Popular Economics Weekly

The plunging financial markets are telling us something depression, but it is more about crowd psychology, than actual events. Americans are very depressed about their financial prospects. Duh, says Paul Krugman, given the congressional deadlock. So why is it causing such market turmoil? I maintain it is because of the unfounded downgrade by Standard & Poors of U.S. Treasury securities to AA+ from AAA. This event has to be almost as shocking as 9/11 to our collective psyches. For just as Bin Laden meant the 9/11 attack to be an attack on our economy, the S&P downgrade means we are no longer the world’s only economic superpower.

So will the downgrade, which hasn’t been matched by either Fitch or Moody’s bond rating services, have an effect on real economic growth is the question. Yale Professor Robert Shiller and other behavioral economists maintain that consumer confidence, or ‘animal spirits’, affects consumers’ behavior. Professor Shiller also says that much of how people judge the economy doesn’t come from facts or economic fundamentals, but the stories they hear, as well as the degree of optimism or pessimism they feel about their own circumstances. For instance, surveys by Professors Shiller and Karl Case in their Macro Markets LLC, show that the housing bubble was fueled in large part by hearsay and media stories that housing values had always risen, and would continue to do so.

So confidence is only one factor that economists look at for their predictions. It’s a good thing, because we are seeing moderate economic growth at the moment and jobs being created. Even retail sales are surging at the same time that consumer confidence measured by the Conference Board and University of Michigan surveys is at recession-levels.

So it may be that plummeting confidence in financial markets is causing the extreme market volatility of late, rather than economic fundamentals. For instance, the rise in the Consumer Price Index showing some inflation was the reason given for the stock market plunge, along with very negative Empire State and Philadelphia Fed industrial sentiment surveys.

But inflation is also a sign of increasing demand, and prices must rise for businesses to expand. The core CPI index without food and energy fluctuations is up just 1.8 percent annually, while industrial production is still healthy, according to the Federal Reserve. On a year-on-year basis, overall industrial production is rising at 3.7 percent in July. Overall capacity utilization in July also improved to 77.5 percent from 76.9 percent the prior month, signaling that businesses are expanding.

Then why were the Philly and Empire State surveys so pessimistic? It may be that since both surveys are a consensus of managers’ predictions about future prospects, they could also have been affected by the S&P downgrade, which is radiating outward as hedge funds and retirement funds with extensive holdings of Treasury securities also risk being downgraded by S&P, who has decided that it has to make up for allowing AAA ratings on subprime mortgage securities during the housing bubble, thus prolonging it.

There are also other indicators that show sentiment doesn’t match behavior. Imports are surging, the reason for the larger trade imbalance, which corroborates the higher retail sales’ numbers. And weekly initial unemployment insurance claims continue to fall. Though there was a slight uptick in last week’s claims, the four-week average fell for the seventh straight week, down 3,500 to a 402,500 level that is nearly 20,000 lower than the month ago comparison. In fact, private sector nonfarm payrolls grew 154,000 in July, following an 80,000 rise in June and 99,000 increase in May.

S&P has admitted their downgrade wasn’t really about the numbers, but about their judgement that the political situation could be gridlocked for years to come. This is because the numbers aren’t that bad. Most of the deficit is short term; caused by the Bush tax cuts, ywo unpaid wars and lost revenues from the Great Recession. The wars will end, so defense budgets will shrink, and revenues rise as economic activity continues to pick up. Politicos might also realize that most of those Bush tax breaks should probably be allowed to expire in 2012, rather than be renewed. This in itself would save some $3.8 billion over the next 10 years, according to the Center for Budget and Policy Priorities.

So S&P wasn’t making a judgment about the near term deficit, which they had overestimated by $2 trillion, but about what the federal deficit may look like in 10 years. Yet how can anyone know about events so far into the future? Though given the post-recession frayed nerves of consumers and investors, even the slightest ‘aftershock’ can cause an outsized response.

Harlan Green © 2011