Tuesday, April 19, 2011

Mules, Elephants, a Trojan Horse and a Snake

Brad DeLong writes in FT, with regard to S&P's placing of U.S. Government debt on watch with negative implications and the market reaction which included a stronger dollar and stronger Treasury securities:

On Monday we saw confidence in the US, and the dollar as a safe haven, strengthen. This means that some who were previously leery of keeping their money in dollars, out of fear of future depreciation, are now less leery. This means some in the markets expect the S&P announcement to be successful as a political intervention. In short, the market thinks the S&P has just increased the chance of a long-term budget deal.

Monday’s pattern makes sense, therefore, if S&P’s announcement is seen as a political move. The market reaction sees Congress like a mule: it only moves when hit with a whip. Normally the whip to get a deficit-reduction deal is fear of the bond market’s producing a spike in interest rates and borrowing costs, but perhaps a fear of a ratings downgrade will do instead. Over the next few months we will see if the market is right.
DeLong has a point here. But it should be added that the Federal Reserve continues to add money to the system, the short-term result of which is strength in Treasury securities market (The long-term price inflation result will be the opposite). On the dollar front we have had China supporting the dollar. Thus, it becomes difficult to clearly understand what the true market reaction would be, given these two elephants operating in the markets.

As far as DeLong's view of Congress as a mule, that may be the case, but the S&P warning, itself, should be considered a likely Trojan Horse, a gift to Americans that will result in Congress using the S&P warning as cover to do just what they would like to do anyway, raise taxes. In this context, one should also keep in mind that Congress can be more like a snake, it may have to be pushed and prodded to do the right things, but when it comes to increasing the take, Congress is always hiding in the weeds waiting for the opportunity to strike.

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