Wednesday, November 5, 2008

The election, markets, and the economy

Obama, the candidate less friendly to capital and markets, will be our next president. I think the prospect of an Obama presidency has concerned the markets for some time, contributing to depressed valuations in recent months. If we knew with certainty that he would raise the tax rate on capital beginning next year, we would be well-advised to sell any stocks this year that we are holding with gains (and with the market down this morning, some appear to be doing that already). And on the margin, we would all be less eager to buy stocks, since the after-tax reward to owning them would be less in the future, and that's not good for stock prices either.

But we don't know for sure what will happen next year. It's hard for me to believe that any new president would make it a top priority to raise taxes on the rich and on capital when the economic outlook is as uncertain as it is today. It's more likely that fiscal stimulus would get top priority, and it's not farfetched to think that Obama would prefer rebate checks and infrastructure spending to tax cuts. In my view this would do little to improve the long-term outlook, but at least that wouldn't be as harmful as higher taxes.

In fact, he might find that the easiest course of action is to leave the tax code alone next year. The Bush tax cuts are set to expire at the end of 2010, which would mean a big increase in taxes in 2011. He could simply let that happen (though he would probably want to exempt the non-rich from scheduled tax hikes), figuring the economy will be strong enough by then to withstand higher taxes, and higher taxes would be necessary to pay for all the deficit spending he is likely to prefer next year and in 2010. And he would never have to take responsibility for increasing anyone's taxes: if the tax increase ended up being problematic he could blame it on Bush. (HT to Greg Mankiw for this idea)

In any event, the market is still deeply concerned about the future, so the question we need to ask is whether the worst that Obama could do has already been discounted into prices. I suspect it has.

Thus, the primary issue for the immediate future is the return to health of our financial markets. On that score, it is clear that progress is being made. Key measures of fear (e.g., implied volatility) are trending lower, and key measures of liquidity (e.g., the TED spread and swap spreads) are showing ongoing improvement. If financial markets regain some semblance of normalcy, this would be a huge positive for the economy, since it would create a positive feedback loop that could pull us out of this mess in fairly short order.

Optimism would therefore seem to be the preferred state of mind at this point, even if one is depressed at the prospect a leftward policy lurch in the future.

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