Investing in a world of austerity

If you are an investor, businessperson or employee, what you care about is outcomes. You want to know what’s likely to happen in the economy and in the markets. That is what this site is all about.

Now obviously, I need to have a keen interest in knowing how policy affects outcomes to know what those outcomes are likely to be. So, in that vein, I present you my opinion on what should be done as well as my analysis as to what likely will be done. On the debt ceiling debate, what is clear to me is that fiscal consolidation has negative short-term consequences for the economy. So when I see US policy makers arguing over where to cut spending and by how much, I know this will be negative for economic growth.

A reader recently commented on my debt ceiling analysis:

Your remarks, especially concerning Mr. Cantor, show that you do not understand the temper of the American times. We’ve had it with this crap. We are not going deeper in debt. We are not accepting higher taxes in any form. It’s that simple. Let the cards fall where they may.

Actually, he is right. That is the mood of many. So I think this reader speaks for a lot of people. That’s what I meant two years ago when I said “Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life” as I reiterated in the recent post on the dénouement of deficit fatigue.

Now intellectually, you can make all sorts of arguments about the US’s being the sovereign issuer of currency or how the government is not like households or how we need to increase aggregate demand or how the government’s deficit is the non-government sector’s surplus. I certainly do. You can make these arguments until the cows come home. It’s not going to work.

I’m just being realistic here. The reality is that people think more about charts and illustrations like this. And what they see is reckless and out of control spending that must be brought to heel. Now, as I mentioned in the deficit fatigue post, “that is certainly why I advised a more aggressive policy response early both on stimulus and recognition of bad debt. A more aggressive response on these two fronts would have dealt with both structural and cyclical causes of recession.” An aggressive response would have been much more effective in holding deficit fatigue at bay. But that is water under the bridge. We’re here now.

What I see says that cuts are coming. What does that mean then for the economy and markets?

  • Economy: consumers are tapped out and have a debt overhang that is not being whittled away by housing gains or salary gains, where most people get their wealth and income. Were stimulus to recede that would mean an economy operating at stall speed below 2% growth, vulnerable to any exogenous shock.
  • Jobs: The business cycle works in a self-reinforcing way. Therefore, if stall speed were to mean recession, consumers would cut back, businesses would then shed workers, causing income to decline further, causing business to shed more workers. In recessions, this dynamic continues until inventories and bad debts are drawn down and government’s automatic stabilsers and a draw down of savings stabilise demand. A second dip would cause the unemployment rate to rise much higher than it is at present.
  • Banks: Another recession would have grave implications for the financial sector because that sector is carrying too many impaired assets at cost. In a downturn, regulatory forbearance cannot hide this as well. These bad debts are crystallized when debtors default. I do not believe extend and pretend in the form of soft-pedaling foreclosures will be effective in preventing a wave of credit writedowns. Because the debt overhang is so high and because consumers will be less creditworthy, credit conditions would reinforce the downward trend of jobs and output. This is negative for bank earnings, and the prospect of bank failures and a loss of capital in bank bonds or bank stocks would increase significantly.
  • Stocks: margins and earnings are cyclically high. To my mind that means stock prices would be doubly compressed by a downturn, as P/E ratios drop along with consensus baseline earnings estimates; a downturn would confirm that we are in a period of declining price earnings ratios. This is how all secular bull and bear markets work. The swings are due predominately to changes in price-earnings ratios with decade long swings. Higher dividend-paying, less cyclical, lower-beta stocks outperform in that environment.
  • Bonds: In a downturn, demand would drop, which is bond-friendly due to inflation and interest rate expectations. That is bullish for Treasuries (unless they lose risk-free appeal due to default risk). Corporate bond spreads would widen because of credit and default risk. High yield, therefore, would underperform the most. Municipals would be cash-strapped and suffer a huge wave of defaults that could invite Fed purchases to alleviate liquidity concerns. Clearly, an aggressive policy response might change inflation expectations and cause the outlook to change for treasuries. However, if a downturn began sometime in 2012, I would expect low and declining yields until the policy response had any inflationary impact. Remember, reflation would be a global phenomenon so the US would not be the only country trying to reflate its economy and asset prices.

If we see a significant reduction in policy stimulus in the US, along with Europe and China, I anticipate we will see the next downturn by 2012 or 2013 at the latest. Again, this is my baseline case. As I said in March 2008 when the credit crisis was raging, “I expect the likely outcome for the next decade is one of sub-par global growth with short business cycles punctuated by fits of recession”.

On the other hand, austerity-light would be my preferred outcome (more stimulus is not a likely outcome; I assign this lower odds, which makes sense given how the debt ceiling debates have developed). Austerity-light could produce a muddle through scenario, which I am hoping for. That is much more benign for jobs, banks, stocks, and corporate bonds and less benign for Treasuries.

  1. Dave Holden says

    Thanks for the analysis. On the “political” mood I think this is in good part because the second of your aggressive policy response “recognition of bad debt” didn’t really happen.

    1. Edward Harrison says

      Dave, I agree with you 100%. It was the bailouts which served to discredit stimulus in the minds of taxpayers. They wonder why banks, who ostensibly caused the crisis could be paying out record bonuses yet credit conditions were tight and households were in a world of hurt. It smacks of corporatism and voters would rather cut back government in retaliation than allow it to deficit spend as that spending is not demonstrably aiding them.

  2. alpwalker says

    I think you are underplaying the role of propaganda and how the right/corporatist media aka Fox has manipulated the public on this issue. It seems to me that this is theater designed to shift the blame for the economy to “Big Government” ie Democratically led government versus the too big to fail parasites and corporatist oligarchs and enabling deregulation.

    So the “temper of American times” has more to do with who is shaping that temper rather than any real awareness on the part of the average American as to who is calling the tune and what it really costs them.

    Your correspondent’s “not accepting higher taxes in any form” comment says it all. I don’t want to pay higher taxes but I sure don’t want someone who is gaming the system to get away with paying far less than they should.

    When I see “the people” calling for real cuts in the bloated defense budget and corporate ag and energy subsidies I might start to believe that it is a real groundswell of disgust with government debt and spending. Otherwise, it’s more corporatist BS.

  3. But What Do I Know? says

    In response to the comment you cite, I think that people who talk this way don’t grasp the implications of “letting the cards fall where they may.” Sure, there are problems with continued record deficits–but those problems are far away and pale in comparison to the social disturbances which will result from austerity and a general decline in living standards.

    1. TaJ says

      I don’t know, the last couple years have shown that there doesn’t seem to be any limit to what the American people will tolerate without causing noticable social disruptions.

    2. Just Tired says

      “People who talk this way don’t grasp the implications of ‘letting the cards fall where they may'”

      When the Banksters caused the crisis, where did the “cards fall”. Maybe the “People who talk this way” want a do-over so the the cards fall a different way. Hard to believe the cards can fall any worse for many!

      1. RA says

        The reason the American people are willing to put up with so much is that they have not been much affected and the big spending is on things they believe in.

        There is really no push for a cut to defense spending because Americans love war. Mix in people of the wrong religion and it only more attractive. For the most part, people are going to wave the flag.

        The middle and upper class have not been much affected. They have had their 401(k) balances reflated so they aren’t too upset anymore. If the market comes down, they’ll get angry.

        The lower class has been hammered but they have no voice and don’t vote or get active so they don’t matter.

  4. Linus Huber says

    It’s all good and nice to defend the idea of more stimulus. In this context one has to consider the concept of the RULE OF LAW. I am not talking about legalities here but the spirit of the RULE OF LAW. The Western Society is based on the rule of law that promisses some reasonable degree of justice. Over the past few years the spirit of the rule of law has been violated in the most serious way in the form of saving the banksters and putting the costs of those actions onto the tax payer which will result in lower levels or service and higher taxes. In addition, the FED arranged the game board in a way that benefits mainly the TBTF banks further and decreases the value of the currency. Justice has not been served and the population has a hard time as the latest speculation has been promoted by the FED manipulating interest rates to such low levels that hurt all savers. I do not believe that anything has been resolved until we return to adhere to the spirit of the RULE OF LAW whatever it may entail. A society can only function properly if rules are clear and not redefined whenever some big actor is in trouble.

  5. David Lazarus says

    Austerity does not just have short term consequences. it also significantly reduces the long term potential of the economy. The medium term is also affected. Even if the population are willing to allow their living standards to be decimated it does not mean that they will return to normal once the initial crisis is over. Look at Ireland its population are emigrating in droves. This is ageing the population significantly and will mean that to sustain its elderly it will have to raise taxes significantly in future to cover this. Even raising the retirement age will have minimal effect because of the reduction of working people.

    1. Edward Harrison says

      Agree, David. Austerity that leads to a double dip would mean dead weight economic losses. It would have serious medium and longer term consequences.

      1. David Lazarus says

        You only have to look at the recession in the UK of the eighties. It devastation many areas of the UK and they have been unemployment black spots ever since.

  6. nariz desnuda says

    doesn’t seem to be any limit to what the American people will tolerate


    In testing his hypothesis, you now have aced your make-up-test. Our intolerance is voiced only when it profits the bankers. The bankers have now decided that We The People will no longer tolerate more tax or/& more government spending unless it is more spending on loans to bankers plus give-a-ways to banker’s lawyers. The bankers have misquoted us yet again.

    But what *is* our best investment opportunity during a stint of austerity? Our best manoeuvre during Treasury-paper-default? Who knows? One thing for sure, *with less government expenditure bidding up the market price of the kitchen-sink, the magic-of-deflation will make America the Beautiful into a shopper’s paradise, a paradise with a make-over*!

    Got make up?

  7. Greg says

    Austerity- the whole concept is flawed. There is not enough demand to support investment so you- take away more demand? If you have a surplus of demand, you might want to call for austerity, to free up money for investment…

    The problem is the distribution of income. (Plus the trade defiicit, which aggravates the excess supply problem, and takes money out of the economy.) No income in the economy, no demand. But the rentiers don’t want to give up their money, even if it means they’ll get it back when they sell their production. They’re strangling their goose. The whole situation is an artifact of their greed, and thanks to our government policies, which the rentiers control, will merely worsen.

    1. David Lazarus says

      Yes distribution of income is the main problem, but the GOP will not allow any changes that address that problem. If they stick to that philosophy you can guarantee the end of the American way of live. Except for the few that benefit from the status quo.

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