What makes these economists so confident? It can not be the slew of recent negative surprises in economic data, which has led to a plunge in Citigroup’s global ‘economic surprise index’ from about 100 points to almost zero – a three month low. It can not be the massive destruction of wealth in Japan after the tsunami either – except for those economists who still believe in the broken window fallacy (you’d be surprised how many of them do – one of the most prominent is even a Nobel Prize recipient – Paul Krugman). It can also not be the recent massive deterioration in the sovereign debt crisis in the euro area’s periphery.
So what accounts for it? Simple – the rise in the stock market. Economists have been led astray by rising stock prices many times before. Famed US economist Irving Fisher believed that ‘stock prices have reached a permanent plateau’ and that ‘nothing can stop a further expansion in prosperity’ – right at the top in 1929. J.M. Keynes lost his shirt in the stock market after 1929, evidently believing the bear market to be an aberration (not coincidentally, his pleading for government intervention in the economy and the adoption of inflationist policies became very pronounced right after this episode). What did the stock market ‘discount’ in early September of 1929? We can tell you what it didn’t discount: the Great Depression. In fact, by September of 1929, the US economy had been in contraction for well over a month already.
The failure of economists then and now is to realize that a boom due to credit expansion and inflation of the money supply is in fact not an increasing wealth but doing the exact opposite: it consumes wealth. The inflation masks this capital consumption by creating fictitious profits – once the inflationary policy is stopped – as the Federal Reserve finally did in 1929 by raising its discount rate to 6.5% – the wealth destruction is unmasked.