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The Stock Market Jitters on Good News for Retirees!

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Message Seymour Patterson

Often it's not easy to appreciate why the stock market reacts so personally and passionately to pronouncements by the Federal Reserve (Fed) chairman, no matter who that person happens to be. It did this again on June 19, 2013, plunging 1.4 percent, or 206.04 points, following statements made by the Fed. The market jitters continued on June 20, bringing a further decline of 353.87 points, or 2.34 percent. All of this happened because Fed Chairman Ben Bernanke held a press conference and expressed optimism about the prospects for the U.S. economy going forward. He said that if the economy continues to improve and the jobless rate falls to 7 percent by mid-2014, he would ease off the money stimulus pedal--not step off the brakes. The salient irony here is that optimism does not bode well for Wall Street. Imagine that! Wall Street gets upset by the optimism of the Fed's chairman about the U.S. economy.

The Market was alarmed and threw a predictable tantrum, closing down 554 points in two days. But why? The money folks on Wall Street have a collective mindset that informs how the market economy works (or should work), and who should benefit from it. It seems they are quite happy with the status quo--low interest rates, record corporate profits, low wages, and over 15,000 on the Dow. This is why they find the prospects of higher interest rates so off-putting. There's no easy way to explain psychological behavior, but the market's robust reaction to Ben Bernanke's announcement reflects the fact that it threatens to upset the financial apple cart. Higher interest rates could undermine the gains the Wall Street folks have been realizing from the way things are now.

Some minds on the Street regard high interest rates, high taxes, and budget deficits as the unholy trinity of a liberal mindset, and believe their coexistence marks the coming of the economic apocalypse. Well, maybe that's a bit too strong. But there are some entrenched views that would have the economic fix we seek revolve around keeping interest rates and taxes low, while at the same time bringing down the deficit. Ironically, two of the variables--interest and tax rates--are low right now, and the budget deficit is falling, yet no trumpet fanfare can be heard announcing a burst of economic growth.

All of the variables we have been talking about are connected in various ways. The country's savings are made up of private saving, government saving, and foreign saving. Private saving is that part of your income you have left over after taxes and the consumption of goods and services; government saving is government tax revenues minus government spending; and foreign saving is made up of what foreigners don't consume--that part of foreign production we import less their own imports from us. 

Government saving is particularly interesting, because the difference between taxes and government spending is the government deficit if spending is greater than tax revenues. That is now the case, and the deficit is about $1 trillion. If tax revenues and government expenditures are the same, the budget is balanced; but if government spending is less than tax revenues, there is a surplus.

There was an alleged budget surplus of $230 billion in 2000, which President Bush inherited from President Clinton. This surplus morphed into a staggering $16.7 trillion national debt as of June, 2013, up from the $5.7 trillion when President Bush left office. Wars, tax cuts, Medicare Part D, and the Great Recession of 2008-2009 explain much of the growth in the deficit. However, the main point is that higher deficits are logically consistent with lower national saving, so current interest rates should be high. Yet, they're not. In fact, they are very low, because of the Fed's "easy money" practice, by which it purchases U.S. government securities (bonds) on the open market to increase liquidity and depress interest rates. The strategy has been successful, insofar as it has met the intended goals of lower interest rates and economic growth.

The market interest rate is determined by the supply of loanable funds and the demand for loanable funds. The demand for loanable funds is negatively related to the interest rates. Higher interest rates will discourage firms from investing in new plant and equipment. The supply of loanable funds will respond positively to increases in the interest rate. Why? Because higher interest rates impose an opportunity cost on people holding cash.

Now, the supply of loanable funds depends on savings, which, as we just saw, can be compartmentalized into personal saving, government saving, and foreign saving. A decrease in government saving, i.e. an increase in the deficit from lower taxes or higher government spending, reduces national saving, which causes interest rates to rise. According to this framework, two bad things happen when the deficit rises: it discourages investment, thereby reducing the country's future capital stock; and taxes must be raised on future generations to retire the debt. This scenario is part of the reason for the stock market jitters.

Deficits or Not, Certain Things Are Worth Spending For

The argument against deficits is plausible, except that it ignores what the deficit, and of course the ensuing debt, pays for. If the deficit were the result only of profligate government spending, then it would not justify bequeathing to our grandchildren the responsibility for retiring the debt through higher taxes; nor would a shrinkage in the nation's capital stock serve our grandchildren well. Both outcomes would force them to bear a penalty for our own misbehavior.

It should not be forgotten, however, that the government also spends on useful things. Among the most important: a strong defense, which can leave our grandchildren a safer America; an upgraded physical infrastructure, including sound roads, bridges, canals, etc. that will still be intact and functioning for our grandchildren (though there is some current opposition to spending on these vital economic tools, allegedly because of budgetary concerns); parks and museums that will contribute to the quality of our grandchildren's lives; programs like Social Security, Medicare, Medicaid and SNAP (Supplemental Nutrition Assistance Program, or "Food Stamps") that add dignity to the lives of those dependent on them in every generation; the Environmental Protection Agency (EPA), which looks after the quality of our environment and can ensure that the environment we pass on to posterity is a healthy one; and the Federal Drug Administration (FDA), which concerns itself with the quality of the food and drugs we (and our grandchildren) will consume.

In a perfect world, all our needs would be satisfied, but political skirmishes that inform decisions on how scarce government resources are allocated take place in a less than perfect world. So public investment might have nothing to do with low interest rates (and declining deficits) and everything to do with politics.

A recent short piece in USA Today tells us that "the Senate [has] killed legislation sponsored by President Obama to spend $60 billion on building and repairing roads, rail lines and other infrastructure to help kick-start the sluggish economy." This infrastructure proposal was not the President's first. A few years ago the governors of Florida and New Jersey spurned stimulus money for a Tampa-to-Orlando train project and a rail tunnel project intended to relieve congested traffic across the Hudson River.

Indeed, the expansion of the nation's capital stock is being constrained not by a lack of funds, but by a lack of political will. What we will pass on to our grandchildren is a reduced and even inferior capital stock, as compared with that in other major economies, including China and Japan. Rather than improved capital stock, we may instead hand down to our grandchildren problematic installations funded by private investment that the government has approved against the will of the people it serves. An example may well be the Keystone XL Pipeline, which has the potential for very serious environmental damage as it transports tar sands oil from Alberta, Canada through six U.S. states to refineries on the Gulf Coast of Texas, a 2,000-mile journey. (See Friends of the Earth)

The Keystone project is still pending the approval of the president of the United States. But it is a good example of foreign saving--properly, foreign direct investment (FDI), which, as indicated above, technically increases national saving and lowers interest rates. This means that, if the pipeline proposal falls through, there would be a loss of savings and higher interest rates, the very result that can cause Wall Street to have a hissy fit.

Higher Interest Rates Will Benefit Many on Fixed Incomes

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Seymour Patterson received a Ph.D. in economics from the University of Oklahoma in 1980. He has taught courses and done research in international economics and economic development. He has been the recipient of two Fulbright awards--the first in (more...)
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