AMERICAN FUTURE

Now that’s a presumptuous title if I ever saw one. Well, maybe not. The policies being followed by the governments and central banks of the U.S. and Europe clearly aren’t solving the economic crisis. The anemic economic recoveries on both sides of the Atlantic have run out of steam and the world’s stock, credit and commodity markets have plunged in anticipation of worse to come. The markets are telling us that time may be running out to preempt another Lehman moment and a further slump in economic activity that would turn recession into depression. Despite rising investor angst and an ever-growing avalanche of weakening economic indicators, there’s no evidence that the individuals in positions to alter the course of economic events are starting to have second thoughts about current fiscal and monetary policies.

How have the advanced industrial countries of the West arrived at what increasingly appears to be a tipping point?

Immediately after Lehman’s failure, fiscal and monetary policies were loosened in true Keynesian fashion. The West didn’t fall into the financial abyss and the recession didn’t turn into a depression.  Asset values recovered and the recession officially ended in June 2009. The economy ended its 18-month stay in intensive care. As it became evident that the world economy would soon be discharged from the hospital, governments, central bankers, economists and the public refocused their attention to the aftereffect of its stay in intensive care:  ballooning public debt. Preventing financial and economic collapse resulted in the shifting of trillions of dollars of debt from the private sector’s to the public sector’s balance sheet. Rapidly rising unemployment reduced government tax revenue and increased government spending. Government debt-to-GDP ratios rose to unprecedented peacetime levels. With economic recovery underway, concern about the future solvency of government rose to the top of the worry list.

Fiscal Policy: Tightened

With fear of public sector insolvency having overtaken fear of depression, economic policy was ripe for change. The change has taken the form of calls for and the implementation of increasingly austere fiscal policies. Austerity, its advocates argue, is the path to economic salvation. In every country, those who would rely primarily on reduced spending and those who would rely primarily on higher taxes on the wealthy have something in common: both assume that heightened fiscal rectitude will reduce their government’s debt-to-GDP ratio. By lowering the perceived risk of future insolvency, they aver, the private sector’s confidence will improve. Facing the future more confidently, consumers will buy more and business will invest more. This positive feedback loop involving consumers and business will create a self-sustaining, accelerating economic recovery. That recovery will create more jobs, leading to reduced government spending on unemployment insurance and related items and increased government tax revenues. The budget deficit will contract, borrowing requirements will diminish, the debt-to-GDP ratio will fall, and the real –as well as the perceived — risk of insolvency will vanish.

The ramifications of faith in fiscal austerity as the exit strategy from hard times extend beyond the economic to include the political sphere. Intrinsic to this exit strategy are political disagreements over the mix of spending reductions and tax increases. The issue of the distribution of austerity’s pain came to the fore during this summer’s debate — I use the word advisedly — in the U.S., which heavily contributed to the downgrading of the credit rating of America’s sovereign debt. More significant than that downgrade was the public’s disgust with the spectacle in the House of Representatives. It can’t be doubted that the extreme partisanship so vividly on display further undermined consumer and business confidence in the ability of the government to come to grips with a sputtering economy. This feedback from the political to the economic realm revealed itself in the aforementioned steep market declines, which can best be interpreted as a discounting of further economic weakness.

It’s as simple as that, or is it? Spending decreases and tax increases have something in common: if everything else remains constant, they both drain purchasing power from the private sector.  The “everything else” is the effect of fiscal austerity on confidence. For austerity to boost consumption, the positive impact on the propensity to consume of a reduction in the perceived risk of insolvency in the long-term must exceed the negative impact of the reduction of purchasing power in the short-term. Said another way, for austerity to have its intended effect, it must result in a decline in the propensity to save. Only if this requirement is met will business have an incentive to accelerate hiring and capital investment.

If, as I anticipate, fiscal austerity has the opposite of its intended effect, the circle will be vicious rather than virtuous. Budget deficits, borrowing requirements, debt-to-capital ratios and insolvency risks (both perceived and real) will increase. Confidence will erode. The evidence, as highlighted by the unfolding Greek tragedy, indicates that the adverse outcome is the likely outcome.  But this conclusion doesn’t rest upon Greece, which might be considered an exceptional case. More significantly, as fiscal impetus has turned into fiscal drag, the economies of both the U.S. and Europe have slowed and are now either on the verge of, or already in, a contraction phase.  If governments react to this development by further tightening fiscal policies, they will assuredly produce a second worldwide recession. Should this occur, the 2010s will be remembered by future generations as the decade of the Second Great Depression. As noted earlier, there is at present no reason for optimism that governments and a broad swath of the public understand the predicament we now face. Absent such an understanding, the likelihood of further contractionary fiscal actions is disturbingly high.

Monetary Policy: Loosened

Three weeks after Lehman’s bankruptcy, the Fed lowered the Fed funds rate (the interest rate banks charge each other for overnight loans) to 1.5 percent from 2 percent. Two more reductions were announced by the end of 2008. At year’s end, the rate had been reduced to zero percent (more accurately, for technical reasons, the rate was 0.00 to 0.25 percent). For the first time ever, banks in the U.S. with insufficient liquidity could borrow from banks having more liquidity than they needed without incurring interest expense. One need not look further than this to appreciate the seriousness of the financial situation as seen by those closest to it. The Fed funds rate is still zero percent.

The European Central Bank (ECB) is the equivalent of the Federal Reserve for the 17 countries that employ the euro as their currency. In the eurozone, the “deposit facility” interest rate has the same role as the Fed funds rate. As shown in the following table, the ECB’s monetary policy has been somewhat less accomodative. Most importantly, it has twice raised the deposit facility rate during 2011. Inflation fears were the stated reason for the interest rate increases. Still, at 0.75 percent, the interest rate is far below the inflation rate.

Overnight Interest Rates, 2008-2011

During the 12 months following the end of the recession, real (inflation-adjusted) U.S. GDP grew at a disappointingly slow 3.3 percent — far below the norm for the first year of a recovery. What made this sub-par performance  particularly worrisome was that it happened while short-term borrowing costs in the private sector, reflecting the zero percent Fed funds rate, were at historically low levels. During the summer of 2010, Fed Chairman Bernanke telegraphed the Fed’s intention to implement a policy — subsequently dubbed “quantitative easing” — aimed at stimulating the economy by driving down long-term interest rates. In a speech delivered on August 26, 2010, he said that one of the options for providing additional monetary accommodation was “to expand the Federal Reserve’s holdings of longer-term securities,” and added that he believed “that additional purchases of longer-term securities . . . would be effective in further easing financial conditions.” By the time this policy was implemented in late 2010, market participants had fully discounted its intended effect by driving down yields on longer-term fixed-income securities.

Chart 1.

Chart 2.

Still, the economy refused to cooperate. Real GDP growth fell to 3.1 percent during calendar 2010, two-tenths of a percentage point lower than it had been during the 12 months ending in June, 2010. Growth continued to decelerate during the first half of 2011. The Fed’s reaction to the persistent and growing weakness in the economy was to announce “operation twist” on September 21. In a press release titled “What is the Federal Reserve’s maturity extension program (referred to by some as “operation twist”) and what is its purpose?,” the Fed explained:

Under the maturity extension program, the Federal Reserve intends to sell $400 billion of shorter-term Treasury securities by the end of June 2012 and use the proceeds to buy longer-term Treasury securities. This will extend the average maturity of the securities in the Federal Reserve’s portfolio.

By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. The reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional stimulus to support the economic recovery.

For three years, the Fed’s policy has been to deflate interest rates. What began as the deflation of short-term rates has been extended all the way out the maturity spectrum to include 30-year Treasury bonds. This latest interest rate deflation, while helping borrowers — in particular, home owners with variable rate mortgages and first-time home buyers — entails noteworthy risks. The most significant of these risks is its impact on bank profitability. Banks, of course, borrow short and lend long. Accordingly, the outlook for bank profits is at its best when the yield differential between short- and long-term fixed-income securities is large. Operation twist narrows the differential; it “flattens” the yield curve. This new headwind facing the banks comes at a time when another headwind — the eurozone’s sovereign debt crisis — is intensifying, with no end in sight. U.S. banks have an exposure of $650 billion to the debt of Greek, Irish, Italian, Portuguese, and Spanish governments. With the housing market still in the doldrums and the mounting possibility of having to write-down the value of their holdings of eurozone public debt, the flattening of the yield curve could not have come at a less propitious moment. The Fed is betting that operation twist won’t increase systemic risk in the U.S. financial system. It’s a bet that the Fed had better win.

The Problem — And the Solution

The U.S. and Europe are suffering from the same underlying disease: economies that never really recovered from the financial crisis and which will continue to stumble along or soon experience the long-feared double-dip. The European situation is worse, and far more complex. The American states are married; they have one monetary policy and one fiscal policy. The eurozone countries are engaged; they have one monetary policy and 17 fiscal policies. Adding to their problems is the fact that their engagement documents don’t allow them to voluntarily break their engagement or to have other members of their extended family force them to call off their engagement. This is reason enough to conclude that, if a way out of the worldwide economic crisis is to be found, it will start in the U.S.

By now, it should be obvious that credit cost deflation — reducing interest rates — isn’t going to revive the American economy. It should be equally obvious that budget deflation — reducing government spending and/or increasing taxes — isn’t going to revive the American economy, either. If the U.S. is going to lead the industrialized West out of the economic wilderness, it must fundamentally change its fiscal and monetary policies.

We should reverse both of these policies. Fiscal policy should become expansionary. Monetary policy should become restrictive. The eurozone’s sovereign debt crisis provides us with a window of opportunity to do both.

The arguments against fiscal stimulus and my counter-arguments are as follows:

• Fiscal stimulus doesn’t work — Those who support this argument point to the anemic economic recovery that began four months after the February, 2009, passage of the Obama administration’s $787 billion stimulus package.  Top advisers within the administration wanted a larger stimulus, but political realities prevailed. In particular, Christine Romer, who was then the chairperson of the Council of Economic Advisers argued for a stimulus package of at least $1.2 trillion. As reported in the New Yorker,

The most important question facing Obama that day [in December 2008] was how large the stimulus should be. Since the election, as the economy continued to worsen, the consensus among economists kept rising. A hundred-billion-dollar stimulus had seemed prudent earlier in the year. Congress now appeared receptive to something on the order of five hundred billion. Joseph Stiglitz, the Nobel laureate, was calling for a trillion. Romer had run simulations of the effects of stimulus packages of varying sizes: six hundred billion dollars, eight hundred billion dollars, and $1.2 trillion. The best estimate for the output gap was some two trillion dollars over 2009 and 2010. Because of the multiplier effect, filling that gap didn’t require two trillion dollars of government spending, but Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be more than $1.2 trillion.

Would a $1.2 trillion plus stimulus have launched the economy onto a faster growth trajectory? There’s no way to know for sure; the best I can do is to provide an analogy. The economy is frequently referred to as an engine. An immobilized car needs to be jump-started. If the external power source that’s connected to the car’s battery isn’t powerful enough, the engine won’t start. A more powerful external source will succeed where the less powerful one failed. Returning to the economy, it’s a fallacy to assert that, because a stimulus program of a certain size produced a disappointing result, any stimulus package, regardless of its size, will be unsuccessful.

• Fiscal stimulus is inflationary — In some circumstances, this is true. But not in the current circumstances. Chart 3 shows that the velocity of money — the rate at which money changes hands in the economy — is now falling after a brief, mild acceleration following the implementation of the stimulus program. With a stagnant or contracting economy ahead, it’s more likely that money velocity will decline further than to reverse direction. Another analogy will drive home this point. The Fed has been pouring billions of gallons of gasoline (money) into the gas tank (the economy), but fewer miles (purchases) are being driven (made).

Chart 3.

• The dollar will weaken — Perhaps, but that’s not necessarily a bad thing, as it would improve our export competitiveness. In fact, as shown in Chart 4, the dollar has significantly strengthened against the euro in recent days. Since the last day depicted in the chart, the value of the dollar has climbed further.

Chart 4.

At the beginning of this section, I said that the eurozone’s sovereign debt crisis provides us with a window of opportunity to reverse the directions of our fiscal and monetary policies. Now it’s time to explain why.

To safeguard their wealth from the effects of the crisis, Europeans are selling euros, buying dollars, and using their dollars to buy U.S. sovereign debt — Treasury notes and bonds. Notwithstanding occasional glimmers of hope, the eurozone’s crisis admits to no simple solution and will continue for an extended period of time. Accordingly, our interest rates will remain at or near their current historical lows. This means that federal government interest expense as a percent of GDP will not become a budget-buster. Simply stated, for as long as the eurozone’s sovereign debt crisis continues, the U.S. will not have a sovereign debt crisis. This provides us with an opportunity to implement a very sizable fiscal stimulus program without risking the deleterious side-effects that such a program would normally entail.

Changing our fiscal policy is only a part of the solution. A sizable stimulus program will put more money into more people’s pockets, but will they, in this age of deleveraging, spend it or save it (paying down credit card debt counts as saving)?

Chart 5.

This is where reversing our monetary policy enters the picture. The price of credit has been declining for three years. Consciously or not, this trend has undoubtedly seeped into the minds of American consumers. This credit price deflation provides an incentive to defer major purchases. The best example, of course, is housing. If, in addition to expecting a further erosion of home prices, a family also anticipates that mortgage rates will continue to decline, it has an added incentive to wait.

With the stimulus program boosting economic activity, the Fed should announce that, starting on a certain date and every three or six months thereafter, it will increase the Fed funds rate by a quarter percentage point and reduce its holdings of long-term government securities by a specified amount. Replacing credit price deflation with credit price inflation will provide the incentive to purchase now rather than in the future.

There you have it. My solution to the economic crisis is to implement policies that are the exact opposite of those currently in place. Replacing one without replacing the other won’t suffice. Fiscal stimulus without credit price inflation would put more money into more pockets without providing an incentive to spend. Credit price inflation without fiscal stimulus would further weaken the economy.

Political Realities

I haven’t been looking forward to writing these final words. Setting forth a solution to the economic crisis is one thing; expecting that for now and the foreseeable future it has a snowball’s chance in hell of being enacted is another.  The current momentum favoring fiscal rectitude is irresistible. Public opinion being what it is, opposing it amounts to political suicide. We will continue down the current path until it has been completely discredited. What will it take for public opinion to reverse direction? One way or another and by the end of this year, we will have started to walk down the path, instead of just talking about it. If my analysis is on the money, it won’t be a pleasant walk. Stagflation without the “flation” is the most optimistic scenario I’m willing to countenance. If, as seems more likely, the unemployment rate rises into the double digits as the effects of fiscal stringency accumulate, it will be interesting to see whether either of our political parties changes its mind as election day approaches. The ideological rigidity of the Republicans makes it next to impossible for them to undertake an about-face. So, if either of the parties is to change its mind, it will be the Democrats. For now, all we can do is to wait and see.

Here’s a nifty idea from William Cohan, a former investment banker:

Why doesn’t Wall Street, along with GM and Chrysler and every other industry that only survived 2008 because of taxpayer TARP money, use some of its new-found profits to bail out the government? The symmetry of that would be elegant, of course. And then Wall Street could appoint some uber-banker like Jimmy Lee of JPMorgan Chase to become the “restructuring czar” and dictate the terms under which the shrinking pie would be carved up. Now there’s a threat that could get Congress to act, even before midnight tomorrow.

It’s not a new idea. My wife proposed it a few days ago.

A definite maybe, says Neel Kashkari, who established and led the Office of Financial Stability and the Troubled Assets Relief Program until May 2009. His view is that

a U.S. downgrade has the potential to be as bad or perhaps worse than the Lehman shock. The more strongly held a belief, and the larger the asset class it supports, the greater the potential damage to the economy when the belief is turned upside down. We may not be certain what will happen if U.S. credit is downgraded, but there is no upside to finding out.

Unfortunately, some politicians seem intent on finding out.

Source: CNNMoney

“If the government can bail out companies, why can’t companies bail out the government”

Source: My Wife

In her column in the Financial Times, Gillian Tett poses five questions for the Fed and Treasury Department. If the Republicans hadn’t linked the budget to the debt ceiling, none of these questions would have to be asked.

● What might the US government do to support the US money market funds if American debt is downgraded, or suffers a technical default? These funds currently hold a large volume of Treasuries, and if Treasury bonds tumble in value – or go into technical default – this could erode the net asset value of these funds. This, in turn, could potentially spark a run on these funds of the type that started to occur in 2008, particularly since these funds (unlike bank deposits) are not protected. But since this might have systemic implications, it is uncertain whether the government will – or will not – act.

● Will the US authorities step into the markets and act as the dealer or financier of last resort, if parts of the market freeze up? Right now, it seems unlikely that Treasury bonds would become illiquid after any downgrade; after all, this is the deepest bond market in the world. But a downgrade of US debt could, ironically, force some asset managers to sell more risky instruments (such as triple B bonds) to maintain average ratings benchmarks in their portfolios. That might create bottlenecks. There is also a risk the so-called repurchase (or repo) market might freeze. That would almost certainly prompt the government to step in (by accepting bonds as collateral and making loans); how this might work, though, is uncertain.

● What will regulators do about capital standards if some banks’ balance sheets balloon? In recent weeks, signs have already emerged of a flight of money towards supposedly “safe” banks in Europe and the US; if this accelerates, it could mess up some banks’ attempts to tidy up their balance sheets. Bankers guess that regulators will be lenient; but – again – this is unclear.

● How will regulators and risk managers respond if the “risk-free” status of US debt starts to crumble? Treasuries are currently zero risk weighted for bank capital adequacy purposes. Bank supervisors are unlikely to change this. However, some banks are reviewing collateral policies. On Thursday the Chicago Mercantile Exchange raised collateral haircuts for clearing Treasuries.

● What rules will apply for paying interest, accrued interest and principal on Treasury bonds, if a technical default occurs? On a normal day, asset managers and custodian banks make huge numbers of payments to investors, linked to the treasury market; but many institutions are uncertain what to do if a technical default occurs.

Finally — and I do mean finally — somebody (besides this egotistical blogger) is looking beyond D(efault)-Day. Mohamed El-Erian certainly has credentials far superior to mine. He’s the CEO and co-CIO of PIMCO, a global investment management firm and one of the world’s largest bond investors with approximately $1.2 trillion of assets under management at the end of 2010.

Before looking beyond D-Day, El-Erian outlines the damage that has already been done by the “political mess” in Washington. The debris: already-weak business and consumer confidence has been dealt a further blow;  companies with massive cash holdings have been given another excuse to stay on the sidelines; and foreigners have been stunned by the political dysfunctionality of the country in which they have placed factories, whose financial instruments they buy with their savings and whose money serves as the global reserve currency.

That’s a lot of damage. But there’s more to come.

In just a few days, analysts will take another slice off their already muted growth projections.  Fed Chairman Bernanke’s recent prediction that economic growth will accelerate in the second half of the year will be proven wrong. The postponement of  the much-hoped-for robust recovery will  result in the deepening of the unemployment crisis. Worse still, the budget reductions may make matters worse:

It is far from certain that, in forcing spending cuts, a resolution to the debt-ceiling debacle will materially improve the U.S. economic outlook. Indeed, because of the standoff’s detrimental impact on growth and employment, it could tip the United States closer to the very debt trap that reformers are seeking to prevent.

What is the “debt trap” and how does it come about?

. . . fiscal solvency is not merely a function of deficits and debt, interest rates and the profile of maturities. It is also highly sensitive to economic growth: The lower an economy’s growth rate, the higher a budget deficit is likely to be, the larger the debt accumulation, and the greater the need for yet another round of fiscal austerity to safeguard solvency. All are components of the much-feared debt trap.

To borrow a phrase from the Brits, El-Erian is spot-on.

Doug Elmendorf is the Director of the Congressional Budget Office. Today’s entry in the Director’s Blog is sobering:

Even a slight increase in the perceived risk of U.S. government securities would probably raise interest payments by a lot for years to come. If Treasury rates were pushed up by just one-tenth of a percentage point, the government would pay $130 billion more in interest over the next decade . . . If, instead, Treasury rates rose by four-tenths of a percentage point, the government would pay more than half-a-trillion dollars in additional interest over the next decade.

. . . public statements by many financial-market participants and experts have made clear that default by the federal government on obligations to debt holders would be a significant shock to the global financial system and economy. That shock could trigger large swings in stock prices, private interest rates, and the value of the dollar relative to other currencies; it might also generate massive disruptions and damage to the payments system and the flow of credit; and it would probably weaken the economy and reduce output and employment relative to what they would otherwise be. Indeed, the lack of a plan for increasing the debt ceiling may already be hurting household and business confidence, and default would reduce confidence further and increase uncertainty about future government policies, which would lower spending even apart from the effects of changes in asset prices and interest rates.

It is also unclear what would happen if the federal government were to default on obligations other than Treasury debt . . . debt holders might be unconcerned because the payments due to them would not be directly affected; however, debt holders might conclude instead that if the government is willing to default on some obligations, it could default on its obligation to them next. In any event, the individuals, businesses, and state governments that are owed money under current law and are counting on receiving it would clearly need to deal with sudden and unexpected shortfalls in their own finances.

The budget is on an unsustainable path. Debt held by the public is already higher relative to GDP than it has been in more than half-a-century, and CBO projects that it will exceed its all-time high in about a dozen years under current policies.

[...] Following the intensive public discussions of the past few months, a failure to agree on credible, specific policy changes would increase doubts about the ability of the government to manage its budget. That could, in turn, raise the perceived risk of U.S. government securities, which would lead to higher Treasury interest rates, higher government interest costs, and the possibility of dislocations in financial markets.

Moreover, and with a larger immediate impact on most Americans, the economy remains mired in a severe slump. Three-and-a-half years after the recession started, roughly 10 million fewer Americans have jobs than if employment had continued to expand at its pre-recession pace. Total output of the economy this year will be about $700 billion less than would occur with high use of our labor and capital resources. In addition, 44 percent of the workers who were unemployed in the first half of this year had been out of work for more than 26 weeks—an unprecedented share in the period since World War II. CBO expects that the lingering difficulties of the long-term unemployed in finding jobs, as well as the loss in business investment during the slump, will weigh on the nation’s output for years to come.

[...] With the federal budget and the economy both facing such serious problems, the additional problems that would probably be caused by a default on the federal government’s obligations could be especially damaging. We are on the brink of harming the budget and the economy, possibly undermining the international financial system, and doing significant damage to the credibility of legal commitments made by the U.S. government.

Gulp.

________________________________________

Congressional Budget Office Analyses

• Of the revised Boehner proposal
• Of the Reid proposal
• Comparison of the two proposals

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Financial Times:

Wall Street bankers, from senior executives to traders, are complaining that the Federal Reserve is refusing to engage in planning for any downgrade or default by the US. With only days to go to the US Treasury’s August 2 deadline to raise the debt ceiling, bankers say they are not getting a response to efforts to discuss the market impact of a failure to reach a deal in Washington or if credit rating agencies cut the US triple A standing.

The Treasury has so far refused to make public any contingency plans for the event that there is no rise in the debt ceiling. Unless the Treasury indicates, for example, whether it would prioritise interest payments, it is hard for the Fed to discuss the implications with banks.

________________________________________

Financial Times:

Presenting, courtesy of Bloomberg, le chart du jour — an eye opening inversion of the US credit default swap curve:

That means, as Bloomberg eloquently put it, that it costs more to insure US Treasuries for one year than it does for five years, for the first time ever.

WARNING: THIS POST IS ABOUT THE PROSPECTS FOR THE STOCK MARKET. PROCEED AT YOUR OWN RISK.

Perhaps the most long-standing and widely-believed part of the conventional wisdom about the stock market is that it anticipates changes in the strength of the economy — and, therefore, of changes in corporate profits — by six to nine months. That’s what I was taught in business school, and that’s what I saw during my Wall Street career from the 1970s to the 1990s. This anticipatory nature explains why the market sometimes responds favorably to bad news and unfavorably to good news.

Something seems to have gone wrong. The conventional wisdom doesn’t seem to be working anymore.  The graph below show the recent levels of after-tax profits for non-financial corporations.

• The Dow Jones Industrial Average (DJIA) peaked in October 2007, despite the fact that profits had been on a modest downward trend since the start of the year. The rate of decline accelerated in first quarter of  2008. The conventional wisdom was violated. It’s impossible to believe that investors were unaware of the downtrend that had been underway starting in early 2007. Yet the DJIA was higher in October than earlier in the year. 
• The DJIA bottomed on March 9, 2009 — one quarter after the bottom in corporate profits.

Based on the two most recent observations, the conclusion is clear: instead of anticipating directional changes in profitability, investors reacted to them. The default explanation for this is that the level of uncertainty was so great that investors, as a group, lacked the confidence to attempt to anticipate change.

In my judgement, investors are still in reactive mode. Notwithstanding the weakness of the past few days, the market has held up remarkably well in the face of the dual debt crises — the one in Europe and the one here. Our crisis has not exacted a toll on profits — yet. Since investors no longer seem to anticipate change, recent experience suggests that the market won’t experience a serious downturn until after corporate profits fall short of expectations. The level of uncertainty — the lack of confidence — is still so high that it’s hard to imagine investors will revert to their former anticipatory ways.

The preconditions for disappointing corporate profits are falling into place. Dismay over the shenanigans in Washington have hurt both consumer and business confidence. Less confident consumers will spend less, as will less confident businesses. Even assuming that a default is avoided, there appears to be a growing likelihood that the credit rating of U. S. government securities will be downgraded. This would result in higher interest rates for the government (adding to the budget deficit), business, and consumers. The larger the cut in government spending, the greater will be the impact on the economy. The smaller the cut in government spending, the lower will be the confidence that the government is capable of dealing with the long-term budget problem.

This is not the time to be fully invested in stocks. Another piece of conventional wisdom — one that I abide by — is don’t catch falling knives.

When I was growing up, I pledged allegiance to the United States of America. Not so for 40 of our senators and 115 of our representatives, who are co-sponsors of this pledge:

I pledge to urge my Senators and Member of the House of Representatives to oppose any debt limit increase unless all three of the following conditions have been met:

1. Cut – Substantial cuts in spending that will reduce the deficit next year and thereafter.
2. Cap – Enforceable spending caps that will put federal spending on a path to a balanced budget.
3. Balance – Congressional passage of a Balanced Budget Amendment to the U.S. Constitution — but only if it includes both a spending limitation and a super-majority for raising taxes, in addition to balancing revenues and expenses.

A list of the sponsoring senators and of upwards of 100 sponsoring organizations can be found here. Sponsoring representatives are here.

The Cut, Cap and Balance coalition isn’t happy with Speaker Boehner’s plan:

The Cut, Cap, Balance coalition understands that bipartisan leadership is under extraordinary pressure to present a proposal this week. We applaud the Speaker’s commitment to avoiding tax increases on job creators as part of an increase in the debt ceiling.  Senate Majority Leader Harry Reid appears perfectly willing to continue the classic Washington parlor game of promising spending cuts now that will likely never materialize . . . Cut, Cap and Balance is not merely a legislative framework, it is a series of principles.  Principles are not subject to negotiation.  Unfortunately, the Speaker’s plan falls short of meeting these principles.  Perhaps most troubling is the proposed Congressional Commission.  History has shown that such commissions, while well-intentioned, make it easier to raise taxes than to institute enduring budget reforms. Additionally, a symbolic vote on a balanced budget amendment at some later time minimizes its importance, as it will not be tied to an increase in the debt ceiling. A BBA [Balanced Budget Amendment] that allows a tax increase with anything less than a 2/3 supermajority is not a serious measure. The fact remains there is only one plan that has passed the House with bipartisan support that will permanently end America’s debt problem and that is the Cut, Cap and Balance Act.  This Coalition is willing to sacrifice much in return for a permanent solution to this issue, but we will not sacrifice the fundamental principles of CCB.  To be clear, we are not criticizing the Speaker; however, we cannot support his framework, and we urge those who have signed the Pledge to oppose it and hold out for a better plan.

No compromise. Come hell (a default) or high-water (a credit rating downgrade).

Since I started this blog a month ago, I’ve studiously avoided adding my two cents worth on the debate (if that’s the right word) over raising the debt ceiling and reducing the budget deficit. I did so with the expectation that an agreement would be reached by now. I saw little point in posting a blow-by-blow, day-by-day commentary. Having just listened to President Obama and Speaker Boehner, I’ve decided to break my silence.

If you took an economics course in college on public finance, you may recall that there are two types of taxes. Regressive taxes, as exemplified by sales taxes, are those taxes that impose a heavier burden on the less economically-fortunate than on the more economically-fortunate. For example, in any given jurisdiction, the sales tax rate is the same for all. The sales tax is a consumption tax — the more you buy, the more tax you pay. The poorer you are, the higher the percentage of your income that is apportioned to spending and the lower to saving. It’s for this reason that the sales tax is a regressive tax.

In theory, the income tax is a progressive tax, as it takes a bigger bite out of larger incomes than out of smaller incomes. In practice, of course, the income tax, as a result of the myriad of deductions that are of little avail to lower income individuals, isn’t very progressive.

I have a reason for insulting the intelligence of those of you who know everything I’ve thus far said.

The reason is that any plan to reduce the budget deficit that relies entirely or almost entirely on cutting spending is regressive. If you favor any of the various Republican proposals, including Speaker Boehner’s, you should be aware that you’re supporting regressive pain. The comfortable among us — a category that includes me — are far less dependent upon government spending to maintain our standards of living. I can’t support any proposal that imposes more pain on those who have the least pain tolerance.

There’s another topic I may as well cover in this post. Calling any of the proposals, regardless of their source, “deficit reduction” proposals is, in my view, to be guilty of a misnomer. Rather, they are spending decrease and tax increase proposals having as their objective the reduction of the deficit. Whether or not the cuts reduce the deficit depends on their impact on the GDP growth rate. Because there is no guarantee that their GDP impact will be positive, there can be no certainty that the cuts will reduce the deficit. The only thing that the government can control is spending. It can’t control the impact of spending reductions on the level of economic activity; accordingly, it can’t control the impact of the reductions on tax revenues. One need only go back to the late 1990s — when it was projected that there would be budget surpluses into the indefinite future  — to see how faulty estimates can be.