The Financial Markets Are Regressing

It's been widely noted recently that individual investors are leaving the stock markets and shifting their savings into bank accounts or bonds. The bond market has improbably rallied in recent months, despite ultralow interest rates. That brings to mind investment patterns from the late 19th Century and early 20th Century. In the Gilded Age, stocks were volatile and viewed as little more than a form of gambling. Ordinary citizens made do with bank accounts. Bonds were a preferred investment for the wealthy. When British and other European investors financed much of the construction of America's railroads, they bought bonds, not stock. (Chinese, Japanese and other foreign investors holding dollars today are similarly conservative, with a preference for bonds.) Individuals with large amounts of savings were advised by financial professionals to choose bonds over stock, and they did. Not until the 1950s did stock investing attain widespread popularity among individual investors.

Most of today's stock trading comes from market pros--hedge funds (including high speed trading firms and other hedge funds), mutual funds and other institutional investors. Such was also the case in the late 19th Century.

Stock markets today are fragmented, with much opaque trading taking place in black pools patronized by big traders. Back in the late 19th Century, there were dozens of stock markets in America--every sizable city had one. Trading information was limited, and known mostly to market insiders. Individual investors in those days didn't have a good idea of what price they might get if they bought or sold. That's also the case today during increasingly common periods of high volatility.

The resurrection of risk accounts for the change in investor behavior. The financial markets of the Gilded Age brimmed with risk, and investors acted accordingly. Today's volatile markets reflect the renewal of risk, and modern investors have rediscovered ancient wisdom.

The big banks have enough power to command bailouts and a gusher of subsidies until they recover profitability. Individual investors take losses on the chin. The first order of business with your hard earned savings is to avoid losing them, particularly as you get older and it becomes more difficult to replace losses. You know you can't count on the government. The administration is tapped out. There won't be more stimulus spending after the funding currently in the pipeline runs out. The Fed can't renew its quantitative easing measures without admitting that the economy is sliding back toward the porcelain bowl, potentially panicking the markets. The government is boxed in. You're on your own.

The flight of investors from risk undermines one of the Fed's goals. By keeping interest rates ultralow, the Fed has implicitly been encouraging investors to put their money into riskier but hopefully higher yielding assets. Such a shift in investing would provide capital to the private sector at a time when banks continue to pull back from lending. But the Fed is fighting human nature--in uncertain times, people seek to avoid loss, not hope for gains.

The financial system is reversing a trend of the last 60 years and moving back to intermediation. Many people are depositing their savings with guardians--i.e., banks--who then have the responsibility of lending it out at a profit in order to pay interest (at meager rates currently) on depositors' savings. Banks, too, steer away from risk and invest customer deposits to a large degree in U.S. Treasury securities or federally guaranteed mortgage-backed securities. About a trillion dollars of banks' excess reserves have simply been deposited with the Fed. In other words, banks are investing in the U.S. government. This is one respect in which the current financial situation differs from the Gilded Age. One hundred years ago, in an era of balanced federal budgets, banks invested scarcely a nickel in U.S. Treasury debt. When they eventually resumed lending, it went to the private sector and the economy recovered.

The key to unraveling the current mess is to promote economic growth. Growth won't come from banks transferring more and more resources to the government. Banks need to go back to their traditional role as lenders to private enterprise and provide more credit to the real economy. That's what they did in the 19th Century, helping the United States industrialize and prosper in spite of all the volatility of the Gilded Age. That's what they need to do again, and federal regulators should push them harder in that direction. With investors regressing and further government deficit spending off the table, there are no other options.