Policy Court

Opinion of the court, delivered by Nicole Adams, signed by David Lamb:
Three decades ago, Alfred Kahn, then an economic advisor to President Carter, warned Americans that double-digit inflation and a stagnant economy might give rise to “the worst banana in forty-five years.”  Although Mr Kahn’s word choice was humorous—Mr Carter had instructed him to avoid the word “depression”—his message was entirely sincere; inflation can be a sign of waning faith in the domestic economy and a trigger to further erosion of faith in the economy and its currency.

The recent stock market rally of the past four months—only now beginning to falter—and results from the Federal Reserve’s bank “stress tests” in May have persuaded Treasury Secretary Geithner and Reserve Chairman Bernanke that America has avoided  the worst banana since the Great Depression.  Before passing such judgments, Mr Geithner ought to examine President Obama’s 2010 budget.

The budget resolutions currently in both houses of Congress are unlikely to reduce the $1.17 trillion deficit that Mr Obama’s plan forecasts.  If that federal deficit—the second largest nominal deficit ever—remains, it will be all but impossible to finance.

When the House and Senate settle differences in their budget resolutions and approve an identical plan, the budget will come into effect for the fiscal year that starts on the first of October and the Treasury will be responsible for bridging the gap between federal revenue and federal spending.  During normal times, faith in the U.S. government and an international need for secure investment allow the Treasury to finance the national debt through Treasury securities and government bonds with low interest rates.  This, however, will prove difficult if China isn’t a returning customer.

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Opinion of the court, delivered by Nicole Adams, signed by David Lamb
Why did the banker cross the road?  Because there was a $100 bill on the other side.  Why didn’t the economist?  Because he reasoned that if the $100 bill was real, someone would have already picked it up.

The bill was fresh from the Philadelphia headquarters of the United States Mint; what the economist thought was a piece of counterfeit currency was actually bailout money, planted on the other side of the asphalt for the banker who the federal government knew didn’t accept the idea of market efficiency.

President Obama and his administration predicted the banker would reason that if the efficient-market hypothesis (EMH)—the theory that the prices at which all financial assets are traded reflect all known information—held true, then commodity prices never would have spiked in the summer of 2008, real estate prices wouldn’t have increased by 50% from 2000-2007 and since lost those gains, and the “dot-com bubble” wouldn’t be a case study on human psychology applied to economics.

Although many economic theorists still hold that investors are rational, and use the EMH as evidence that stock prices mirror real stock values and that outperforming the market is therefore impossible through any means other than luck, a growing number of financial economists are beginning to doubt the EMH.  Over the past fifteen years, free stock-trading websites have made available information that was previously difficult, if not impossible, to find.  And yet an increase in real-time financial information has correlated with an increase in bad investing—the dot-com bubble, the oil speculation bubble, and the American housing bubble have all come since then.

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