A sigh of relief at last, but there is more negative effects coming our way than we imagined. Not many investors were anticipating that the U.S would default on its debt, but also on the other hand, many were caught unawares by the deal that was brokered by the lawmakers. The deal proposed tax cuts over a period of 10 years, which are bound to slow an already slowing economic growth rate. That means that the real deal is to brace yourself for a longer economic hardship, because the debt deal will bring more economic consequences as illustrated in the following article by Daniel Gross, economics editor at Yahoo! Finance.
At long last, a deal on raising the debt ceiling and cutting spending has been reached. The agreement, which the White House dubbed “a Win for the Economy and Budget Discipline,” includes: a $2.1 trillion increase in the debt ceiling and 10-year discretionary spending caps generating nearly $1 trillion in deficit reduction (balanced between defense and non-defense spending) over ten years. What’s more, a super Congressional committee will come up with a package of $1.5 trillion more in cuts and/or revenue enhancements that’s guaranteed an up-or-down vote by December. And if Congress can’t agree to a package, automatic cuts will commence in 2013, split 50/50 between domestic and defense spending (exempting entitlement programs like Social Security and Medicare).
Should it pass, the deal will have far-reaching consequences. The conventional wisdom on the politics of the deal have already hardened: good for the GOP and especially its Tea Party base; bad for President Obama, who gave in to repeated threats; bad for Congressional Democrats, who were marginalized; a slight gain for the U.S., which finally affirmed it would live up to its financial obligations. Much of this conventional wisdom is likely to prove wrong in time. And the impact is likely to be larger in the coming months on the markets, the economy, consumers and taxpayers than on politics.
Is this deal good for investors? It sure seems to be a plus for global stock markets, as Asian stock markets and U.S. stock futures rose after the deal was announced. It’s difficult to see why, though. The U.S. stock market isn’t a barometer on the U.S. economy any more. The typical member of the S&P 500 already gets about half of its revenues (and almost all its growth) from overseas. It’s a truism that equity markets hate uncertainty. And the quick positive reaction is the latest example of the risk-on/risk-off trade. When bad things happen, or when investors think bad things are going to happen, they sell stocks. When anxiety fades, they buy stocks. That’s what is happening now.
But when there are crises over government debt, doesn’t the real action take place in the bond markets? Yes, it does. And the action in the U.S. bond markets has been odd in recent weeks. As the U.S. careened toward a debt crisis, people and institutions around the world continued to buy U.S. government bonds, pushing interest rates down further. In fact, last Friday, the 10-year bond closed at 2.8 percent. Investors never really believed that the U.S. would not pay its debt. They did believe, correctly, that large budget cuts would slow growth in an economy whose rate of growth is already slowing. And that tends to push interest rates down. So bonds may fall as investors embrace risk again. But over the long-term, this deal in and of itself, is likely to act as downward pressure on rates.
Isn’t slower growth a potential negative factor for stocks? Exactly. While the deal takes uncertainty over debt payments off the table, it does contribute to other types of uncertainty for stocks in general, and for certain classes of stocks. For example, the deal calls for real cuts in defense spending (with the prospect of much more), which would be negative for the large defense contracting/aerospace complex. And as a general rule, actions that reduce domestic demand (as across the board budget cuts would) are a negative for companies that derive a disproportionate share of their revenues from the U.S.
If this is resolved, can we get back to worrying about the ongoing crisis in Europe? Yes. As the U.S. flailed toward an agreement, Europe has continued to grapple — or fail to grapple — with its own sovereign debt crisis. Spain is paying high interest rates to borrow. There’s no path toward a resolution of Greece’s severe fiscal problems. And don’t look now, but Cyprus, the island nation whose banks are heavily exposed to Greece and that just suffered a huge power plant explosion, could be the next problem spot.
How will this deal affect growth? Poorly. Government spending is demand. If you don’t believe it, try asking Wal-Mart or any food retailer what would happen to sales if food stamp payments were to be disrupted. As we’ve noted many times, government, at all levels, has already been throttling back employment for many months. The private sector is driving growth and will increasingly have to do so on its own. Cuts in discretionary spending, even if they are back loaded and spread over ten years, will mean less money for scholarships, for education, for health care, transportation and infrastructure — all vital parts of the economy.
How will this affect consumers? There was great concern that a debt crisis would cause interest rates to spike and ignite inflation. That prospect now seems unlikely. In fact, interest rates remain extraordinarily low. On net, for those with jobs and decent credit scores who want to borrow, the deal is likely to be a plus.
And America’s long-suffering taxpayers, who pay the salaries of the politicians who brought us to the brink of default? How do they come out?
That remains to be seen. The big concern among many was that this crisis would result in significant tax increases. All the big discussions — the Simpson-Bowles Commission, the Gang of Six in the Senate, the potential Grand Bargain between President Obama and House Speaker John Boehner — included revenue enhancements, the elimination of loopholes, the termination of tax credits. In other words, tax increases on some people. And at time when income tax rates and overall tax receipts as a percentage of GDP are as low as they’ve been in recent history, the prospect of making a huge dent in the deficit through spending cuts alone seemed politically unviable. And yet, thanks to a combination of Republican intransigence, moderate wishy-washiness, and Democratic lameness, the deal included no revenue enhancements. People worried about higher taxes have dodged a bullet, for now.
So taxes will never go up? Remember, I just said “for now.” As always, the devil is in the details. As the White House noted in its fact sheet, tax cuts are always just over the horizon. President Obama couldn’t get the Republican agreement to raise taxes on the wealthy, but he may not have to. Current law calls for the Bush-era tax cuts on income and investments to expire at the end of 2012. All that has to happen for taxes to rise is for President Obama and Congress *not* to agree on how and whether to extend them. And as this whole artificial crisis has shown, Washington as it is currently configured has a great capacity for not agreeing.