August 14, 2009
The Obama-Summers-Geithner federal deficit financing plan assumes success because it ignores the principle of “Ricardian equivalence.” And it is based on the assumption of the Alan Blinder-Robert Solow argument that over a longer term the outcome of government borrowing will be an offsetting higher wealth effect.
It will fail. We could see an offsetting positive wealth outcome if the borrowed money were all spent on productivity-enhancing societal improvements. Sadly, it is mostly spent on current consumption; hence, the Blinder-Solow argument fails.
Let’s examine Ricardian equivalence applied to the stock and bond markets.
David Ricardo (1773-1823) is ranked among the classic British economists, along with others like his good friend Adam Smith. He sponsored the notion that consumers were able to distinguish between currently financed government expenditures (through taxes) and debt financing of the same expenditures. Ricardian equivalence equalized them.
An American classical economist, Robert Barro, advanced and modernized this theory in his writings. Others like Thomas Sargent and Robert Lucas, Jr. were part of the chorus that argued that consumers and agents were “rational” and that “expectations” would act as a prompt and current adjusting force when government ran large deficits.
The risk of failure with those theories arises from what economists call “inconsistencies.” In today’s world those risks are both in time and in composition of the actors. For Ricardian equivalence to have a chance, there has to be homogeneity among the agents and policymakers in the economy. In the US today, we do NOT have it.
We are issuing massive amounts of debt in order to finance loads of current consumption. Rational expectations would have the markets immediately adjust prices for the future tax burden associated with the servicing of the debt. But more than HALF OF THE WAGE EARNERS IN THE COUNTRY ARE NOW NOT PAYING ANY SIGNIFICANT INCOME TAXES. Sure, they are paying Social Security withholding and state taxes, but their share of the federal personal income tax receipts is very small. They are positioned with inconsistency when thinking about Ricardian equivalence, since they do not experience nor expect to experience the tax burden associated with the huge debt.
The taxing decisions that impact the minority of the American wage-earner population are not made by them. Those decisions emanate from the Congress and the White House. Those policy makers have a time inconsistency which conflicts with successful Ricardian equivalence. Their time horizon is mostly less than two years until the next election. In the case of Obama it is less than four years, and the handlers of his political apparatus are already at work on the re-election campaign.
So we have two inconsistencies at work. Agent inconsistency exists, wherein only the minority of the taxpayers is paying the longer-term burden of the substitution of debt for taxes. And time inconsistency, where the decision-maker’s time horizon is much shorter than the expected debt-load servicing time horizon. Two inconsistencies equal a failure of the Ricardian equivalence.
For portfolio managers this poses a difficult dilemma. We know about the inconsistencies. We can estimate the impacts when they are finally resolved. But we have no way to estimate WHEN the inconsistencies will emerge as the force that alters market values. And we cannot be sure of the method by which they will impose their imprint on the markets when they do. Sure, it could be higher taxation or slower growth or more inflation or a weaker dollar or flight of citizens or less productivity or diminished innovation. There are many such characteristics of a society that has overextended itself and has to pay the price. But WHEN and HOW and at WHAT COST? These are the imponderables.
At Cumberland we are devoting time and energy to these strategic issues each and every day. We scour markets for clues. Meanwhile, we try to position our clients in the opportunistic sections of the markets. In bonds we are favoring tax-free Munis and taxable Build America Bond issues with good credits and tied to revenue streams from essential services provided by states and local governments. In stocks we are diversified worldwide. In our Global Multi-Asset Class, the US stock market is well under half the weight. Non-stock ETFs make up a significant portion of that portfolio.
In the US we have just raised a little cash after being fully invested for most of the rally. Our sector preferences are narrowed and favor cyclical recovery candidates. We have successfully redeployed from a cap-weighted strategy to an equal-weighted and broader strategy, with good results. Now we are putting some of that success in the bank.
Stock markets around the world have an upside bias as long as the massive and zero interest-rate liquidity remains in place. Bonds are cheap and the fear of immediate inflation resurgence is overdone. Longer-term issues are much more difficult. We are operating in an environment where Ricardian equivalence does not apply.
Two other items are unrelated to today’s commentary on markets.
First, this is from fishing guide Randy Spencer, who is a regular with our group at Leen’s Lodge and who is a personal friend. Randy is also a writer (new book is Where Cool Waters Flow) and musician. Enjoy: The Maine Guide.
Secondly, readers may be interested in the new section on Cumberland’s website. It was developed by Michael McNiven and Alex Warzecha at the request of readers who either missed or were seeking press references originating from Cumberland’s activities. The new section is entitled “Cumberland Advisors in the News” and can be found at the bottom of our homepage, www.cumber.com. The section tracks our ongoing modest contributions to the worldwide discussion regarding investing and the financial markets. The list of media quotes will be largely confined to quotes or appearances in local, national, and international media. As such, our section may be a useful portal for accessing important financial articles and content. Some relevant commentaries found in serious blogs or other online venues may be included from time to time. Our section will publish the name of the Cumberland Advisors personnel who are mentioned or quoted, the date, the media source, and the title of the article, including the link where you can go to access the content. We only publish a hotlink to the published media, and therefore some of the articles in the archive may be inoperable after several days or only partly available at the discretion of the publishers.
For starters, you may want to see many of the excellent CNBC links from the Maine fishing trip last week.
Thank you for your interest in Cumberland Advisors.
David R. Kotok, Chairman and Chief Investment Officer, email: firstname.lastname@example.org