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The Price Of Oil, China And Stock Market Herding – Analysis

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he world economy at the start of 2016 is a genuinely confusing place, with stock markets plummeting. This column discusses the mainstream narratives behind this – China and the oil price dip – and finds them wanting. The economic linkages seem too weak to justify the gyrations. Instead, they may be the result of herding or a delayed reaction to the global economy’s lower-for-long growth prospects.

By Olivier Blanchard*

The stock market movements of the last two weeks are puzzling.

Take the China explanation. A collapse of growth in China would indeed be a world-changing event. But there is just no evidence of such a collapse. At most, there is suggestive evidence of a mild slowdown, and even that is far from certain.

The mechanical effects of such a mild decrease on the US economy should – by all accounts, and all the models we have – be limited. Trade channels are limited (US exports to China represent less than 2% of GDP), and so are financial linkages. The main effect of a slowdown in China would be through lower commodity prices, which should help rather than hurt the US.

Take the oil price explanation. It is even more puzzling. Traditionally, it was taken for granted that a decrease in the price of oil was good news for oil-importing countries such as the US. Consumers, with more money to spend, would increase consumption and increase output. Energy-using firms, with lower cost of production, would increase investment. We learned in the last year that, in the short run, the adverse effect on investment of energy-producing firms could come quickly and temporarily slow down the effect, but this surely does not undo the general conclusion. Yet the headlines are now about low oil prices leading to low stock prices. I can think of two potential explanations, neither of them convincing.

  • First, that very low prices lead to such serious problems for oil producers that this will end up affecting the US and dominating the scene.

I have no doubt that some countries and some companies will indeed be in serious trouble; indeed, some already are. I can also think of ways in which low oil prices also change the geopolitics of the Middle East, with uncertain effects on oil prices. I find it difficult to think that these will dominate the direct real income effects for US consumers.

  • Second, that the low prices reflect a yet unmeasured decrease in world growth – a decrease much larger than is apparent in other hard data – and that the price of oil, like the celebrated canary in the coal mine, is telling us something about the state of the world economy that other data do not.

There is no historical evidence that the price of oil plays such a role. But suppose, for the sake of argument, that, indeed, the low price told us that China is really slowing down. (The fact that non-oil commodity prices, for which China plays a bigger role than for oil, have decreased much less than oil does not support this interpretation.) Then, we would be back to the previous conundrum. It is hard to see how this could have such an effect on the US economy, and in turn on the US stock market. Another variation on the theme, which has been raised in some columns, is that the low oil price reflects a slowdown in the US far beyond what the other current data are telling us. There is zero evidence that this is the case.

Alternatives

Maybe we should not believe the market commentaries. Maybe it was neither oil nor China. Maybe what we are seeing is a delayed reaction to the slowdown in the world economy, a slowdown that has now gone on for a few years. While there has been no significant news in the last two weeks, maybe markets are only realising that growth in emerging markets will be lower for a long time, that growth in advanced economies will be unexciting. Maybe…

I think the explanation is largely elsewhere.

  • I believe that to a large extent, herding is at play.

If other investors sell, it must be because they know something you do not know. Thus, you should sell, and you do, and so down go stock prices.

Why now? Perhaps because we have entered a period of higher uncertainty. The world economy, at the start of 2016, is a genuinely confusing place. Political uncertainty at home and abroad, geopolitical uncertainty, are both high. The Fed has entered a new regime. The ability of the Chinese government to control its economy is in question. In that environment, in the stock market just as in the Presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fear mongers to gain popularity.

So how much should we worry?

This is where economics stops giving an answer. Or, more specifically, where it gives the dreaded two-handed answer.

  • If it becomes clear within a few days or a few weeks that fundamentals are in fact not so bad, stock prices will recover, just as they did last summer, and this will be seen as a hiccup.
  • If, however, the stock market slump lasts longer or gets worse, it can become self-fulfilling.

Low stock prices lasting for long lead to lower consumption, lower demand, and, potentially, to a recession. The ability of the Fed, fresh out of the zero lower bound, to counteract a slowdown in demand remains limited. One has to hope for the first scenario, but worry about the second.

About the author:
* Olivier Blanchard
, Fred Bergsten Senior Fellow, Peterson Institute; Robert Solow Professor of Economics Emeritus, MIT

Editor’s Note: This was first posted on the Peterson Institute for International Economics’ RealTime Economic Issues Watch on 17 January 2016.

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2 thoughts on “The Price Of Oil, China And Stock Market Herding – Analysis

  • January 20, 2016 at 12:52 pm
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    This view is really very bad for economic analysis. Herding is not a new idea. T. Veblen and other economists and non-economists have analyzed it in the past. Simply, human and animals live in groups, and these groups move together with some outliers. If you stick with good economics you need to go back and use ideas from Sismondi, Marx, Veblen, and Mitchell to understand the current crisis of globalized monopoly capitalism. Currently, the core problem is with the US economy, and the issue is a profit squeeze. Corporate profits are declining due to lower revenues which ar due to low prices of commodities. Cost has been cut and wages are not increasing and jobs are those of low wages. Lower revenues are translated into lower demand by consumers. Corporations are not investing, and most of their investments are in stock buyback to make higher rates of profit with the help of the Fed’s low interest rate, a policy that has created inflation in asset prices and a very high income inequality for the top one percent. The wealthy people have not been able to lift aggregate demand. Manufacturing in the US is shrinking and cannot create high-wage employment. This sector is also squeezed due to a strong dollar, and strong dollar affects US corporate profits obtained from foreign countries: revenue declines in dollar unit. Retail sales are declining, because people are not buying that much. People do not have extra income to spend. People are squeezed by the oligopolistic prices of utility, health care, medicine, TV cable, insurance, rent, etc. For producers, low oil prices are hurting the energy sector, and many Ponzi fracking oil industry will go out of business soon. Trillions of dollars are invested in this risky sector for higher returns. This risky investment was pushed by the Fed zero interest rate policy. Junk bonds in fracking industry are collapsing. These loses do affect the stock market because energy is an essential component of the stock market. Corruption is hurting large banks and so are loans to oil frackers. Low oil and commodity prices are hurting many countries in the world, including the Kingdom of Saudi Arabia, Iraq, Venezuela, Brazil, and the like. Those countries do import from other countries in the world. These low imports create lower economic growth in the world, and all are translating into lower revenues and demand and profit squeeze. China’s slowdown is translating in lower oil imports and lower demand for other commodities. China’s devaluation is also affecting the deflationary trend in commodity prices. All these issues plus the political problems in the Middle East from Daesh to Iran and Israel have created uncertain economic environment that is not conducive to high economic growth. To tackle this crisis, the Fed is already setting the rate of interest at a very low rate but the government must due expansionary fiscal policy to inject spending into the real civilian economy such as the infrastructure. Government spending is currently directed toward the war economy which is not helping the economy. In fact, this military spending is putting more pressure on the deflationary trend. Lastly, the view that wealth effect generated by keeping the interest rate at zero has enrich the wealthy and has generated slowdown in economic growth. It is a failed idea and policy designed to enrich the financiers.

    Reply
    • January 20, 2016 at 6:45 pm
      Permalink

      Adil you are a true genius with an ability to see all the pieces. The bitter truth includes the non-stop blame game created by corporate media. New headlines blaming Iran for dumping oil shows a lack of creativity in the media. Oil consumption in 2014 was over 94 billion barrels. Iran could soon be selling, if they find a buyer, 500,000 barrels as day. As you have clearly shown the economic chaos began at least a decade ago. I do find it a bit confusing how prices are inflating while the price of oil is low. With low oil cost shouldn’t the cost of production be lower?

      Reply

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