AUG 5 2024 will probably be remembered as another Black Monday: a heavy selloff of shares hit hard in Japan, with the Nikkei index down 12.4 per cent, its worst day since October 1987.
All the other markets were affected, in particular in Asia, where the FBM KLCI lost 4.63 per cent and the Jakarta Comp went down by 3.4 per cent.
Why did it happen?
In a nutshell, we can say that this is the hard wake-up call after a long night of artificial dreams induced by easy money, in turn created by extremely expansive fiscal and monetary policies adopted during the Great Lockdown, with governments and central banks trying to convince themselves and the public that their irresponsible actions could go through without consequences.
Instead, the Centre for Market Education predicted these troubles as early as May 2021 (https://marketedu.me/the-post-covid-economic-crisis/).
Now, two factors came into play at the same time toward the end of last week:
The Federal Reserve opening the door for interest rate cuts in September, accompanied by relatively bad news for the American economy in terms of data about employment and manufacturing;
The Bank of Japan (BoJ) moving in the opposite direction, explicitly - and unusually - announcing an interest rate hike to defend the falling yen.
During the first part of the year, the yen fell while the Japanese stock exchange recorded high times.
The falling yen was caused by the interest rate differential (spread) between Japan and the USA, which induced investors to borrow in Yen and invest in American dollars. In turn, the falling yen pushed up the Japanese stock exchange as it created positive expectations about an export-oriented economy which benefits from a weak currency.
So, the high spread damaged the currency but pushed investors toward Japanese companies.
Now the situation is reversing: not really in real terms (the Fed cuts are still announcements and BoJ rates cannot be considered high), but in terms of expectations: the relationship between objective economic variables or 'business situations' and expectations depends on the interpretation which the agents give to the former; this is what Ludwig Lachmann called the subjectivism of active minds.
With good news about inflation and sign of weakness from some economic fundamentals, the Federal Reserve opened the doors to interest rate cuts, while BoJ increased rates to protect the falling currency.
This is reducing the spread which crushed the yen and favoured Japanese stocks: paying back loans in yen is becoming more expensive, while the expected returns on the investment in dollars are lowering. Furthermore, a stronger yen is going to frustrate export-oriented profit expectations.
End of the story? Not really. As is well known, Warren Buffet halved his participation in Apple, summarising all the concerns about high-tech stocks and long-term expectations on their profitability.
As had to be expected, the prolonged period of easy money (low rates), accompanied by the excess money creation via expansive fiscal policies, induced investors to venture into territories which they would have not explored without the abundance of cheap money (a typical case of "Austrian" boom).
Investments flowing into high tech stocks fueled profit expectations and generated a boom, attracting new rounds of investors and creating an asset price bubble (what J.A. Schumpeter called secondary prosperity).
In order to be sustained, this process would have required credit expansion without respite – which would bring about a cumulative increase in prices that sooner or later would exceed every limit.
At this point, the interest rate could not but rise, frustrating investors' demand for capital. Entrepreneurs who invested in the expectation that low rates and the ample supply of money would last indefinitely, find these expectations disappointed.
This phenomenon of a sudden scarcity of capital (higher rates, end of expansive policies) is probably the central point of a true explanation of economic and financial crises (as argued by Arthur Spiethoff and F.A. Hayek in the 1930s).
Therefore, if we want to find a real explanation of the recent crash, we must not just look at it per se; rather, we should look backward, at an artificial boom which was ignited by the artificial abundance of money, in turn creating an asset bubble even where prices remained relatively stable.
As the Wall Street Journal put it, "cheap money is never free, and it can't last forever. It builds distortions and excesses that are unsustainable and must eventually be addressed. That's what the Fed had to do by raising rates to arrest inflation, and part of that bill is now coming due. Government spending is also restrained by rising debt, even as low-income consumers have spent down their pandemic savings. The current economic slowdown is one result".
* Dr Carmelo Ferlito is chief executive officer of Centre for Market Education, while Nick Chong is its general manager.