Today’s lead New York Times story (2/1/09)–subheaded in the print edition “Scant Details, and Wall Street Reacts With a 4.6 Percent Plunge”–is a classic example of the fallacy of treating stock market prices as a kind of opinion poll. Reporters Stephen Labaton and Edmund L. Andrews wrote: “The initial assessment of the plan from the markets, lawmakers and economists was brutally negative, in large part because they expected more details.”
Presumably the reporters talked to lawmakers and economists and got their responses directly. But when one is talking about the reaction of the market, one can only look at the direction of prices, which are set by traders who are primarily interested not in assessing economic plans, presumably, but in valuing stocks at what they’re actually worth.
There’s a school of thought that holds that the best response to the banking crisis is to declare that troubled banks are insolvent, have the government take them over and run them until they have a positive value again, and then sell them off. Some economists suspect that this may actually be the administration’s unspoken plan, with the thinking being that the government might be reluctant to publicly acknowledge that major parts of the financial system are worthless. If stock traders believe that this is in fact the plan, then they would rationally sell problematic bank stocks for whatever they can get, because those stocks would soon be worthless.
Conversely, many economists believe that it would be a bad idea to give large sums of money to insolvent banks, because the banks’ management and stockholders might just pocket the money without improving the health of the financial sector. Such a plan might boost bank stocks without actually helping the economy.
Yesterday, according to the New York Times business section (“Stocks Slide as New Bailout Disappoints,” 2/10/09), the stock market decline was
led by steep declines in Bank of America, Citigroup and large banks already leaning on taxpayers for support. Regions Bank, SunTrust, KeyCorp and Fifth Third fell even more as investors worried that regional banks could be vulnerable to a new “stress test” aimed at revealing the weakest links in the industry.
In many ways, the financial crisis is about assets being misvalued and the system threatening to grind to a halt as institutions are reluctant to acknowledge more realistic valuations. If the Treasury plan means that banks that are worth nothing will soon be treated as though they are worth nothing, that could be a big step in the right direction. In short, plunging bank stock prices could mean that Wall Street thinks the administration is on the right track.