Financial historian
Liaquat Ahamed
warns Washington against heeding the wrong message
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.
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.
Graphic
A look at the bear and bull markets through more than a century of ups and downs.
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.
It is hard to debate the economic logic of this argument — but the political reality is that such a move is just not in the cards. As the drama of the past few weeks has affirmed, while our major parties differ on how to cut the debt, it is almost impossible to find any politician on either side who is willing to endorse a big push in public investment and continued high deficits. It doesn’t matter that interest rates this low make it a superb time for the government to borrow or that the bond market has made clear that it doesn’t think we’re Greece. No one wants to listen.
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