A key source of the today’s economic weakness is uncertainty that led firms to postpone investment and hiring decisions. This column, by the authors whose model forecast the recession as far back as June 2008, report that the key measures of uncertainty have dropped so rapidly that they believe growth will resume by mid-2009. This means any additional economic stimulus has to be enacted quickly. Delaying to the summer may mean the economic medicine is administered just as the patient is leave the hospital.
A big part of what happened in the last few months after the Lehman failure is what is known in economics as regime uncertainty. When business people are uncertain about the rules, they won’t invest in their business. After the serial bailouts and then non bailouts of the Bernanke/Paulson team, who knew what they would do next? In that environment, better to pull back and wait to see what happens. And that is exactly what businesses did over the last quarter of 2008. The same is true of investors.
Prior to the panic of the Fall of 2008, it was my belief that the economy, while not great, was not terrible either. I believed that while we would go through a period of rebuilding our balance sheets – saving more, spending less – there was no reason for the economy to fall off a cliff. I expected to have a fairly lengthy period of sub par growth and weak job creation, but growth. What I didn’t foresee was the panic created by the regime uncertainty.
We’ll never know if I was right about that, but it seems to me it was a reasonable expectation. Just for a minute, assume I was correct. What happens when the uncertainty lifts? My guess is that the economy would return to that low growth, muddling through scenario. Absent the fiscal stimulus plan, we would pay down our debts to a more reasonable level and the savings would eventually translate into higher growth a few years down the road. What the paper at the link posits is basically that. The uncertainty is lifting and therefore, growth will resume shortly.
Assuming this is correct, what will be the effect of the stimulus plan? It will mean government competing for scarce resouces which will lead to inflation. It may mean higher growth in the short term, but only at the expense of future growth. The saving that individuals are doing will be offset by increased government borrowing and the time it takes to pay down our debts will be lengthened. Government borrowing will mean less capital available for entrepeneurs and innovation will be less than would otherwise occur. In short, it wil make things worse in the long run.
The implications for the markets are interesting if the economy does resume growth sooner than expected. Right now, the consensus expectation is for a rebound in the second half of the year. Investors working off that hypothesis are not buying stocks now, but will wait until we are closer to their expected recovery time. If their expectation turns out to be wrong they may have to move up their buy date for stocks and commodities. While this is not a prediction, I think there is a decent chance of a melt up in stock and commodity prices in the first half of the year. One thing I’m pretty sure of though; the consensus will be wrong. That either means that growth resumes sooner than expected or it doesn’t resume at all in 2009. Which will it be? I don’t know yet but I think the risk of a rising market (and missing the rally) is much greater than the opposite.