Evidence of the Distortive Effects of Government Policies on Financial Markets

Howard Simons at the Minyanville explains, (bold emphasis mine)

The Chicago Federal Reserve produces a personal consumption & housing (PCH) index dating back to March 1967; it has declined every month since January 2007. The duration and extent of this decline, 52 months and counting, is unprecedented in the series and most likely is the longest and deepest downturn since the Great Depression.

Note, however, what its relationship to the S&P 500’s year-over-year changes has been. It used to be the stock market led the PCH index by about three months. More important than the lead-time was the congruence of direction: If the stock market rose, so did the PCH and vice-versa.

What happened after QE1 began? Let’s run a simple in-sample regression model with the PCH index as a function of the S&P 500’s year-over-year changes lagged three months over the June 1967 – February 2009 period and save the coefficients. The fitted values of that model are shown in red below. If we then apply those coefficients to the March 2009-forward out-of-sample period, we see the fitted values in green. They are, starting one year after the 2009 rally began, much higher than the actual PCH index in blue. For example, the actual value of the PCH index at the end of April was -0.39; the out-of-sample fitted value was 0.04.

This is equivalent to saying the change in policy produced a change in financial markets without producing a change in the underlying real economy. There is your circus; you are on your own for the bread part of the deal.

This shows of the distortive effects of government policies on financial markets.

Also this represents additional evidence where markets today don’t accurately signal the actual balance of demand and supply.

Government policies have been major (if not the primary) factors in determining asset values.

It also shows that government can rig the game to benefit specific interests (banking sector over the real economy)

Finally, that the correlation-causation dynamics can change depending on the underlying forces, which in this case has been government interference.

So looking solely at correlation would signify as a dicey and tenuous way to analyze events unless one understands the likely (causal) drivers behind the market's actions.

Chicken Tax: Example of Distortive Effects of Taxes and Regulations

This is a superb example of the distortive effects of taxation and regulations on the marketplace.

Fundamentally, regulations and taxes affect people's behavior. And market participants usually circumvent or go around regulations to resume their business, even in odd or perverse ways.

This From Wall Street Journal's To Outfox the Chicken Tax, Ford Strips Its Own Vans

(Bold highlights mine)

``BALTIMORE -- Several times a month, Transit Connect vans from a Ford Motor Co. factory in Turkey roll off a ship here shiny and new, rear side windows gleaming, back seats firmly bolted to the floor.

``Their first stop in America is a low-slung, brick warehouse where those same windows, never squeegeed at a gas station, and seats, never touched by human backsides, are promptly ripped out.

``The fabric is shredded, the steel parts are broken down, and everything is sent off along with the glass to be recycled.

``Why all the fuss and feathers? Blame the "chicken tax."

``The seats and windows are but dressing to help Ford navigate the wreckage of a 46-year-old trade spat. In the early 1960s, Europe put high tariffs on imported chicken, taking aim at rising U.S. sales to West Germany. President Johnson retaliated in 1963, in part by targeting German-made Volkswagens with a tax on imports of foreign-made trucks and commercial vans.

``The 1960s went the way of love beads and sitar records, but the chicken tax never died. Europe still has a tariff on imports of U.S. chicken, and the U.S. still hits delivery vans imported from overseas with a 25% tariff. American companies have to pay, too, which puts Ford in the weird position of circumventing U.S. trade rules that for years have protected U.S. auto makers' market for trucks.

``The company's wiggle room comes from the process of defining a delivery van. Customs officials check a bunch of features to determine whether a vehicle's primary purpose might be to move people instead. Since cargo doesn't need seats with seat belts or to look out the window, those items are on the list. So Ford ships all its Transit Connects with both, calls them "wagons" instead of "commercial vans." Installing and removing unneeded seats and windows costs the company hundreds of dollars per van, but the import tax falls dramatically, to 2.5 percent, saving thousands."

Read the rest here

(Hat tip: Mark Perry)