So a deal’s been done, just like everyone knew it would.
The markets were relieved for about five minutes. A ‘dead cat bounce’ duly ensued.
(In case you haven’t heard that term before, it’s the City’s nickname for the almost inevitable rebound that occurs after something has fallen heavily. The idea is that even a dead cat bounces if you drop it from a sufficient altitude. And you thought these guys were sophisticated.)
Then grim reality came along in a series of miserable manufacturing reports from around the world, and slapped the markets right back down.
The drama over the debt ceiling was just that – a drama, with a bunch of actors playing their pre-set roles. The trouble is, beneath all that, there’s a genuine crisis afflicting Western countries.
And unlike the debt ceiling pantomime, this crisis is going to take a lot more than a bit of Punch and Judy from the world’s politicians to sort out…
Lessons from the debt ceiling debacle
The final vote on raising the US debt ceiling is due today, but it seems a done deal. There’s been the usual partisan blame-throwing on either side of the political divide. If it was our own government I’d be happy to delve into the morass of who won which concession, and how it might affect you.
But it’s not. From a British investor’s point of view, all that really matters is that the Democrats managed to kick the prospect of another debt ceiling vote to beyond the next election. Meanwhile, the Republicans managed to avoid any tax hikes.
Beyond that, the ratings agencies are surely being put under severe political pressure to not kick up too much of a fuss about the small print. The likes of Moody’s and S&P must know that the US government could make life incredibly difficult for them. Few people would speak up on their behalf, given their disastrous role in the credit crisis, and rightly so.
And as I noted last Thursday, even if the US was downgraded to AA, it’s not that big a deal. Investors are already well aware of the nature of the risks around US government debt. Changing the health warning on the label isn’t going to make any real difference.
There are two main lessons to learn from this episode as investors. One is that you can’t take anything for granted in markets. My colleague Cris Sholto Heaton wrote a good piece about how to cope with this by diversifying your portfolio the other day – I’d recommend you read it here: Don’t panic over the US debt debacle.
The second is that this is yet another reminder that political risk is back in a big way. Politicians across the globe are going to be causing havoc in markets for quite some time to come. How do you cope with that?
An irrational fear of recession
Politicians are terrified of recessions. “It’s the economy, stupid” is branded into their collective consciousness. That’s understandable. Gordon Brown did a lot of economic damage to this country while he was in charge. Indeed, I suspect one of his first acts – the raid on pensions – has probably hurt UK investors far more than even the credit crunch did.
But despite all that, he really only lost the last election because people looked up from their morning cornflakes and noticed that their houses had fallen in value.
The message is clear: recessions are election-losers. So no one wants to admit that sometimes a recession is the unavoidable consequence of doing what it takes to get the economy back to working order.
As a result, the debate at the moment is very artificial. Supporters of austerity (which in most cases isn’t even that austere) argue that if the public sector gets out of the way, the private sector will pick up the slack. Supporters of pseudo-Keynesianism argue that the private sector is paying off its debts, and if the government stops spending, the economy will slow down.
They’re both right. Shrink the government, stop interfering so much, and the private sector will make a comeback. But it won’t happen right away. And if the prices of assets from property to companies have been propped up artificially in the meantime, they’ll have to fall before individuals and corporations decide they are worth investing in. So you probably will get a recession and some hairy moments during the transition.
That makes the idea of the government ‘picking up the slack’ very seductive. But this ignores the nature of government spending. The main problem is that it’s motivated by politics rather than profits, so it’s unpredictable. The government is not a reliable customer or business partner. And that makes it hard to plan ahead or base investment decisions on.
And all the government can ultimately do is shuffle money from one place to another. Just look at the efforts by the US government to put a floor under house prices. In 2009 the government introduced a first-time buyer tax credit. Effectively, anyone buying a house got $8,000 knocked off the price. It expired in April 2010.
A study by two Northwestern University economists, Jonathan Brogaard and Kevin Roshak, found that the tax credits barely affected the number of sales. They also found that “sellers in markets with low and stable prices captured most of the credit, and the effects of the credits sharply reversed after expiration.” Overall, “the tax incentives were a simple redistribution of wealth.”
‘No more boom and bust’ is nonsense
So the truth is that anyone who talks of “unnecessary recession” is just making the same empty promise of “no more boom and bust” that we heard back before the crash.
And more to the point, Western governments don’t have any more money to spend – not here and not in the US. The larger the debt burdens grow, the greater the chance of disaster. It’s like building a tower on unstable foundations. You don’t know when it will collapse. Maybe you’ll reach 20 storeys, maybe you’ll reach 200. But when it does topple, it’ll go all at once. And the higher it is when you get to that point, the worse the outcome.
However, it’ll take a long time before anyone accepts that. Meanwhile, we’ll see lots more experiments with quantitative easing (yes, this is monetary policy, but it falls into the category of political interference), and more calls for ‘Plan B’. And all the while, the spectre of the huge debts our countries are carrying will hang over the markets and leave them directionless at best.
We look at what all this means for investors in the next issue of MoneyWeek magazine, out on Friday. (If you’re not already a subscriber, subscribe to MoneyWeek magazine.) The upshot is, stay defensive.
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