Last week amateur traders took on the mighty short-selling hedge funds and won, causing more than $70 billion in losses. In the process, they drove the share price of a small and probably failing company, the retailer GameStop, as well as those of a couple of other troubled companies, to crazy and totally unrealistic heights.
It was a strange week on Wall Street. While the meaning of those events remains obscure, their long-term consequences are going to be momentous. And, given the pivotal role of US financial markets in the global financial and economic system, repercussions will surely be felt around the world.
Here are some lessons we should be learning.
Lesson One: The internet, smartphones, and social media continue their disruptive march through the 21st century. They have disrupted various industries and the news media. Over the past four years, we have seen how they have changed politics and we are only now becoming dimly aware of how they will disrupt warfare.
Financial markets, driven by the powerful force of investor greed, have been complicit in these disruptions since their money financed the breakneck speed of technological progress. Sure, everything we have seen on the technology front would have probably happened anyway, but at a more gradual pace. There is a direct correlation between the onset of the technological revolution of the past 40 years and financial market deregulation, which began in the Ronald Reagan/Margaret Thatcher years and was completed by Bill Clinton.
Now, however, these same forces have come home to roost, disrupting financial markets themselves — and the disruption is still in its early stages.
Lesson Two: Day traders first emerged thanks to cheap and accessible online brokers such as E*Trade, which popped during the 1990s. Their numbers fluctuated, rising during boom years and falling sharply whenever financial crises wiped out small players. But even when seemingly everyone was trading, they were disorganized and didn’t move the market much.
With the pandemic, however, new and numerous groups of players have turned to trading. They include people working from home and sitting in front of the computer all day long anyway. Others have lost their jobs, and have lots of time on their hands and no other way of earning a living.
Finally, college and high school students have turned to trading as well. Their remote learning is not really working, social life is limited and job prospects after graduation are uncertain. They have computer skills, they’re adept at using social networks and they have a lot of time on their hands.
The retail trading phenomenon has spread around the world and, thanks to financial engineering, you can now take both long and short positions on pretty much any asset, regardless of where it is located or traded.
Last week’s events showed how those day traders have become organized using social networks. They can now coordinate their positions and make concerted moves. They have become a force in the market and, naturally, big money is now watching those forums, looking for opportunities to get in on the action.
Lesson Three: The chaos in financial markets is entirely due to crazy amounts of excess liquidity sloshing about the global financial system. Governments everywhere have been relying on paper money to support economic growth. The United States, as the provider of the global reserve currency, has been the main offender — simply because unlike Argentina or Venezuela, it can get away with it. While any other country will run into trouble sooner or later, the rest of the world has to support the dollar out of basic self-interest.
After a string of surpluses in the 1990s, the US government began running widening structural deficits once George W. Bush slashed taxes in 2000. America’s fiscal position deteriorated after the 2008 global financial crisis and then in 2017, due to another tax cut.
Despite the longest economic boom in US history, Donald Trump’s government was running trillion-dollar deficits even before covid. Once the pandemic hit, the fiscal hole widened to $3.3 trillion in fiscal 2020. A comparable gap can be expected in the current year.
The deficit was always financed by printing money, but in the past, it was done cautiously and on the sly. Last year marked the start of blatant use of the printing press. In fiscal 2020 money supply rocketed by nearly 40%.
Washington needs to spend money to keep the economy afloat but by pumping liquidity into the financial system it is creating a situation that is similar to what happened in 2009 — only worse. Most of the money the Fed printed has gone to those who are close to the financial trough: financial institutions, large corporations and wealthy individuals, while the truly needy got crumbs. As a result, the recovery is once again shaping up to be painfully slow and uneven.
At the same time, those who didn’t really need the money to survive have been throwing their windfall at every possible asset they could find, creating bubbles in investable real estate, modern art, and, of course, financial markets. A key reason why stocks have been going up over the past year while the economy suffers is that the beneficiaries of the Fed’s largesse had so much cash they needed to buy something, anything. So they have been snapping up everything from bigger and better houses to stocks and bonds.
We now have an amazing, truly unprecedented situation. Paper money has been massively debased. A million dollars in the moneyed parts of the economy has become a small sum — and has, increasingly, a billion. A holder of GameStop stock sold out a position at the height of last week’s frenzy for $1 billion. At the same time, a dollar is still a dollar for people who live on the paltry minimum wage of $7.25 an hour.
Lesson Four: Hedge funds, investment banks, and other big-money players have long been inflating the asset bubble by stoking the irrationality of the market. They have been flogging stocks that are unrealistically overvalued by any measure.
But while undermining market rationality, those same players still believe that the market is fundamentally rational. No one could have rationally expected the stock of a failing company such as GameStop to rise 800%. Now the belief in the rationality of the market is being shaken, and this means that risk management strategies across markets will start failing. This exposes major financial institutions and corporations to the risk of sudden, unexpected bankruptcy. You may remember a fund called Long-Term Capital Management, the bluest of the blue, which failed in 1998 when its risk management strategy was undermined by the irrational behavior of the markets.
Lesson Five: Since last week’s market disruptions, there have been calls by big financial players to investigate and regulate those freebooters who are manipulating the market. But a number of populist voices on the right and on the left have rushed to defend the right of small investors to do what big players have been doing all these years.
Populism can be defined as the unscrupulous taking advantage of the witless. Sure, some of those small players will end up making millions. And it is a good thing that some will make enough money to put food on the table, get out of debt, or pay medical bills. There is also some highest justice in seeing big bad hedge funds and short-selling speculators punished, especially as they put out of business companies that many of those day traders grew up with.
But the big picture is still grim. In the 1990s, when the stock market was in a huge bubble, many also became convinced that the dot.com boom will make them wealthy. The bubble burst and everyone ended up with a lot less than when they started.
The huge liquidity overhang created by the Fed and other central banks will eventually be destroyed. Just as alchemy didn’t work in the Middle Ages, so the printing press cannot create real money out of nothing. One way liquidity is destroyed is through inflation: if you give everyone a million dollars, prices will rise accordingly and no one will be any richer.
But inflation is unlikely to happen now. Inflation has been nonexistent because the common folks are not making more money; on the contrary, they are getting poorer. Hence, liquidity will be destroyed by different means: by the deflation of asset bubbles. This can happen quickly. Last March, the stock market destroyed over $10 trillion in a matter of days. Last week’s events, and the irrationality that was spreading around financial mergers, suggest we are heading for a repeat performance.
