Why Markets Plunged on This Year’s ‘Black Monday’
August 5th was supposedly a “Black Monday.” Stock markets around the world suffered declines that were far greater than normal. The VIX Index, which measures the volatility of financial markets, reached a level not seen since March 2020.
Financial turbulence always sparks criticism of speculation. John Maynard Keynes (1883–1946) thought that investors often fall prey to mania or “animal spirits.” But alluding to animal spirits is unconvincing. Rational explanations should be preferred over simplistic allusions to human psychology. Is there a rational explanation for what we saw in the first weeks of August?
The answer is yes, and the key to understanding what happened is to look at interest rates.
Austrian economists Ludwig von Mises and F. A. Hayek warned us of the consequences of manipulating interest rates. Manipulating interest rates leads to investment patterns that are unsustainable in the long run. Japan’s prolonged low-interest-rate environment, for instance, provided incentives to engage in risky financial practices.
Japan’s economic policy has been characterized by a persistent effort to stimulate growth through near-zero interest rates. This policy, deeply-rooted after the economic crisis of the 1990s, was intended to pull the country out of a deep recession. The Bank of Japan’s commitment to keeping interest rates close to zero for such a prolonged period created a unique environment that encouraged risky financial practices such as a currency carry trade.
Carry Trade
A currency carry trade consists of borrowing in the currencies of countries with low interest rates in order to invest in the currencies of countries with higher interest rates. In this case, investors borrowed Japanese yen to invest in assets denominated in other currencies paying higher interest rates. This practice was profitable as long as the yen did not gain value against other currencies and interest rate differentials were maintained. However, these two conditions have recently changed.
The Role of Expectations
In recent weeks, the Japanese yen has appreciated significantly. The yen reached a seven-month high against the US dollar, driven partially by fears of a slowdown in the US economy. This appreciation, coupled with other economic factors, has led to a decline in carry trade yields, forcing many investors to reevaluate their positions. For the first time in four years, funds have gone long on the yen.
Further, the recent release of lower-than-expected US employment data has led many to anticipate an interest rate cut by the Federal Reserve. The potential lowering of the Fed’s benchmark interest rate has become a key factor influencing market behavior as investors brace for the impact of easier monetary policy on global currency and bond markets. According to a Reuters report, Fed officials have expressed unease over the current labor market situation, hinting that a policy change could be discussed at the upcoming Jackson Hole Economic Symposium.
Investors Are Rational
The appreciation of the yen, the change in interest rate expectations in the United States, and the halt of Japan’s near-zero interest rate policy caused significant turbulence in global markets. Investors, trying to avoid losses, have quickly unwound their carry trade positions, triggering sharp movements in stock markets and exchange rates. This is not the result of “animal spirits,” as Keynes might have suggested, but rather an entirely rational response to changes in the economic landscape.
Interest rate manipulation is not a free lunch. While it may bring short-term benefits and stabilize markets temporarily, it also distorts the natural economic order, leading to long-term instability. These events were due not to speculative mania, but to a rational reordering of investments in response to changing economic realities. If we want to avoid such instability in the global financial system, we need to address the real source of the problem: government intervention in the market.
This piece originally was published by the Foundation for Economic Education.