Empty Words For An Empty Set Of Policy Choices
Recently, I have noted several times that the failure of the massive federal fiscal stimulus to provide a lasting spark to growth should not be particularly surprising, since when the government spends it also takes the money away from alternative spenders currently (through taxes) or in the future (by borrowing). For example, see Monday's comment here. Moreover, while small deficits might provide a spark, since the government's ability to service debt - and therefore to postpone indefinitely the repayment of that redirected spending - grows with the economy over time, large deficits should have less current impact than a mere multiplication of small-deficit effects would suggest. This happens because with mammoth deficit spending, as we have seen, the rational response of the folks who know they will one day have to pay taxes to service this debt is to start saving now.
I was delighted to find out that recent research has actually established a pretty clear link between increased government spending and decreased private spending. A friend pointed me to research done by Harvard Business School professors that examined what happens to private spending in states when pork-barrel money starts to roll in. Advocates of deficit spending would say that this should have a salutatory effect on private production, or at worst is neutral. In fact, the authors of this paper ("Do Powerful Politicians Cause Corporate Downsizing?", available here) find that once a powerful congressman ascends to a committee chairmanship and begins dispensing pork, the average firm in his/her home state cuts capital expenditures by 15%.
The implications are clear, as spelled out in the question-and-answer on an HBS blog:
Q: These findings present something of a dilemma for public policymakers who believe that federal spending can stimulate private economic development. How would you suggest they approach the problem that federal dollars may actually cause private-sector retrenchment?
A: Our findings suggest that they should revisit their belief that federal spending can stimulate private economic development. It is important to note that our research ignores all costs associated with paying for the spending such as higher taxes or increased borrowing. From the perspective of the target state, the funds are essentially free, but clearly at the national level someone has to pay for stimulus spending. And in the absence of a positive private-sector response, it seems even more difficult to justify federal spending than otherwise.
I post this mainly to reassure readers who may think I assert such verities based on theory but who do not believe there is empirical support for the matter. In fact, as if the experience of the last year is not sufficient anecdotal evidence, the academic case appears even stronger than I would have suspected (given how messy data tends to be when studying this sort of thing).
But enough of self-congratulations; let's talk about the markets. Today the 10y Note futures declined 5.5/32nds, remaining in the recent holding pattern (10y yields rose to 3.19%), while stocks shrugged off solid early gains to slide on increasing volume into the bell, finally finishing at -0.6%.
The initial rally seemed driven by the same relentless, unreasoning optimism that keeps investors believing that the problems in Europe and in the U.S. are going to go away. Of course they will, eventually; but probably not the way these folks want it to happen. Whether the crisis in Europe experiences a short-term lull or not, the mathematics are compelling. Greece has a better chance of winning the World Cup than of escaping the clutches of the crisis, and the rest of the developed world is in not much better shape. Look, following from the argument above: if government spending makes things worse in all but the very near-term, then public spending cannot be the answer. But private spending appears unmoved, locked in its own overdue retrenchment. This leaves two possibilities, and they're the same ones a no-longer-competitive company faces: a long, grinding restructuring of its business or a short, bloody restructuring of its debt. Neither one will be fun, and neither one will admit to equity market values like we are seeing now.
Now, that's a long-term concern of course. In the short term, stocks are being supported by investors who are deterred by the apparent opportunity cost of being in low-yielding debt. This causes stocks, too, to be priced (high) to deliver low returns (with the added benefit of extra risk). The stock market is unlikely to experience its ultimate lows until interest rates come unglued and start to price a higher cost of public and private capital.
The simmering crisis keeps those rates down, ironically providing a measure of support for equities. But I fear that the break will be unlike the usual pattern with interest rates, with a reasonably gentle rise. If debt markets become sated or scared, the break to higher rates could be sudden. Greece's rates, after all, were so low that they were complaining about selling debt at 5% rates, but those rates rose rather quickly. Portugal, today, sold some new debt at what some analysts said was "50bps too high." (Unlike Greece, Portugal didn't complain and I imagine they would gladly hit the bid to roll over all their debt at today's rates, if the bid was there).
But consider again where we may go from here. Additional federal spending is neither useful nor, probably, available - the best we can hope for at this point is for Congress to delay the huge tax increases due next year so that we don't have taxes and spending. Monetary policy can help, but is being held in abeyance on what is I think a vain hope that somehow we'll get out of this mess organically. The Fed is limited at the moment to putting the Chairman on television to coo reassuringly, "...we will take the actions necessary to ensure stability and continued economic recovery." Investors liked those words, but they are empty. We don't know what those actions are; they may even be the proverbial empty set.
I continue to regard the market defensively. The schuss into the close, on rising volume, is disturbing. The market traded more than 1.6bln shares today although at 3:00 we were trailing yesterday's pace. There is no scheduled economic news that might lighten the mood; today's Beige Book showed growth, albeit modest, in all twelve districts but the market didn't seize on such a Pollyanna depiction of the current situation. I think the math is starting to dawn on some of the savvier investors, and I think we have some distance to go on the downside.