What is the stock market telling us?

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.

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A look at the bear and bull markets through more than a century of ups and downs.
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A look at the bear and bull markets through more than a century of ups and downs.

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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. 

The reason this argument is falling on deaf ears is that, over the past two years, we’ve experienced a true citizen’s revolt in America against public spending and government debt, embodied most visibly by the tea party movement. 

When the financial crisis hit in 2008 and 2009, officials from both the Bush and Obama administrations and the Federal Reserve resolved to avoid repeating the errors of the 1930s. So they poured enormous amounts of money into saving the banking system and cut interest rates to the bone. That worked to prevent another Great Depression, sure, but it provoked a public backlash against all forms of government spending. Voters lumped the 2009 stimulus package together with the Troubled Asset Relief Program (TARP) — that politically toxic government initiative to inject capital into banks — and concluded cynically that all this federal money was just propping up Wall Street. 

Then, a few months later, when Wall Street announced high profits — an unfortunate but predictable side effect of low interest rates and the bank bailouts — and went back to handing out large bonuses, the public was further outraged at the spectacle of bankers making money when rest of the country was mired in unemployment. 

We are thus hamstrung in our ability to deal with the slowing U.S. economy, not because of some deeply flawed strategy, but because public support for a plan based on vigorous government spending has evaporated. Indeed, since last year’s midterm elections, we have been contending with a strong and politically influential movement to shrink the size of government.

Harvard economist Ken Rogoff, the co-author of a masterful history of financial crises over the past 800 years, points out that economic recoveries from such crises tend to be anemic and protracted. This one will not be different: American households entered this latest recession so weighed down with debt that — the massive stimulus package notwithstanding — consumer demand has been held back as families desperately try to repair their balance sheets.

Government programs to help households deal with the debt overhang have been a complete failure, only aggravating the political fallout. Indeed, one of the reasons that the public reaction to the bank bailouts was so intense was the sense of injustice: Banks were receiving help while ordinary Americans struggled with foreclosures. 

Nearly three years after the financial crisis began, a third of residential mortgages in America remain underwater. Since then, about 1 million homes have been foreclosed on every year, and by one estimate, an additional 11 million households — one out of every five — could lose their homes unless something is done. A large-scale government program to restructure residential mortgages and help households refinance underwater mortgages would reduce the debt overhang and support consumer demand. Most important, by channeling public money to help individual families, rather than Wall Street, this initiative could alter the political dynamics that currently doom any government efforts to jump-start the economy.

It wouldn’t be cheap. But it would be less expensive than another deep recession.

Untangling what the financial markets are saying is rarely easy or straightforward. If the Dow and other major indices continue to zigzag their way down, there is a very real danger that politicians will draw the wrong conclusions — and begin to push for policies that would only make things worse. 

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.

Liaquat Ahamed is an investment manager and the author of “Lords of Finance: The Bankers Who Broke the World,” which won the Pulitzer Prize for history in 2010.

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