual unemployment rate and in estimating the natural rate of unemployment, some economists inside and outside of the Fed have argued that the employment-population ratio for prime age workers is a better measure of the state of the labor market.  The following shows movements in the employment-population ratio for workers aged 25 to 54 between January 2000, when the ratio was near its post-World War II high, and February 2021. 

Employment-Population Ratio for Worker Aged 25 to 54, 2000-2021

The figure shows that in December 2015, when the Fed began to raise its target for the federal funds rate and when the average estimate of the FOMC members indicated that unemployment was at its natural rate, the employment-population rate was still 4.5 percentage points below its level of early 2000. The FOMC members do not report individual forecasts of the employment-population ratio. If they had focused on that measure rather than on the unemployment rate, they may have concluded that there was more slack in the labor market and, therefore, have been less concerned that inflation might be about to significantly increase.

In 2019, the Fed began to cut its target for the federal funds rate as the growth of real GDP slowed. In March 2020, following the start of the Covid-19 pandemic, the Fed cut the target back to 0 to 0.25 percent. During that time, some members of the FOMC and some economists outside of the Fed concluded that the Fed may have made a mistake by raising the target for the federal funds rate multiple times between 2015 and 2018. For example, Bostic in a speech in November 2020, noted that “the actual unemployment rate exceeded estimates of the NAIRU by an average of 0.8 percentage points each year” between 1979 and 2019. He concluded that “If estimates of the NAIRU are actually too conservative, as many would argue they have been …unemployment could have averaged one to two percentage points lower” between 1979 and 2019, which he argues would have been a particular benefit to black workers. In a speech in September 2020, Lael Brainard, a member of the Fed’s Board of Governors, noted that the Fed’s previous approach of making policy less expansionary “when the unemployment rate nears the [natural] rate in anticipation of high inflation that is unlikely to materialize risks an unwanted loss of opportunity for many Americans.”  

in August 2020, the Fed announced the results of a review of its monetary policy. In a speech that accompanied the statement Fed Chair Jerome Powell noted that in attempting to achieve its mandate of high employment, the Fed faces the difficulty that “the maximum level of employment is not directly measurable and changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.” Powell noted that the in the Fed’s new monetary policy statement, policy will depend on the FOMC’s: “’assessments of the shortfalls of employment from its maximum level’ rather than by ‘deviations from its maximum level’ as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.” 

At this point, the details of how the Fed’s new monetary policy strategy will be implemented are still uncertain. But it seems clear that the Fed has ended its approach dating back to the early 1980s of raising its target for the federal funds rate when the unemployment rate declined to or below the FOMC’s estimate of the natural rate of unemployment. Particularly after Congress and the Biden administration passed the $1.9 trillion American Rescue Plan in March 2021, some economists wondered whether the Fed’s new strategy might make it harder to counter an increase in inflation without pushing the U.S. economy into a recession. For instance, Olivier Blanchard of the Peterson Institute for International Economics argued that the combination of very expansionary fiscal and monetary policies might lead to a situation similar to the late 1960s:

“From 1961 to 1967, the Kennedy and Johnson administrations ran the economy above potential [GDP], leading to a steady decrease in the unemployment rate down to less than 4 percent. Inflation increased but not very much, from 1 percent to just below 3 percent, suggesting to many a permanent trade-off between inflation and unemployment. In 1967, however, inflation expectations started adjusting, and by 1969, inflation had increased to close to 6 percent and was then seen as a major issue. Fiscal and monetary policies tightened, leading to a recession from the end of 1969 to the end of 1970.”

Fed Chair Jerome Powell seems confident, however, that any increase in inflation will only be temporary. In testifying before Congress, he stated that: “We might see some upward pressure on prices [as a result of expansionary monetary and fiscal policy]. Our best view is that the effect on inflation will be neither particularly large nor persistent.” 

Time will tell which side in what one economic columnist called the Great Overheating Debate of 2021 will turn out to be correct.

Sources: Neil Irwin, “If the Economy Overheats, How Will We Know?” New York Times, March 24, 2012; Olivier Blanchard, “In Defense of Concerns over the $1.9 Trillion Relief Plan,”  piie.com, February 18, 2021; Paul Kiernan and Kate Davidson, “Powell Says Stimulus Package Isn’t Likely to Fuel Unwelcome Inflation,” Wall Street Journal, March 23, 2021; Federal Open Market Committee, “Minutes,” various dates; Lael Brainard, “Bringing the Statement on Longer-Run Goals and Monetary Policy Strategy into Alignment with Longer-Run Changes in the Economy,” September 1, 2020; Raphael Bostic, “Views on the Economic and Policy Outlook,”  December 6, 2018; Raphael Bostic, “Racism and the Economy: Focus on Employment,” November 17, 2020; Jerome Powell, “New Economic Challenges and the Fed’s Monetary Policy Review,” August 27, 2020; and Federal Reserve Bank of St. Louis. 

Annoucing Hubbard and O’Brien, Money, Banking, and the Finacial System, Fourth Edition.

The new fourth edition of our Money, Banking, and the Financial System text is hot off the presses. The new edition is thoroughly updated and includes coverage of the effects of the Covid-19 pandemic on the financial system, the Fed’s policy response to the pandemic, and issues raised by the Fed’s close collaboration with the U.S. Treasury during the pandemic and by the Fed’s expansion into lending to nonfinancial businesses. 

We’ve also revised and updated our discussion of how the Fed uses the interest rate on excess reserves and the rate on its reverse repurchase agreements to manage the federal funds rate. Other new content with respect to monetary policy includes a discussion of the Fed’s shift away from emphasizing open market operations and toward relying on quantitative easing and forward guidance. We discuss many other current issues in monetary policy including whether the Fed has done enough to reduce Black unemployment.

For more details on the many revisions, the new material included literally in every chapter, and for ordering information, please click HERE.

The Wild Ride of GameStop’s Stock Price

Supports:  Hubbard/O’Brien, Chapter 8, Firms, the Stock Market, and Corporate Governance; Macroeconomics Chapter 6; Essentials of Economics Chapter 6; Money, Banking, and the Financial System, Chapter 6.

We’ve seen that a firm’s stock price should represent the best estimates of investors as to how profitable the firm will be in the future. How, then, can we explain the following graph of the price of shares of GameStop, the retail chain that primarily sells video game cartridges and video game systems? The graph shows the price of the stock from December 1, 2020 through February 9, 2021. If the main reason the price of a stock changes is that investors have become more or less optimistic about the profitability of the firm, is it plausible that opinions on GameStop’s profitability changed so much in such a short period of time?.

  Sometimes investors do abruptly change their minds about the profitability of a firm but typically this happens when the firm’s profitability is heavily dependent on the success of a single product. For instance, the price of the stock a biotech firm might soar as investors believe that a new drug therapy the firm is developing will succeed and then the price of the stock might crash when the drug is unable to gain regulatory approval.  But it wasn’t news about its business that was driving the price of GameStop’s stock from $15 per share during December 2020 to a high of $347 per share on January 27, 2021 and then down to $49 per share on February 9.

            To understand these prices swings, first we need to take into account that not all people buying stock do so because they are making long-term investments to accumulate funds to purchase a house, pay for their children’s educations, or for their retirement. Some people who buy stock are speculators who hope to profit by buying and selling stock during a short period—perhaps as short as a few minutes or less. The availability of online stock trading apps, such as Robinhood, that don’t charge commissions for buying and selling stock, and online stock discussion groups on sites like Reddit, have made it easier for some individual investors to become day traders, frequently buying and selling stocks in the hopes of making a short-term profit.

Many day traders engage in momentum investing, which means they buy stocks that have increasing prices and sell stocks that have falling prices, ignoring other aspects of the firm’s situation, including the firm’s likely future profitability. Momentum investing is an example of what economists call noise trading, or buying and selling stocks on the basis of factors not directly related to a firm’s profitability. Noise trading can result in a bubble in a firm’s stock, which means that the price rises above the fundamental value of the stock as indicated by the firm’s profitability. Once a bubble begins, a speculator may buy a stock to resell it quickly for a profit, even if the speculator knows that the price is greater than the stock’s fundamental value. Some economists explain a bubble in the price of a stock by the greater fool theory: An investor is not a fool to buy an overvalued stock as long as there’s a greater fool willing to buy it later for a still higher price. 

Although the factors mentioned played a role in explaining the volatility in GameStop’s stock price, there was another important factor that involved hedge funds and short selling. Hedge funds are similar to mutual funds in that they use money from savers to make investments. But unlike mutual funds, by federal regulation only wealthy individuals or institutional investors such as pension funds or university endowment funds are allowed to invest in hedge funds. Hedge funds frequently engage in short selling, which means that when they identify a firm whose stock they consider to be overvalued, they borrow shares of the firm’s stock from a broker or dealer and sell them in the stock market, planning to make a profit by buying the shares back after their prices have fallen.

In early 2021, several large hedge funds were shorting GameStop’s stock believing that the market for video game cassettes would continue to decline as more gamers switched to downloading games. Some people in online forums—notably the WallStreetBets forum on Reddit—dedicated to discussing investing strategies argued that if enough day traders bought GameStop’s stock they could make money through a short squeeze. A short squeeze happens when a heavily shorted stock increases in price. The speculators who shorted the stock may then have to buy back the stock to avoid large losses or having to pay very high fees to dealers who had loaned them the shares they were shorting. As the short sellers buy stock, the price of the stock is bid up further, earning a profit for day traders who had bought the stock in anticipation of the short squeeze. One MIT graduate student made a profit of more than $200,000 on a $500 investment in GameStop stock. Some hedge funds that had been shorting GameStop lost billions of dollars.

Some of the day traders involved saw this episode as one of David defeating Goliath because the people executing the short squeeze were primarily young with moderate incomes whereas the people running the hedge funds taking substantial losses in the short squeeze were older with high incomes. The reality was more complex because as the price of GameStop stock declined from $347 on to $54 on February 4, some day traders who bought the stock after its price had already substantially risen lost money. And all the winners from the short squeeze weren’t day traders; some were hedge funds. For instance, by early February, the hedge fund Senvest Management had earned $700 million from its trading in GameStop’s stock.  

Economists had differing opinions about whether the GameStop episode had a wider significance for understanding how the stock market works or for how it was likely to work in the future. Some economists and investment professionals argued that what happened with GameStop’s stock price was not very different from previous episodes in which speculators buying and selling a stock will for a time cause increased volatility in the stock’s price. In the long run, they believe that stock prices return to their fundamental values. Other economists and investors thought that the increased number of day traders combined with the availability of no-commission stock buying and selling meant that stock prices might be entering a new period of increased volatility. They noted that similar, if less spectacular, price swings had happened at the same time in other stocks such as AMC, the movie theater chain, and Express, the clothing store chain. An article on bloomberg.com quoted one analyst as saying, “We’ve made gambling on the stock market cheaper than gambling on sports and gambling in Vegas.” 

            Federal regulators, including Treasury Secretary Janet Yellen, were evaluating what had happened and whether they needed to revise existing government regulations of financial markets.  

Sources: Misyrlena Egkolfopoulou and Sarah Ponczek, “Robinhood Crisis Reveals Hidden Costs in Zero-Fee Trading Model,” bloomberg.com, February 3, 2021; Gunjan Banerji,  Juliet Chung, and Caitlin McCabe, “GameStop Mania Reveals Power Shift on Wall Street—and the Pros Are Reeling,” Wall Street Journal, January 27, 2021; Gregory Zuckerman, “For One GameStop Trader, the Wild Ride Was Almost as Good as the Enormous Payoff,” Wall Street Journal, February 3, 2021; Juliet Chung, “Wall Street Hedge Funds Stung by Market Turmoil,” Wall Street Journal, January 28, 2021; and Juliet Chung, “This Hedge Fund Made $700 Million on GameStop,” Wall Street Journal, February 3, 2021. 

           

Questions 

  1. During the same week that the price of GameStop’s stock was soaring to a record high, an article in the Wall Street Journal noted the following: “Analysts expect GameStop to post its fourth consecutive annual decline in revenue in its latest fiscal year amid declines in its core operations [of selling video game cartridges and video game consoles in retail stores].” Don’t stock prices reflect the expected profitability of the firms that issue the stock? If so, why in January 2021 was the price of GameStop’s stock greatly increasing when it seemed unlikely that the firm would become more profitable in the future?

Source: Sarah E. Needleman, “GameStop and AMC’s Stocks Are on a Tear, but Their Businesses Aren’t,” Wall Street Journal, January 31, 2021

2. In early 2021, as the stock price of GameStop was soaring, a columnist in the New York Times advised that: “A better option [than buying stock in GameStop] would be salting away money in dull, well-diversified stock and bond portfolios, these days preferably in low-cost index funds.”

a. What does the columnist mean by “salting money away”?

b. are index funds and why might they be considered dull when compared to investing in an individual stock like GameStop?

c. Why would the columnist consider investing in an index mutual fund to be a better option than investing money in an individual stock like GameStop? 

Source: Jeff Sommer, “How to Keep Your Cool in the GameStop Market,” New York Times, January 29, 2021.

Instructors can access the answers to these questions by emailing Pearson at christopher.dejohn@pearson.com and stating your name, affiliation, school email address, course number.

Christopher Waller Confirmed by Senate as Federal Reserve Governor

Christopher Waller

On Thursday, December 3, Christopher Waller, executive vice president and research director at the Federal Reserve Bank of St. Louis, was confirmed by the Senate as a member of the Federal Reserve’s Board of Governors.  The Board of Governors has seven members and, under the Federal Reserve Act, is responsible for the monetary policy of the United States and for overseeing the operation of the Federal Reserve System.

Board members are appointed by the president and confirmed by the Senate to 14-year nonrenewable terms. The terms are staggered so that one expires every other January 31. Members frequently leave the Board before their terms expire to return to their previous occupations or to accept other positions in the government. The following table shows the current Board members, when their terms will expire, and which president appointed them.  Note that one seat on the Board is vacant. President Trump nominated Judy Shelton to fill this seat but it appears unlikely that she will be confirmed by the Senate before the change in administration takes place on January 20.

NameYear Term EndsAppointed to the Board by
Jerome Powell, ChairAs Chair: 2022
As Board member: 2028
As Chair: President Trump
As Board member: President Obama
Richard Clarida, Vice ChairAs Vice Chair and as Board member: 2022President Trump
Randal Quarles, Vice Chair for SupervisionAs Vice Chair for Supervision: 2021; As Board member: 2032President Trump
Michelle Bowman2034President Trump
Lael Brainard2026President Obama
Christopher Waller2030President Trump
Vacant

Information on the history and structure of the Board of Governors and on the backgrounds of current members can be found HERE on the Fed’s website.  An announcement of Waller’s confirmation can be found HERE on the website of the St. Louis Fed. A news story discussing Waller’s confirmation and the likely outcome of Shelton’s nomination, as well as some of the politics involved with current Fed nominations can be found HERE (those with a subscription to the Wall Street Journal may also want to read the article HERE).