Since starting this blog a couple of weeks ago, I haven’t put my old hat — that of a Wall Street analyst — back on. I can no longer avoid doing so.
For weeks, if not months, one of the primary issues that investors have been focusing on is whether Democrats and Republicans will reach a deal to prevent the first-ever default by the United States government. Judged by the recent trends in our equity and fixed income markets, it’s quite clear that participants in those markets are confident that a deal will be struck. If this were not so, the prices of both stocks and bonds would have been heading south.
Let’s assume that a deal is struck and that default is avoided. What happens then? As I argued in a recent post, the immediate impact of the agreement will be to put pressure on the near-term performance of our economy. Employment will grow more slowly than it would have if maintaining the triple-A credit rating of the country hadn’t been held hostage to reducing the budget deficit. Considering how weak the recent employment reports have been, the number of Americans having jobs may even decline. In such a climate, it is highly unlikely that business — however much its confidence in the long-term outlook may be enhanced — will be more confident about the short-term outlook. If, as I have argued, the employment situation worsens, business will be even less likely to accelerate its investments in property, plant, and equipment, and more likely to continue to hoard cash as protection against a rainy day.
Why have I chosen to call this post “Be Careful What You Wish For”? Right now, the Street is wishing for a deal and is confident that one will be struck. Immediately upon the removal of that uncertainty from investors’ minds, there will be a new uncertainty: what will be the impact of the deal on the U.S. (and world) economy and, more specifically, on corporate profits. Every investment bank and every money management firm will make that assessment. If I’m right, the overwhelming majority of those assessments will be bearish.
There’s a precedent for my view. In February, according to ABC News, a confidential report that had recently been prepared by Goldman Sachs for its clients said spending cuts passed by the House of Representatives in the previous week would be a drag on the economy, cutting economic growth by about two percent of GDP. While reading the following excerpts from the report, bear in mind that Goldman was assuming that Congress would reduce discretionary spending by $25 billion from the Congressional Budget Office’s baseline for fiscal 2011, and another $25 billion (for a total of $50 billion below the baseline) for fiscal 2012. The legislation passed by the House called for a reduction of $60 billion. According to Goldman,
Both scenarios would add to the drag from federal fiscal policy on growth:
- The modest spending cuts we assume in our own budget forecast would lead to renewed fiscal drag. Since spending cuts could be enacted no earlier than next month, when the current fiscal year will be nearly half over, $25bn in cuts would require spending in the second half of FY2011 to be reduced by $50bn at an annual rate. Since the cut would be phased in abruptly, it could result in a drag on growth in Q2 by as much as one percentage point (pp), but would quickly fade over the next two quarters as spending stabilizes at a lower level, with little effect versus current policy on the rate of real GDP growth by year end.
- The spending cut package that passed the House of Representatives would have a deeper effect. Under the House passed spending bill, the drag on GDP growth from federal fiscal policy would increase by 1.5pp to 2pp in Q2 and Q3 compared with current law.
At an annual rate, the soon-to-be-announced budget cuts will be considerably larger than $50 to $60 billion. Would you want to bet against Goldman and others marking down their forecasts of economic and profit growth? These downward-revised forecasts will diminish — not enhance — business confidence, further lessening the prospects for reducing the unemployment rate.
Our tough times are about to get tougher. The possibility of a continuing downward spiral is growing. Fed Chairman Bernanke, in couched words, warned about this in his June 22 press conference, saying that
I think it would be best not to — in light of the weakness of the recovery, it would be best not to have sudden and sharp fiscal consolidation in the very near term. That doesn’t do so much for the long-run budget situation. It just is a negative for growth.
[ . . . ] I don’t think that sharp, immediate cuts in the deficit would create more jobs. I think in the very short run that we are seeing already a certain amount of fiscal drag coming from state and local governments, as well as from the withdrawal of previous federal stimulus. So I think in the very short run that, you know, the fiscal tightening is — is, at best, neutral but probably somewhat negative for job creation.