Economics
Gridlock for equities
Oct 25th 2010, 12:55 by R.A. | LONDON
THERE is a portion of the commentariat which feels that "uncertainty" is constraining America's recovery. In my view, this explanation isn't so much incorrect as it is incomplete. A firm considering whether to invest or hire tries to figure whether hiring and investing is likely to pay off. This calculation involves weighing the expected value of the benefits of investment against the expected value of the costs of investment (and, if we're being complete, setting the net return against other potential activities). What some commentators appear to be arguing, then, is that uncertainty over the likely path of tax and regulatory policies is making this calculation difficult and causing some firms to delay investment.
The reason this is an incomplete explanation, however, is that this kind of uncertainty is always present, but in other times firms nonetheless manage to invest and hire. What that tells us is that firms are happy to estimate the likely changes and costs to come down the pipeline, figure them into a distribution of cost outcomes, and compare that distribution to a parallel one for expected benefits. In other words, no firm knows whether a hire or investment is likely to pay off. But they can analyse the way that investment decisions would likely play out in many different circumstances and come up with a reasonable guess of how often a particular investment would wind up paying off. If it pays off often enough, they move forward.
But these analyses don't just consider potential changes to the cost equation; they also take into account the benefit side. There is a probability distribution associated with potential benefits, just as there's one for potential costs. And for a given distribution of costs, if one shifts the median gain from the investment upward, said investment will pay off more often. People focusing on uncertainty are basically taking demand as given and saying that for that given level of demand, a trickier tax or regulatory environment produces less investment. But one could just as easily say that for a given set of potential regulatory outcomes, a higher level of demand would produce more investment. In other words, the businessman who says he's not expanding because he thinks his taxes might go up might well be saying that he's not expanding because"”given expected low sales figures"”an increase in taxes could make expansion unprofitable. What's preventing expansion, in this case? Well, that depends on what you choose to emphasise.
And so it's important to think critically about claims, for instance, that if forthcoming elections produce political gridlock markets will cheer because, hey, no more uncertainty: nothing will happen. In fact, markets tend not to do well under divided government:
The authors find that stocks performed better under Democratic administrations. The results, however, were significant only in the case of small stocks, and the significance diminished in the later period. Bonds performed significantly better under Republican administrations, again consistent with previous research. The authors did not find that gridlock improves security returns. In fact, small stocks performed better absent gridlock, although the results were not statistically significant. They find that periods of expansive Fed policy were strongly and significantly related to positive stock performance. Bonds also did well during expansive policy, but the results were not significant.
Those are the findings of researchers who studied market performance from 1937 to 2000. What's interesting to me, in addition to the determination that unified government is at least as good for markets as divided government, is that the Fed's monetary stance is much more important to market outcomes than what's going on between the president and Congress. Pundits and markets will be watching extremely closely on November 2, but the most consequential decision for the economy was probably made months ago, when Barack Obama opted to reappoint Ben Bernanke.
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"What some commentators appear to be arguing, then, is that uncertainty over the likely path of tax and regulatory policies is making this calculation difficult and causing some firms to delay investment."
It's basically a political argument. Your analysis shows why. It's the ol' "got something that ails you? A tax cut is the cure" mentality.
I could argue the same for some of us consumers who are not spending.
"I don't know if they will increase my retirement age." "I don't know if they will reduce the amount I'm due at retirement." "I don't know if the 14% increase in property taxes will pass this time - after 6 failures." "I don't know if I'll have a job 3 years down the road."
Etc. Remember, a poor excuse is better than none.
Regards
Yes, uncertainty is always with us, but sometimes it is much worse than at other times. Why are corps sitting on mountains of cash? Are they just mean or stupid? Do they not want to make money? Or are they just waiting for the details of the healthcare and financial reg bills to come out. Even though each bill was over 2,000 pages both are short on details and specify that the details will come much later when thousands of new boards and regulatory agencies are created and given the power to make the specific new regulations. Congress could not have done a better job of creating maximum uncertainty.
fundy,
They could be sitting on mountains of cash because during the '08 meltdown they couldn't get credit to roll over short term paper.
"Fool me once..." type mentality.
Also Capacity Utilization is STILL under 75%. Spend to expand? Tax cut to expand? Then to much supply may occur, leading to that boogieman: Deflation
Regards
hedge, true, but those are common uncertainties that businessmen are experienced at handling. Congress has taken uncertainty to new heights.
"They find that periods of expansive Fed policy were strongly and significantly related to positive stock performance."
Exactly! Most people in finance understand this. In fact, the Austrian (by birth and persuasion) economist Matchlup explained this in the 1930's. From inception, the Fed has always believed that it could create credit and direct to exactly the industry it wanted to. But as Matchlup demonstrated, it can't. Investors determine where new credit goes, not the Fed. And when does the Fed engage in expansionary policy? During depressions, obviously. And where does the money tend to go? To the stock market for the most part in the early days of expansion.
But let's talk about unemployment. When does expansionary policy help employment? When businessmen have resolved the uncertainty problem and begin investing again. Then unemployment falls and we enjoy several years of a boom. But the boom is unsustainable because it is built upon credit creation out of thin air. The artifical boom created by the Fed runs smack into the Ricardo Effect and crashes.
In this blog, our correspondents consider the fluctuations in the world economy and the policies intended to produce more booms than busts.
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