"Kee" Points with Jim Kee, Ph.D.

Well, I think the elections pretty much validated the more objective predictive voting models that I alluded to (e.g. PollyVote), and they also identified many who really didn’t know what they were talking about. We’ve had two great uncertainties to get past this quarter -the election and -the fiscal cliff. With the election over we’re halfway through the unknown. This means the fiscal cliff is, of course, the big issue now. We are looking for evidence that will tell us which we are likely to see more of - compromise or conflict. This means we are watching the pronouncements of officials and the behavior of markets.

Here are my thoughts: Going into the debt-ceiling debates of 2011, there was a sizable group who felt that markets would react positively to a “hold your ground” stand-off. What happened instead was a big downward market correction, including a one day, 5.6 percent sell-off. Today we remember it as the U.S. debt-ceiling crisis, and I doubt seriously that politicians want to relive it. In other words, the fact that we know the outcome of political intransigence because of a recent prior episode makes a repeat less likely, just like the existence of the Lehman Brothers' bankruptcy and the subsequent market capitulation lowers the probability of allowing a “Lehman event” in the future. Recognizing the fact that people learn and update their beliefs led to the “rational expectations” school of thought in macroeconomics. Overlooking this insight is one of the reasons why people mistakenly overweight the importance of recent events when looking forward (according to “behavioral economics,” another new macro field).

To take a more obvious example, the failure of the central bank (the Federal Reserve) to provide liquidity and act as a lender of last resort at the onset of the Great Depression led to the collapse of the banking system in the 1930s, an observation that won economist Milton Friedman a Nobel Prize. That episode, though it happened over 70 years ago, has lessened the likelihood of a repeat. We saw this in Fed Chairman Ben Bernanke’s unprecedented actions during the 2007/08 financial crisis. He’s not popular now, but as a result of his actions we had two quarters of negative GDP growth instead of the four years of contraction experienced during the Great Depression. 

So far markets have sold off more than 2% since the election. Of course, having had such a strong run up before the election, it doesn’t take much of a catalyst to get a pull back. As mentioned above, most attribute last week’s decline to concerns over falling off the fiscal cliff; that is, the sun-setting of the Bush-era tax cuts (extended in 2010) and the implementation of automatic spending cuts (sequestration) slated for 2013. The idea is that this would push the U.S. economy into recession. The problem with this interpretation of the market’s behavior is that it is inconsistent with other recession indicators, like corporate credit spreads, which aren’t signaling recession. And globally there’s a growing perception that the economic data, while weak, is stabilizing. No one expects Europe’s problems to end anytime soon, but the vehicles put in place over the past year give it a better outlook than it had, say, a year ago. Nevertheless I think markets are looking to see whether or not compromise or conflict will best describe the U.S. political landscape going forward, because there are other issues, like regulatory stances, that go beyond the fiscal cliff. While the rational expectations model suggests more compromise, we will be watching news and the markets for additional indicators. I’m fairly confident that we’ll get more clarity over the next week or two.