Perception is the new reality

The situation of the US economy Is pretty bad, and today’s figures add to the gloom, but the markets seem to take it all in their stride. Very curious.  Why are the markets holding up?
Consumer confidence fell further, house prices are now down 11% and in both statistics there is absolutely no guarantee that it won’t get worse. Home foreclosures more than double versus the first quarter last year.

Against this tidal wave of bad news, there are a couple of forces at work that are supporting the markets. Monetary and fiscal policy are very expansionary but, as we have discussed yesterday, we have reservations about whether they are as effective as many people seem to think (or hope).

Interest rates could be lowered again, but how effective that is in an environment in which banks are very reluctant to expand new credit remains to be seen. Also, inflation is becoming a serious problem that the FED cannot ignore for too long.

The Government budget is already balooning, so there is hardly room for another tax cut. It is also questionable whether these tax cuts have targetted the right people. In order to be effective, the people (or institutions) on the receiving end of them should spend it immediately, as you want the biggest bang for every dollar of tax cut.

If people just put the money in a savings account it won’t really help a whole lot. So it’s best to target people in distress, the unemployed, people who’s homes have been repossessed, local government with financing problems who would otherwise cut back on spending, things like that.

I’m afraid the tax cut has been too general, not targeted at those sectors which most likely would spend most of it immediately. If the $150B or so would have been concentrated on sorting out the victims of the mortgage mess, it might have had the additional benefit of helping to stabilize that market, much increasing the effectiveness of the tax cut.

Also, there is not much room for further expansion.

Perception might be the new reality though, at least for a while. One reasons the markets hold up so well might just simply be that the authorities seem to have responded swiftly. That’s kind of reassuring, as long as not too many awkward questions are asked about the effectiveness of the measures. But perceptions can change swiftly.

A second force holding up the markets is the falling dollar, exports are booming as a result. But there are limits here as well. A falling dollar makes import prices more expensive, contributing to inflation, which is already high. And a falling dollar exports American problems abroad.

A beggar-thy-neighbour round of devaluations which brought world trading to a grinding halt in the 1930s is still far off, but protectionary forces are on the rise.

The last force holding up the markets is that unemployment has been holding up surprisingly well. If that starts to drop, things will get ugly, and since unemployment is typically a lagging indicator, this might happen any time. In fact, we’re already in the early stages of this.

Unemployment rose from 4.8% to 5.1% of the labour fource in March. That figure, 5.1%, still looks pretty good. Perception rules again. Wait how things will look when it hit 7%, which it very well might.

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