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Sunday, December 02, 2012

Investment Musings

Our society is highly dependent upon the value of assets such as stocks and bonds.  Typically, for example, our government leaders will take action when the stock market plummets.  We last witnessed this in the fall of 2008 when the financial system teetered on the edge of collapse, the stock market plunged, and Congress (both Democrats and Republicans) and the Federal Reserve stepped in to rescue the financial system by bailing out banks and related financial institutions.  The Democrats were also able to push a stimulus bill through Congress, thanks to the voters throwing out the Republicans who had been in power when collapse took place.

In terms of investments, the role of the government in maintaining asset prices varies between stocks and bonds.  U.S. Treasury debt held by the public amounts to about $11.5 trillion.  The total value of the U.S. stock market is about $14 trillion.  Both of these investment classes are extremely important to middle class Americans, and to the health of the overall U.S. economy.  A precipitous drop in value for either of these asset classes will create an overwhelming demand for government action.

In this post, I consider just U.S. Treasury bonds and U.S. stocks (equities).

The United States government, through the federal reserve, has fairly direct control over the prices of U.S. Treasury bonds.  This is seen in the ongoing quantitative easing operations, in which the Federal Reserve is directly purchasing U.S. Treasury bonds.  Any precipitous fall in Treasury prices can be met by Fed purchases to shore up the price, and this would be accepted as legal and, nowadays, conventional practice.  Thus, U.S. Treasury bonds are a relatively safe purchase.  Of course, the principle and interest payments are guaranteed by the U.S. government.  But also, with the logic expressed above, there is also a likelihood that the government will intervene if necessary to protect the prices of longer term bonds.

Equity prices, on the other hand, cannot directly or conventionally be maintained by government action.  There is no government guarantee on principle or dividend, and there is no provision for direct government purchase of stocks to boost prices.  The government has and can be expected to intervene indirectly to boost stock prices, but such action may not always be effective.

During the past 30+ years of Reaganomics and the ownership society, we have seen every possible trick used to stimulate the capitalist sphere of the economy and, by extension, stock prices.  Interest rates have been lowered to zero, to encourage the accumulation of private debt.  Labor has been outsourced and offshored to cut costs, while union power has disappeared and worker benefits, especially pensions, have dwindled.  Regulations and taxes on capital have been cut.  All of these indirect methods have been successful in maintaining stock prices, although for the last 12 years stocks have stopped rising.

My question is whether these indirect methods have run their course, and if it is possible or even likely that stocks will fall considerably before effective government action will be taken to save the pensions of retiring baby boomers, many of which are invested in the stock market.  Clearly, interest rates cannot be cut any further.  And there is little political support for further reduction of taxes and relaxation of regulations, as these tactics have clearly shown marginal utility over the last 12 years.  Labor power is already very weak, and it is difficult to imagine that the national pie can be further redistributed to capital.  Moreover, this would be counterproductive since aggregate demand is clearly lacking.  Finally, many would-be consumers lack collateral and credit worthiness, so aggregate demand cannot be boosted by measures to encourage household borrowing.

So what will the government do if we again slip into recession and stock prices fall?  The obvious solution is to boost aggregate demand by increasing spending and decreasing taxes on middle and lower income people, those who would be likely to spend any such windfalls.  Actually, this tactic is another that has been tried again and again over the past 12 years, mainly via tax cuts which are the only stimulative actions supported by Republicans.  While these repeated tax cuts (including, in some cases, outright payments to citizens) have provided temporary jolts, they have not been enough to offset the otherwise deteriorating employment and wage situation.  Now it seems likely that the temporary payroll tax cut will be ended, thus reversing this stimulus.  Of course, the "Bush tax cuts" are due to expire and are the subject of intense "fiscal cliff" negotiations.  At best we are now looking at the status quo in terms of net government spending to boost consumption.  The most likely outcome of the fiscal cliff negotiations is a slight tightening.

In my opinion, the most likely scenario going forward is for diminishing corporate profitability and falling stock prices, as wage income and aggregate demand languish due to the factors mentioned above, as well as to the global slowdown that is currently occurring.  The political situation is such that both parties are in favor of reducing government deficits.  The Republicans control the House, where spending must originate, and the Democrats control the other 2 branches of government.  There are stark philosophical differences between the two parties, as well as distrust and attention to power rather than good governance.  Thus, there is unlikely to be concerted action to effectively address the problem of a stagnant economy and falling stock prices.

Compounding this bleak outlook is, ironically, the fact that corporate balance sheets are strong.  So the downturn is unlikely to be a repeat of the financial crisis of 2008, which demanded immediate and overwhelming action to save capitalism.  Rather, it is more likely that there will be a fairly gentle, but ultimately devastating, downward trajectory.  Partisan maneuvering will take precedence over emergency rescue action for the foreseeable future.  Eventually, the voters will demand change, and perhaps that will be the time to invest in the stock market again, assuming that Democrats prevail and take action to boost aggregate demand and income security (e.g. wages, pensions, health insurance) for the majority of working Americans.


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