This article was originally published by Jonathan Newman at The Mises Institute. 

When Nvidia reported high fourth-quarter earnings for 2023 in February 2024, it sparked a general rally in stock markets. Stock markets in the United States, Japan, and Europe jumped to all-time highs after a few days of slight declines.

It seems strange for one company’s earnings call to have such a widespread effect, but many are saying that this is all a part of a technological revolution, in which real productivity will increase dramatically due to artificial intelligence powered by chips and hardware developed and produced by companies like Nvidia.

This is certainly possible, but it’s worth remembering that the entire global economy is still in the throes of COVID-19 interventions and their lagged effects, active geopolitical turmoil, and financial instability due to manipulated interest rates and unprecedented monetary policy. In this kind of environment, is it safe to say that speculation in the stock market is based on true economic fundamentals?

Murray Rothbard discussed the effects of speculation on market prices in Man, Economy, and State. He said, “The same process of revelation of error occurs in the case of errors of anticipation by suppliers, and thus the forces of the market tend inexorably toward the establishment of the genuine equilibrium price, undistorted by speculative errors, which tend to reveal themselves and be eliminated.” That is, we need not worry about speculation per se because errors are quickly found out. Those who correctly anticipate price changes bring prices closer to “equilibrium,” meaning there are no remaining tendencies for market participants to find a new price for more mutually beneficial exchanges to occur.

If market participants guess incorrectly, then “the discrepancies between total demand and stock will be far greater, and the underbidding and overbidding will more quickly bring about the equilibrium price.”

However, anybody with eyes can see that this process doesn’t always work the way Rothbard describes here. Sometimes, especially in financial markets, it appears as if there is a “speculative frenzy,” in which everybody is overreacting to news, or FOMO (“fear of missing out”) takes over, and investors all jump in simply because everybody else is jumping in. However, when the stock market crashes, it becomes obvious that these investors were all jumping aboard a sinking ship.

Rothbard has an explanation for such a phenomenon, which he dubs a “cluster of errors.” What looks like an episode of mass psychosis has an economic explanation: artificial credit expansion. In America’s Great Depression, Rothbard describes how entrepreneurs are “misled” when “new money pours forth on the loan market and lowers the loan rate of interest.” This can be instigated by expansionary monetary policy by the central bank, but it can also occur through the “normal” operation of fractional reserve banking, in which credit expands beyond real savings.

A healthy economy allows for real savings to be channeled into productive enterprises. An increase in savings results in lower interest rates and bigger production projects. Starting new, longer lines of production requires a sacrifice of present consumption due to the inescapable fact of scarcity. In contrast, artificial credit expansion encourages increased consumption and increased investment in big projects, in nominal terms at least. These projects, however, are eventually revealed to be mistakes (hence, “malinvestment”) once the reality of capital scarcity becomes apparent. Usually, this happens when interest rates are allowed to rise, forcing entrepreneurs to reevaluate the profitability of their prior investments. Rothbard characterizes this reckoning as a healthy correction of past mistakes:

The “depression” is actually the process by which the economy adjusts to the wastes and errors of the boom and re-establishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments. . . . the depression is the “recovery” process, and the end of the depression heralds the return to normal, and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom.

What have we seen since 2019? The Federal Reserve was already anticipating a crisis in 2019 and had started pushing its target interest rate down, but then covid gave the Fed all the cover it needed to lift the monetary floodgates in 2020. M2 expanded by over $6 trillion, and the fed funds rate dropped back down to zero.

Figure 1: The federal funds rate and M2

Source: FRED; data from the Board of Governors of the Federal Reserve System.

Hundreds of billions of dollars in government stimulus and low-interest rates brought about large increases in both consumption and investment. There was no discernible increase in savings that would allow for sustainable economic growth.

Figure 2: Personal consumption expenditures and gross private domestic investment

Source: FRED; data on personal consumptions expenditures and gross domestic product from the US Bureau of Economic Analysis.

This leads us to the complex of actions taken by the Fed and the government in 2023 and early 2024. While the Fed has allowed interest rates to rise due to the unpopularity of price inflation, we have not yet seen a reckoning on the part of investors and entrepreneurs. We have only seen some stock market volatility as investors try to gauge when the Fed will cut rates and try to make sense of all the uncertainty surrounding the interventions and wars around the world.

The correction has been forestalled by a Fed that is trying to deal with general price inflation, a smattering of bank failures in March 2023, and a bloated, debt-heavy financial sector. At the same time, the federal government has been running unprecedentedly large deficits for a supposedly noncrisis period. The Fed and the US Treasury are pushing against themselves and against each other, with monetary contraction, high-interest rates, deficit spending, massive government debt auctions, emergency lending facilities, and mixed messaging. It’s like a circus act with a juggler and a plate spinner trying (pretending?) to sabotage (help?) each other’s performance. I don’t think it will end without some dropped balls and broken plates. The whole circus tent may come crashing down.

Regarding the interplay of the central bank and the treasury, Brendan Brown reminds us that “Fed independence” is a farce—we should assume Fed actions are inherently political:

When and where did this political decision to continue monetary inflation take place? In the case of the US Fed appointments, the re-nomination of Chief Powell in early 2022 is an important component of the answer. The White House appointers and the Senate ratifiers doubtless understood that these individuals would not stray from the politically convenient path—especially when a mega rise in fiscal spending was under way.

These insights lead us to the conclusion that the stock market speculation we see today is not the innocuous kind described by Rothbard in the early chapters of Man, Economy, and State but a cluster of errors as he describes in America’s Great Depression.

Jörg Guido Hülsmann refined Ludwig von Mises’s and Rothbard’s arguments regarding the ultimate source of errors in “Toward a General Theory of Error Cycles.” According to Hülsmann, “Recurrent clusters of errors can be deduced from the existence of government activities.” In particular, fiduciary media, central banking, and fiat money can only be sustained by government abrogation of private property and the accompanying illusions that these institutions, which are encouraged or created by the state, are necessary and beneficial.

While the future is uncertain, we can be sure that these institutions, which emanate errors and illusions “must either grow and thus destroy society or be abolished in a crisis-like situation.”