The media (and the public) believe that the stock sell-off began on Monday as a direct result of the rating downgrade last Friday, but this is false. Stocks were losing in value for two weeks prior to the downgrade. From July 25th through August 5th the S&P 500 dropped over 10% in value, and the Dow lost over 1,200 points. This chart shows the daily returns of the S&P during this time:
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In my opinion, the sell-off can almost 100% be attributed to a negative outlook for the economy based on three reasons:
1. Incoming austerity measures in the US
2. The European debt crisis
3. Emerging market slowdown
Households are still tremendously weak and our politicians (on both sides, but overwhelmingly Republicans) have shown a complete lack of understanding towards our current economic situation. Imposing austerity measures when the private sector is deleveraging (paying down debt) will be contractionary.
As I've touched on before, the private sector's net financial surplus (or savings) is equal to the government sector's deficit plus the foreign sector's balance. This is true by accounting identity. A decrease in the deficit will lower the private sector's net savings, which will stall the deleveraging process and result in even weaker domestic demand. We have a debt crisis in this country, but you never hear about it.
From 1980 through 1996 the private sector had positive savings rates and household debt grew at a reasonable, linear pace as shown in the first chart below. Not surprisingly, the government ran deficits every year during this period. When the Clinton administration decided to balance the federal budget in the late 90's, savings rates turned negative and households were plunged into debt in order to maintain their standard of living. This was easy to do thanks to the deregulation of the financial sector that started under Reagan and flourished during Alan Greenspan's reign as the Fed chief. From 1997 through 2007 private sector saving was negative every year except 2002, and household debt grew at an unsustainable, exponential pace as shown in the second chart.
The bursting of the housing bubble led households to increase their saving to start paying down their debt, and they have been able to do this because the government has run massive deficits. Unfortunately, the deleveraging process has been slow, and at its current pace will not be back to the 82-96 trend until 2021, as shown in the third chart.
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The biggest problem confronting our economy is the lack of aggregate demand caused by unemployment. This is a circular problem. Businesses, while flush with cash, are not hiring domestically because domestic demand has been weak. Businesses won't invest, and hire more people, until sales increase. Sales won't increase until people start buying things. People (collectively) won't start buying things until they have jobs and are out of debt. People won't have jobs until businesses start hiring. As you can see, this is difficult cycle to get out of.
The only way the Fed can affect the economy is by keeping interest rates low, which is supposed to increase borrowing in order stimulate consumption and investment. Unfortunately, we are in a
balance sheet recession, and households are trying to delever, not take on additional debt. Businesses have increased their borrowing over the past few years, but once again, they won't invest until they are confident there will be consumers to buy their products. What we need is more fiscal stimulus in order to expedite the deleveraging process and strengthen household consumption. The best way to do this is through a full payroll tax holiday that instantly gives everyone working a 4% raise. We should also hire anyone who wants a job but is unable to find one. It shouldn't be hard to find them something, anything productive for them to do.
We need to stop worrying about the fabricated public debt "crisis" and start realizing this country has no solvency risk, is not suffering from inflation (much less hyperinflation), and is being seriously threatened by the huge number of people who want to work but can't.
