Why Are Stock Markets Up? They Love Washington Gridlock

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Many commentators have wondered why the stock market has done so well during a period when the economy has been relatively weak. A common explanation has been that the Federal Reserve has pushed interest rates so low that investors have little choice but to buy stocks in hopes of returns that exceed inflation. There is some truth to that, but another reason is the gridlock on Capitol Hill.

A poorly kept secret is that almost all laws are bad for business. Some regulation is necessary. Clear rules are beneficial to business. But changing regulations frequently is bad for business and reduces the value of past investments made in conformance with now-supplanted legislation. Uncertainty over regulation is also costly.

Bill McNabb, chairman and CEO of the Vanguard Group, recently wrote in the Wall Street Journal that policy uncertainty has slowed GDP growth by about one percent per year since 2011, costing the economy 45,000 jobs per month and about $800 per person in income (read his op-ed here). This is based on work by economists Nicholas Bloom, Scott Baker, and Stephen Davis who have created a policy uncertainty index (www.policyuncertainty.com); their estimate of the cost of policy uncertainty is even higher than Vanguard's.

Historical studies have also been done on what political situation in Washington is best for the economy. The answer is divided government is the best (see Robert Barro's book Getting it Right for a review of the evidence). In fact, the best government for the economy is a Democratic president and a Republican Congress, which is roughly what we have right now. The next best is a Republican president and Democrat Congress.

The important thing for the economy is that government be divided so that it gets little done. Having the two parties restraining and blocking each other helps businesses because the politicians pass fewer laws and thus do less damage to the economy.

For the past few years, the politicians in Washington have been well and truly deadlocked. After the Democrats pushed the Affordable Care Act through Congress by the narrowest of margins and every procedural trick in the book, very little has been accomplished. This is about as divided as our government has ever been.

Budget deadlocks, stalled environmental regulations, the National Labor Relations Board stymied by the lack of a quorum, and federal spending stuck more or less in place for the last several years; all this partisanship means almost nothing has passed in the last three years.
While this frustrates politicians and political partisans, business could hardly be happier. And it looks like they will remain happy.

Washington appears to be entering an era of scandals. Benghazi and the edited talking points, the IRS harassing tax-exempt groups that appeared to be conservative based on their names, and the Justice Department searching AP reporters' phone records in pursuit of a government leak are all about to consume much of the time Congress spends in session. Given a choice between important legislative duties and political grandstanding for cameras, politicians generally choose the grandstanding. Thus, little legislation is likely to make progress while Washington is in scandal mode.

But how does slower growth equate to higher stock prices? The key is to understand the difference between strong economic growth and strong corporate profits. All the policy uncertainty is slowing economic growth. Businesses are not making new investments that would create new jobs. However, existing businesses are free to focus on cost-cutting, increasing productivity, and boosting demand where they can, all of which are producing higher profits from their already established operations.

In this economy, just hanging onto your job is a small victory. Therefore, employees are willing to work harder to help increase company profits in exchange for keeping their jobs. The sorry state of our labor markets means that companies can increase profits without having to pay particularly large wage increases. This has contributed to the above average returns in the stock market during a weak economic recovery.

There is still plenty of bad news looming on the horizon that could hurt the economy, shrink corporate profits, and sink stock returns. The list of possible triggers includes the trillions in unfunded Medicare liabilities, rising interest rates on the enormous federal debt, the explosion of income redistribution programs, or some other unsustainable policy that has not been addressed. When one or more of these reaches a tipping point where reality must be reckoned with, the stock market's nice run will end. When that happens, both the economy and stocks will likely suffer through a rough period of adjustment to a new reality in which we learn to live within our national means.

Unfortunately for investors, predicting when that will occur is nearly impossible. Regardless of what some experts say, everyone is just trying to make money in the market while it lasts while hoping to get out before the inevitable stock market correction. If I, or anyone else, knew what was going to happen next in the markets, we would be busy getting rich with that information, not sharing it with other people. We know the good times will end; we simply do not know when.

Physicians take an oath to do no harm to their patients. Politicians take no such oath with regard to the country or its citizens. Thus, political gridlock does have an upside-while good legislation may not get passed, neither does bad legislation; and on average more bad laws are passed than good ones. The current partisan standoff is likely to have some severe long-term consequences for the country. We can only kick the can down the road for so long. In the short-term, however, Washington's failures are the stock market's gain.


Jeffrey Dorfman is a professor of economics at the University of Georgia, and the author of the e-book, Ending the Era of the Free Lunch

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