15/02/2018 1:08 AM IST

Why You Shouldn't Freak Out Even If The Stock Market Does

Everything is fine ... except your paycheck.

Spencer Platt via Getty Images

Stocks plummeted in pre-market trading on Wednesday as a herd of speculators briefly lost their wits over … not much, really.

The proximate cause of the stock plunge was almost universally identified as a monthly consumer price report from the Department of Labor. This is confusing for sane people, because the results of the report were quite good. Consumer prices rose by a half of 1 percent in January, on an annual path of 2.1 percent ― almost exactly the rate top officials at the Federal Reserve believe is healthiest for the overall economy. Great job, prices!

So why did futures for the Dow Jones Industrial Average drop 500 points in an instant? There is a widespread view among the investment community that the stock market is overvalued. Whether there is such a thing as a correctly valued stock market is a genuine financial dilemma, but what mattered on Wednesday morning was that most traders believe that stock prices are too high. The market has been more or less steadily rising since February 2009, with the Dow, NASDAQ, S&P 500 and Russell 2000 indices all more than tripling. President Donald Trump’s election ushered in a wave of euphoria among traders expecting deregulation and big corporate tax cuts, and while we’ve seen exactly that, people got a little carried away. The Fed, moreover, had been keeping interest rates close to zero since the 2008 financial crisis to support a flailing economy. With job numbers looking better, the central bank has been steadily raising rates, which typically depresses stock values.

As a result, the people who guess where the market is going for a living are looking to sell stocks quickly before they drop, and any smidge of disappointment in an economic report can serve as a trigger. The consensus among market experts was that January’s prices would rise by 0.3 percent. The difference of 0.2 percentage points was enough to roil stocks for a couple of hours. (Technically the Fed targets a slightly different measure of inflation than the report issued Wednesday, but the two metrics generally track each other closely.)

To be clear ― the inflation report should not have been a big deal. It indicated almost ideal price levels for the U.S. economy. But traders are worried that much higher levels of inflation will eventually become a problem, and used a tiny uptick in prices to a healthy level as grounds for a freakout because they feel, generally, that the stock market is currently too high.

Conservative economists have been warning about imminent, violent inflation for almost a decade now. It hasn’t materialized, and we have instead consistently undershot the Fed’s target inflation rate of 2 percent. But the idea that some inflation could be coming down the pike at some point isn’t totally crazy.

When the economy is humming and workers have money in their pockets, they can afford to buy more stuff. That encourages companies to make more stuff, and to hire more people to make it. This in turn gives workers more money to spend on stuff. That’s great.

But when people have more money to spend, they can also afford to pay higher prices for the stuff they buy. And so a byproduct of job creation can be price inflation, as better-off workers bid up prices. That hasn’t happened during this recovery. Inflation has been essentially nonexistent as the unemployment rate has slowly declined. Wages for workers have been consistently flat, leading plenty of economists to believe there is still a lot of room for production to expand before we really have to worry about prices going up. Obvious infrastructure problems ― like trains that crash all the time for no reason ― add to the impression that the economy needs to see more investment, not less.

The tax cuts signed into law late last year gave people some reason to pause, though. Taxes, contrary to popular belief, do not fund government operations. The federal government controls its own currency and can print however much it wants to. If it wants to build a bridge, it can just print money and pay it to someone who can build it. This, in reality, is how we “finance” public projects.

What taxes do, instead, is make sure prices don’t get out of control. If there is too much money sloshing around the economy and pushing prices up, the government can take it out of circulation by taxing it.

This strategy is perfectly consistent with an ambitious government spending program. If we have roads and bridges that need to be repaired and trains that need to be upgraded to make transportation and business more efficient, the government can spend freely to make sure these very real needs are met. And because this kind of spending increases overall productivity and brings down costs, it probably doesn’t drive up prices all that much, even if it puts more money in workers’ pockets.

But if it does, there’s an easy solution: just raise taxes.

The trouble of course is that the Republican Party’s raison d’etre is essentially cutting taxes for the rich. The tax legislation the GOP passed late last year costs about $1 trillion over the course of a decade, meaning, essentially, that there will be $1 trillion more dollars in the economy, the vast majority of them in the hands of the very rich. Persistent budget deficits can’t bankrupt the government, since the government can’t run out of money. But they can eventually spur inflation.

We are still not experiencing anything resembling harmful levels of inflation ― but the tax cut is the sort of thing that gets us closer without offering very much in return. CEOs have openly acknowledged that they won’t invest the money they’ll save on their tax bill in new plants or equipment, and there is no reason to believe boosting corporate profits by lowering the corporate tax rate will make firms any more efficient.

Because low taxes are a matter of quasi-religious faith among the GOP, there is good reason to believe Republicans in Congress will resist calls to raise taxes if inflation ever does really get serious.

But even in this scenario, all is not lost. The Fed has plenty of tools available to fight inflation. If it raises interest rates, banks tend to lend out less money (or lend it out at higher rates), which either forces some companies out of business or raises their costs, leading to unemployment and downward pressure on worker wages, which in turn keeps prices in check. It’s not an ideal solution, but it does work.

But all of these problems are pretty far away, if indeed they ever actually materialize. Right now, the stock market is looking for an excuse to go wild. When bad news can’t be found, good news will suffice.