Why the Stock Crash Should Not Matter to Policymakers

Written by: Jason Geissler

When the Dow Jones falls 1,175 points in one day—the largest single-day drop in history—people are going to ask: what happened? A myriad of explanations have emerged as to just what could have caused the crash, such as this reasonable argument that this is a simple bubble collapse and that stock market indexes will likely drop a bit further before rebounding or this important reminder that the stock market and the economy are not the same thing and that this may actually be a sign that we have finally passed the 2008 recession. By Thursday, February 8th, however, the clear answer by many accounts was that the anticipation of the Fed raising interest rates over the concern of inflation led to the crash.

Notably, this was not a uniquely American market drop: the Nikkei saw its largest single-day decline since the 2016 Brexit vote and the gold, silver, copper, aluminum, and crude oil markets all saw drops with similar timing and trends as those of their stock market index counterparts. It is interesting to consider, then, the power that this consensus argument implies the Fed wields over world markets. In fact, the simple uncertainty over a future policy was allegedly enough to cause market declines from New York to Australia and much of Asia. This implies that the policymakers of a single nation can affect a wide variety of markets around the world. Considering the impact that this has on the world population, we should all be very interested in how these policymakers go about setting economic and fiscal policy and how accurate the information they use in setting policy is. 

Forecasting is hard. Arguably, accurate stock market forecasting is impossible because predictions themselves affect the stock market. The multitude of factors that influence stock and commodity prices in complex ways should make it come as no surprise that we fail to see record-setting economic fluctuations from time to time. It should also be unsurprising that news coverage of this latest crash has focused on determining causes. Certainly this autopsy of the crash has produced some arguments that seem perfectly reasonable ex post. There is a downside to using this line of historical examination, however.

When we view an event after the fact, not only do we benefit from a more complete set of information, but we also know the final outcome. This is like a watching a mystery; the first time through, you have all the information that you need to understand the conclusion, but you may not see it coming because excess information crowds out everything that is relevant. After the big reveal, the conclusion feels so obvious that you are shocked that you did not see it coming. In the real world, though, the mystery includes far more red herrings than anything Arthur Conan Doyle produced.

When you couple our inability to accurately forecast and the potential power of policymakers to affect markets, the outcome is a bit concerning. Even if the Federal Reserve Board is composed of the best experts who are consistently working toward the same goals and acting entirely in good faith, they will make decisions based on these moderately accurate estimates of how the economic future will look. Moreover, those decisions have real consequences —even 4 trillion dollar consequences.

Yet on a long enough time scale, a 1,175 point drop and any missed opportunities to avert it are unremarkable. The field of economics is far more concerned with aggregates and averages than with any particular bubble collapsing or single change in interest rates. So too should the Federal Reserve Board and other central banks not be bothered by any one market drop, and they certainly should not make large policy changes based on the autopsy of a single, albeit dramatic swing in stock prices. Demanding that policymakers do everything possible to prevent or mitigate economic crises is not only unrealistic, it requires governments to err on the side of caution to the detriment of the economy. Forecasts of economic disasters that will never materialize must be acted on with the same respect as those that later do manifest, thereby prompting a higher degree of underlying uncertainty and subsequently lower long-run investment.

When the future is hard to predict and any actions taken based on those predictions can alter the validity of the initial prediction, it is more reasonable to simply accept that markets are going to fluctuate in the short-run. Yes, it is tempting to ask more of policymakers when you see your 401k take a hit, but that does not make such a request prudent. Economic policy must remain concerned with long-run trends and use trusted tools to influence them. Slow and steady economic growth may not be sexy, and is almost never exciting enough to get someone re-elected, but it is a major component of a healthy economy and should be the main component of decisions made by policymakers.