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The stock market plunge is plain stupid, but the Great Deleveraging will continue

by Aaron McCormack on August 9, 2011














The all powerful “market” showed us what we should already be aware of – that it doesn’t really know very much in the short-run.  Perhaps it’s because the vast majority of decisions are made by computer algorithms written by “quants”.  Certainly it is true that the biggest firms at the heart of the market make money on movement, whether it is up or down. In fact because of the power of shorts, an instrument inaccessible to the common investor, the firms make even more money in a plunge.  I wonder if they are smiling inside even as they go on CNBC and CNN to wring their hands.

The blame for the sell-off is laid firmly at the twin doors of the S&P downgrade of US sovereign debt and the Euro crisis.  At a more abstract level some commentators will talk of a “breakdown in confidence” in our economy in general.

Well, here is the news, the real economy out there in most of the Western world is no better or no worse off than it was on Friday, or a week ago, or even a month ago.  Specifically, the prospects for many corporations listed on the markets remain bright – huge amounts of wealth continue to move from consumers and governments into the pockets of private enterprises.

In fact, the real market reaction to the US downgrade – the price/yield of US treasury bills – was that investors bought more!  The prospect of slightly better returns and no real change in the likelihood of default means that shrewd investors are finding a way to make a wee bit more money investing in treasuries.

Meanwhile in Europe, a similar positive reaction was felt as Spain and Italy saw their costs of borrowing come down – although that is more likely to be temporary.

Let’s look briefly at these two threats, before coming back to the bigger global picture.

Last week, the US was within hours of defaulting on its debt obligations.  The President signed the bill extending the debt limit just 10 hours before the assigned deadline.  The rating downgrade from S&P (one of three main ratings agencies – the other two have left the USA at AAA) is not a reflection of the USA’s lack of ability to pay it’s debt.  Interest is still about 7% of the total federal budget.  It is a reflection of the risk that this grand battle over the USA’s direction as a nation will result in investors not getting paid.

If someone is renting a house from you, and comes within hours of saying that they won’t be bothering to pay you this month, you are going to change your view of how risky they are as tenants, regardless of how wealthy they are.

So the S&P decision is understandable and does reflect the fact that the USA is one of the few places in the world that votes directly on debt ceilings, as well as having a political system where it can be held hostage (it wouldn’t happen in a parliamentary system with a working majority).

The USA does have to take significant action on its debt – but it is a long-run problem with two giant levers to pull….simple entitlement reform and tax increases on corporations and the wealthy.  The solutions exist for the USA to make smarter investments in the short run (to help further stimulate growth and prepare people for the jobs of the future) AND to reduce the debt over the long run.  The question is whether or not the political system is fit for purpose for those solutions to be enacted.

The Euro-zone crisis is a different beast altogether.  It is an urgent and shorter-run problem that has been exacerbated by EU leaders’ refusal to both acknowledge and deal with immediate issues.  Buying time is one thing when your problems have a 20 year time horizon.  But it is not usually a successful option when your problems are both massive and immediate, as they are for the Eurozone.

BUT, apart from the issue of general stability, neither of these challenges should be drags on the real economy – which is lethargic enough already.

The macro-level process at play in Western Europe and the USA is a great deleveraging.  For about 10 or 15 years our people and our governments have been living off of an artificial prosperity, fueled by borrowing.  This is typified by the Irish or American property markets.  By the banking systems in most countries. By the debt and deficit situations in most Western nations.  And while the USA probably has some time on its side, many European nations do not.

As I keep saying, debts have to be paid.  Normally, they will be paid by the people who borrowed in the first place.  In the case of a structured default, the borrower and the lender will work out a deal and share the pain.  In bankruptcy, the lender carries the can.  Occasionally, inflation will do the heavy lifting for the borrower so that what looked like a crushing debt seems much more manageable a few years later – but this rarely happens and is unlikely in our current situation.

This great deveraging must continue.

The tragedy in Europe is that governments are wasting precious time and money attempting to hold back deleveraging in King Cnut-esque fashion.  That time and money and intellect and political capital should be spent on smart entitlement reform, stimulating weak economies and retooling for our future – processes that are painful enough at the best of times.

The tragedy in the United States is that the system and nature of government prevents tough (but somewhat “out-year”) choices, whilst creating an environment where immediate investment is politically impossible.

All the while the Great Deleveraging will continue regardless.



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