Tuesday, August 9, 2011

An Alternate View on the Stock Market

From a post on the Cheap Talk blog:
You might have thought it obvious that the stock market would go down after S&P downgraded US government debt. The bad news about US debt made investors worry, and worried investors are usually less enthusiastic about holding stocks.

But there is something wrong with this view. Ask yourself, when fearful investors sell their stocks, what do they buy? They sell their stocks for cash, of course; and then, being fearful, they typically want to keep the proceeds in the nearest thing to cash that pays interest: US government debt. Thus, as investors’ demand for stocks goes down, their demand for dollars and other US liabilities goes up. Such a surge in demand for US government debt would cause the price of US bonds to go up, which means that the interest rate on US debt would go down. Doesn’t it seem paradoxical, that a downgrading of US government debt could cause demand for this debt to increase?


We have seen, however, that the investors’ movement from stocks to bonds today is very hard to reconcile with fears of default on these bonds. So to explain the stock market decline, we have to look at the other side of the story, the very real possibility that a politically constrained US government might have to cut expenses for essential government services. Broad fears of a crippled US government that is unable to enforce laws or invest in infrastructure could do very serious damage to investment and economic growth in America. Indeed the possibility of such government paralysis could be far more economically damaging than any marginal increase in taxes.

Thus, there is every reason to believe that investors are reacting, not to fears of too much government debt, but to fears of too little government spending where it is needed. Investors are expressing fears that the US government may become unable to do its essential part in maintaining the strength of this country. Pundits and congressmen should take note.
This makes a lot of sense to me. The stranglehold that the Tea Party has on Congress means that austerity now in and that means less government, less stimulus, less infrastructure, less regulation, less public spending to replace the missing private spending, less public investment, etc. It is a pretty bleak picture all thanks to the right wing nuts in the Republican party.

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