Wednesday, August 25, 2010
These charts use data from the Markit indices of credit default swaps, as of yesterday. Spreads have widened a bit over the course of this month, but when you put this in the context of the past few years, the widening is hardly noticeable. Is the recent widening a sign of emerging economic weakness (e.g., the dreaded double-dip)? I don't think so. The magnitude of the widening isn't big enough to signal anything other than random noise or subtle shifts in sentiment—there has been no significant or fundamental deterioration in the economic outlook at all this year, according to these figures. And the outlook remains dramatically better today than it was early last year.
Of course, these charts also show that the fundamentals of the economy are still much worse than what we would expect to see in a normal expansion—spreads are still substantially higher today than they were in early 2007. So the economy is doing much better than the market expected a year ago, but the economy is still far from being termed "healthy." I think the explanation for the relatively poor performance of the economy is not too difficult to pinpoint: it's fiscal policy, stupid—huge increases in government spending and regulatory burdens, coupled with huge uncertainty over the level of future tax burdens. We could argue about monetary policy, since it has created huge uncertainty about future inflation risk, but at this point monetary policy is a minor problem compared to fiscal policy. The Fed can't create growth out of thin air, but intelligent tax and spending policies can, by altering the incentives to working and investing.
The economy has been facing serious fiscal headwinds for the past several years. That's a bummer, to be sure. But if anything, the outlook for fiscal policy today is not as bad as it was a year ago. Cap and trade is dead, and it appears highly likely that the Democrats will lose enough seats in Congress this November to make regulatory gridlock a reality (and one devoutly to be wished). With a little luck, the November elections could result in outright reform of fiscal policy.
My point here is that the problem of bad fiscal policy is nothing new, and sensitive indicators of the economy's health (e.g., swap spreads and credit spreads) do not reflect any meaningful deterioration in recent months. All of the angst and hand-wringing over a double-dip recession might just be the growing realization that we have had a big fiscal problem on our hands for quite some time. If that's the case, then the hue and cry might actually be a good thing, since it could nudge policymakers and the electorate in a direction that might restore some common sense to Washington.
Yes, things are bad, but that's nothing new. What's important on the margin is how things are likely to change in the future, and whether those changes are being factored into today's prices.
Posted by Scott Grannis at 11:11 AM