Markets and Uncertainty: The Uneasy Union of Policy and Free Enterprise

Coming off the heels of the vote to raise the debt ceiling, the U.S. bond rating downgrade and the market volatility that resulted, it’s a wonder investors can keep up with the constant frenetic activity happening on Wall Street.  As result of these uneasy economic times, President Obama has attempted quell jittery investors by claiming the historic strengths of the economy are still intact.  “The United States is still a AAA nation,” argues the President which appears, from the standpoint of investors, to be nothing more than a simple ploy at rhetoric to boost confidence in the market.  The problem is, all President Obama’s talk flies in the face of reality.  The market, made of the millions of daily decisions of individual investors, does not trust the actions of the President’s regime.

As a result, the Federal Reserve stepped in and tried to ease this uncertainty in the market (and lack of trust in the President’s policies) by announcing a two-year rate freeze keeping its key interest rate at near zero until 2013.  The goal: provide the market with the stability it desires in the face of Schizophrenic government policy.  Regime uncertainty is the core problem which destabilizes the market.  When market actors are uncertain in how to plan for the future; business, firms, and individual market participants pull back and act very cautiously.  They simply do not invest in any long-term projects for fear of the unknown and this includes both capital investment (machines, buildings, etc.) and labor investment (they fail to hire).  The Obama administration has firms guessing, which forces the engine of economic growth (the private sector) to take few risks and pull back.  The President’s healthcare legislation is a perfect example of policy that creates this uncertainty, and thus causes businesses to pull back for fear of how policy will impact the future.

So, has the Federal Reserve solved the problem?  Does the certainty of low interest rates provide the stability necessary for the market to flourish?  The answer to these questions is twofold; maybe in the short run but with a significant cost.  Ben Bernanke, the chairman of the Federal Reserve, appears to have a very short memory.  His decision to lock in the Feds key interest rate for two years is one that looks an awful lot like typical public policy.  That is, a focus on short-term impact with a “let’s hope for the best” in the long-run.  The policy process encourages a myopic view of the world because it is so often driven by election cycles.  Hence President Obama’s push for a “Big Deal” in the debt ceiling debate in order to get issue off the table for his 2012 Presidential campaign.

Yet, Fed policy should focus much more on the long-run.  The Federal Reserve is, in theory, insulated from the political process as the chairman serves a 14-year term.  Mr. Bernanke does not have to worry about the economic climate during the 2012 election, yet the move to lock in a two-year interest rate is bound to result in short-run stability but with a serious long-term cost.  One need not go back further than the economic boom of 2003-2007 to see the severe consequences of artificially low interest rates.  The housing bubble which burst to usher in the recent recession and economic downturn was caused in large measure by interest rates that were kept too low by the Fed.  Money was too cheap, lending standards were too generous (also a result of government policy), and economic collapse resulted.  Why does Mr. Bernanke want to put in place similar economic conditions that led to this collapse?

The answer here is the same as what has plagued the uneasy relationship between markets and government for centuries.  The belief is simple, we must do something.  The government must do something, or as Keynes argued decades ago, “In the long-run we are all dead.”  So, use any policy tools available to intervene in the market to ward off calamity.  Thus, the Americans and Europeans are scrambling to use policy in order to stabilize the market.  The reality is all these policy tools have short-run effects and huge long-run costs.  Is the Fed setting up the U.S. economy for another bubble?  It appears that this is a very real cost to the two-year interest rate lock.  Bubbles eventually burst, and when the price of money is artificially lowered an economic bust always follows.

Is It Time to Make a Deal?

With the debate intensifying over raising the debt limit and cutting federal spending, all eyes are on the GOP.  Many conservatives are arguing that Republicans must give in to President Obama’s desire for elimination of tax loopholes on corporate taxpayers and other reforms that could raise taxes on the American people.  The mantra of the Republications is quite simple: spending is the problem and there is no need for revenue increases (read tax hikes).

Democrats on the other hand claim that certain programs are untouchable such as Medicare, Medicaid and Social Security.  Thus, the proposals outlined to cut $2-4 trillion from the Federal budget over the next decade must leave these entitlements alone.  These conflicting philosophical positions continue to arise: cutting spending and the size of government alone or continue the course by raising more revenue?  Should Congress agree to spending cuts AND tax increases in order to make a deal and act before the August 2 deadline to raise the debt ceiling?  David Brooks of the New York Times  recently wrote cutting a deal is the “mother of all no-brainers.”  Others are claiming that certainly the wealthiest Americans can afford tax increases (yet these increases are always couched as “allowing the Bush tax cuts expire”).  Consequently, the debate ensues and each side, Republicans and Democrats alike, are blaming each other for the pending default if a deal on the debt ceiling is not reached.

Again Americans are experiencing the tension between politics and economics that is as familiar as a thunderstorm on a hot summer evening.  The political process creates incentives for spending and compromise while the economics reflects an unsustainable budget shortfall that has implications that are not fully known.  The easy solution is to make a deal, raise the debt limit, and spend tax payer and borrowed dollars to oblivion.  Thus, the debate is one of principles that are on very different poles: limited government and incentives push to market participants versus government solutions to basic economic problems with little to discipline political actors.

The debt ceiling is the only tool left that provides for the possibility of fiscal discipline by politicians.  In the past, raising the debt ceiling has been a relatively simple policy option for a spendthrift Congress.  Yet, with the election of conservative Republicans in November 2010 there is a new push toward actually maintaining a principled position regardless of the political cost.  Many Republicans see this issue as that is, spending billions over budget, controlled by special interests, and taking control of the very market incentives that drive economic growth.  Why should high income earners pay higher tax rates (either via marginal rate increases or lost deductions) simply to fund programs that are inefficiently administered via the federal government?  Or to put it more clearly, why are Democrats set on maintaining or growing the current federal budget?

These are the questions that must be asked long before the question of “should the Republicans make a deal?”  According to those close to the debate, the big concern is that failing to raise the debt ceiling could likely lead to skyrocketing interest rates and a plummeting dollar.  Hence, the President and his party are characterizing the Republicans as willing to sacrifice economic stability for wealthy tax breaks.  Once again, this myopic view of the economy is endemic within the political process.  Obama is looking to the 2012 campaign and many in Congress are doing the same, yet the discussion of core principles must remain in this debate.  Any compromise at this point, as obvious as it may seem to some, is tantamount to once again throwing away all the economics for politics alone.  In congressional districts throughout the county, a majority of voters spoke loudly last November saying that they wanted a principled position on tax and spend policies to re-enter the political process.  Many Americans are tired of the bickering over billions when they have made significant cuts in their own budgets.  It is time for Congress to stop pandering to the few and start worrying about spending less for the entire country.