When the stock market zigs and zags its way to a 12 percent loss in three weeks, wiping out $2.5 trillion in wealth, it is clearly sending a message. But what, exactly, is the market telling us? The most obvious answer is that it is simply agreeing with Standard & Poor’s, which in its Aug. 5 decision to downgrade U.S. government debt from a AAA rating to AA+ decried Washington’s “political brinksmanship” and said that the recent debt deal “falls short” of what is needed to bring U.S. finances under control. The implication of such an answer is clear: To turn things around, the administration and Congress will have to act more vigorously on the deficit, either by raising taxes or cutting spending. This has become a popular interpretation, particularly in Washington, but it is difficult to reconcile with what else has gone on in the markets over the past several days.The above is simple good sense, but in today's world "good sense" is a rare commodity. Fanatics on the right have seized the imagination of most people and are prescribing poisonous potions to "cure" the economy. These are mostly the voices of the rich and powerful who stand the most to benefit from the current mess. They are top dog and are manipulating the situation to benefit themselves. They have no real interest in relieving the horrors being imposed on the bottom 90% of society through unemployment, home foreclosures, economic uncertainties (the gyrating stock market and prophets of doom declaring that people must gird themselves with sackcloth and ashes and propitiate the moral sense of the market gods to qualm the economic storms, i.e. "austerity", the modern day equivalent of medicinal leeches of the middle ages).
Look at the bond market, which is twice the size of the stock market and was, after all, the main audience for S&P’s analysis. If market participants were truly concerned about the inability of the U.S. government to deal with its budget, we should have seen a spike in interest rates as bond investors became more nervous about the continued flood of government debt and the heightened risk that they may not get their money back.
But instead, interest rates fell by a significant amount. Ten-year government bond rates went from slightly above 3 percent in early July to 2.1 percent this past week. Far from viewing U.S. bonds as a risky proposition, market participants continued to treat them as a safe haven.
So, if financial markets aren’t worried about the full faith and credit of the United States, why is the stock market falling? An alternative view, most prominently expressed by New York Times columnist Paul Krugman, is that the markets have concluded, given the struggling economy, that budget cuts are precisely the wrong medicine for what ails us. The Obama administration was backed into a corner by the S&P downgrade and must now focus on cutting the budget deficit to the exclusion of all other policy objectives. Such austerity — whether achieved through spending cuts or tax increases — at this moment in the business cycle would only exacerbate a slowdown. In this reading, the stock market is preparing itself for the coming double-dip.
If this is the market’s message, what should we do? Instead of instituting deeper budget cuts and other austerity measures, the government should pursue the opposite: It should take advantage of the fact that it can essentially borrow for free to finance badly needed infrastructure investments. After all, our airports, roads and bridges are in need of urgent repair, and the extra investment would provide job opportunities and inject money into the economy.
The missing piece in the above is the need for real leadership in an economic crisis. FDR stepped forward and moved the US beyond the hand-wringing austerity of Herbert Hoover with a panoply of iniatiatives under FDR that finally kick-started the economy. Obama needs to be a leader and tell the people the truth: austerity only feeds the monster at the centre of this economic storm. Cutting government spending at the same time as the private side of the economy is cutting spending to reduce private debt only shrinks the economy which brings on a positive feedback loop of less jobs -> less income -> less spending -> less business -> worse economy -> less jobs.
The political crazies are raging about government deficits and failing government, but they don't realize that the only way to break the positive feedback look is to stimulate the economy:
It wouldn’t be cheap. But it would be less expensive than another deep recession.
At the moment, the bond market and the stock market are signaling very clearly that the greatest threat to U.S. prosperity is the lackluster recovery, not the budget deficit. We can only hope that Washington is reading the signals correctly.