How to Respond to an U-G-L-Y Market

In today’s edition of The New York Times, Nobel Prize winning economist Paul Krugman of Princeton notes that the stock market is in terrible shape — which is obvious — while also making the point that the bond market highlights what is really going on. 

The US 10-year [note] rate is now down to 2.5%. So much for those bond vigilantes. What this rate is saying is that markets are pricing in terrible economic performance, quite possibly a double dip.

Brad DeLong of Berkeley agrees, as does Ryan Avent,economics correspondent for The Economist.  As Avent puts it:

WALL STREET is betting on a double-dip recession.

All financial-market signs now point to a return to economic contraction. The S&P 500 has dropped 9% in two weeks. American government borrowing costs are plummeting, which could conceivably be construed as a result of increased confidence in America’s finances in the wake of the debt-ceiling deal, except for three things: 1) the deal didn’t fundamentally improve America’s finances, 2) equities are tanking, and 3) so are inflation expectations. Yesterday afternoon, yields on inflation-protected Treasuries signaled a 5-year expected inflation rate of about 2.08%. That has since fallen to about 1.86%. The yield on 3-month debt is back to 0.0%, the yield on the 30-year Treasury is 3.79%, and 10-year yields are back to levels observed last August, which prompted the Fed to engage in QE2. Commodities are dropping like rocks—oil is back below $90 a barrel—except for gold, which continues to hit nominal highs. The dollar is also strengthening.

Ask why if you want; there’s no shortage of reasons. American growth dropped to stall speed in the first half of the year, and the government is content to saddle the recovery with substantial fiscal tightening over the next year. Europe is on the brink, and its leaders are on vacation. Falling markets will add to reduced confidence. At this point, the self-fulfilling spiral back into recession is underway.

Clearly, the news is ugly.

Krugman, DeLong and Avent focus their prescriptions on what the Fed should do in response.  But Ken Rogoff of Harvard and one of the authors of the outstanding This Time is Different suggests that the answer lies elsewhere

But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.

Accordingly, he suggests a different approach.

Many commentators have argued that fiscal stimulus has largely failed not because it was misguided, but because it was not large enough to fight a “Great Recession.” But, in a “Great Contraction,” problem number one is too much debt. If governments that retain strong credit ratings are to spend scarce resources effectively, the most effective approach is to catalyze debt workouts and reductions.

I’m with Rogoff.

3 thoughts on “How to Respond to an U-G-L-Y Market

  1. Congratulations on your new blog!

    I’ve signed up for the email updates, and I’m looking forward to following it.

    I’m trying to stay calm about the plummeting markets, and remind myself that this can be good news for those with long-term horizons.

    Best wishes, Wade

  2. I have a lot to do here before I am ready to “go public,” but I appreciate your visiting and subscribing, Wade. With respect to the market, I am hoping for the best but have been expecting a major correction.

  3. Pingback: U.S. Downgrade Deserved | Above the Market

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