Tuesday, August 2, 2011

Stock Market Declines Sharply. Is Debt Deal to Blame?

The stock markets declined sharply today. Several sources point to various factors -- including the passage of the debt deal -- as the cause of today's dramatic decline.

Because the debt deal requires an extraordinary reduction in government spending, many analysts fear that this will worsen an already struggling economy. Governmental participation in the market for goods and services increases demand and generates economic activity. If this demand declines, however, then so will the overall volume of business activity. This is basic macroeconomic theory.

Bloomberg/Business Week:
Many economists, including Federal Reserve Chairman Ben Bernanke, have said the U.S. economy would gain momentum in the second half of the year as gas prices fall and Japan's factories recover from the earthquake disaster in March. Slow U.S. manufacturing growth, a weak job market and concerns about spending cuts in the debt deal have cast doubt on those predictions.
The Street:
The parade of poor economic numbers has started to fuel speculation about a possible need for further monetary easing by the Federal Reserve, although the rise in inflation in recent months presents an obstacle to further stimulus. The deep pullback in government spending necessitated by the deficit reduction legislation, coming as it does amidst a time of high unemployment, added to nervousness over the economic outlook.
Some economists had already predicted that the spending cuts would harm the economy.

Paul Krugman

Krugman criticized President Obama for "surrendering" to the Republicans. Krugman also argued that cutting spending was bad news for a potential economic recovery:
Start with the economics. We currently have a deeply depressed economy. We will almost certainly continue to have a depressed economy all through next year. And we will probably have a depressed economy through 2013 as well, if not beyond.

The worst thing you can do in these circumstances is slash government spending, since that will depress the economy even further. Pay no attention to those who invoke the confidence fairy, claiming that tough action on the budget will reassure businesses and consumers, leading them to spend more. It doesn’t work that way, a fact confirmed by many studies of the historical record.

Indeed, slashing spending while the economy is depressed won’t even help the budget situation much, and might well make it worse. On one side, interest rates on federal borrowing are currently very low, so spending cuts now will do little to reduce future interest costs. On the other side, making the economy weaker now will also hurt its long-run prospects, which will in turn reduce future revenue. So those demanding spending cuts now are like medieval doctors who treated the sick by bleeding them, and thereby made them even sicker.
MSN Money
Joel Naroff, president of macroeconomic consulting firm Naroff Economic Advisors, disagrees with the plan on this fundamental level. "The idea that increasing taxes cuts jobs but decreasing spending doesn't is silly," he says. Instead, a decrease in government spending is going to slow economic growth, worsening an already dismal national economic situation. "It's going to slow growth. If you have slow growth, you're going to have less hiring. In some parts of the economy, there are actually going to be layoffs." In particular, Naroff foresees further job losses in state and local government.

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