Investors have held their breath for the past couple of weeks. Now, finally a deal has been reached between the congressional leaders of the two parties and President Obama. While it’s not yet clear whether congress will approve of it, it seems very likely.

So how will the market react? What will happen to the economy?

Initial reactions today were positive. Will this continue? Let’s summarize the positive and negative effects this will have on the market:

On the + side:

– Bondholders can relax. The US will continue to make its debt payments. And if you have money in an american bank or a mutual fund (even a retirement fund), chances are that you’re a bondholder. If the US had been forced to cancel payments, a lot of retirement savings would have been gone with the wind. Civil unrest is a possible scenario.

– Interest rates stay down. A default, or even something close to a default, would lead to catastrophic increases in interest rates. Not just on bonds, but on all loans. The value of the dollar would start to crumble. Note that you don’t actually have to default for this to happen; it’s enough if investors think that you’re going to default. And since President Obama himself had said that a default was imminent if the debt ceiling wasn’t raised, investors had good reason to believe that was the case.

– Unemployment. Making the kind of massive cuts necessary to balance the budget immediately would almost certainly increase unemployment in the short term. And since wages are “sticky” (as Keynes said – see, he wasn’t wrong about everything), it would have taken some time for them to adjust down. Former public servants would remain unemployed because their wage demands would be too high; many of them have grown accustomed to a standard of living that the private sector can’t give them (unless they’re willing to work uncomfortable and long hours – and they’re not). Also, many of the skills used in the public sector would be hard to transfer to the private sector, leading to what is known as a “mismatch”, where you have a lot of unemployed and a lot of unfilled positions, but the unemployed lack the skills needed to fill the unfilled positions. Ie, there might be a great demand for engineers and computer scientists, but all the unemployed (who used to work in the public sector) are a bunch of teachers and cops.

– Consumer confidence would have dropped if the ceiling had not been raised, since as I mentioned before interest rates would have skyrocketed and entitlement programs might even have had cancel payments. How much confidence do you think consumers would have had in the economy if their mortgage payments suddenly doubled at the same time as their old parents stopped receiving social security cheques? Since entrepreneurs follow consumer confidence closely, it’s a very important factor. An entrepreneur may decide that now is not the time to hire if they see consumer confidence falling, as they suspect consumption will fall with it.

So far so good. Nothing to be worried about then, right? Unfortunately, there is. Let’s have a look at the – side:

– Interest rates stay down… for a while. The problem with raising the debt ceiling is that allowing the Treasury to borrow another 2.1 trillion is basically the same thing as promising the markets that the US will indeed borrow another 2.1 trillion. This is my biggest problem with the deal; the increase is too big. Who knows if there will even be enough investors willing to buy US bonds so that you can borrow another 2.1 trillion? And who knows what interest rates they might ask for? To be clear, I’m quite sure the US can borrow another 2.1 trillion, but I’m not sure at what rates. “Deciding” today that you’re going to borrow another two trillions without knowing how the market will react is clearly unwise. Interest rates are based on expectations; if the market expects that the US will go into default in 10 year, then interest rates will start to rise (some) today. If I were a bondholder, I’d feel pretty uneasy about this; it looks like the US intends to borrow money until there is no more money to borrow. And at that point, who knows if they’ll have enough money to pay back what they owe me? While there are spending cuts, most of them occur in the distant future and might (will?) be reversed by future congresses. The only thing that is certain is that the US will borrow at least another 2 trillion dollars. Whether any significant cuts will follow is anyone’s guess.

– Unemployment. Since the US intends to borrow another 2 trillion, it’s quite clear the federal government does not intend to stop crowding out private investment. Rising interest rates (see above) will make life harder for private investors and employers. Hiring, as we all know, is a long-term decision. Insecurity about the future is still there, even with the debt ceiling raised. Does the government intend to continue with “stimulus”, or will it allow stimulus programs to be phased out? Since unemployment probably won’t be anywhere even close to normal levels by the time all the stimulus money has been spent, the dilemma is whether to allow the economy to recover naturally, or whether to infuse even more (borrowed) money into it. By raising the debt ceiling by this much, I think its quite clear Barack Obama wants to go down the second path, if he’s re-elected that is.

– No honeymoon for the next president. The debt ceiling, according to current estimations, will have to raised again in early 2013. This means whoever is elected President in 2012 will have to deal with the issue immediately. No honeymoon, just tackle it heads-on. This doesn’t directly affect the market of course, the big exception would be if government revenue is lower than expected (which it may be if the US economy falls into another recession). Then, we may hit the ceiling just in time for the election. If that happens, and there is a disagreement between the Republican candidate and Obama, investors will have to decide who they think will win and what chance this person has of getting his will through. Let’s say the Republican candidate doesn’t want to raise the debt ceiling at all (ie, imagine we nominate Palin or Bachmann), and investors think there’s a 50 % chance the Republican candidate will win, then they will place 50 % of their money in investments which will increase in value would the US default (they might short Dow Jones, buy credit default swaps etc). This will certainly affect the market, whether the US actually defaults or not. Investors are notoriously bad when it comes to pricing political risk – during the height of this debt ceiling mess, investors still thought there to be only a 1 in 2000 risk that the US would default within a year. That’s clearly based on unrealistic mathematical formulas, not common sense. The next president (or Obama, if he’s re-elected) will have to spend a lot of political capital immediately upon being elected. We’ve already seen how hard it can be to get everyone to agree on anything when it comes to the debt ceiling. In other words, no honeymoon.

– A secret deal. This deal is a very good deal for Republicans. No tax hikes and relatively big spending cuts. What struck me as I read about this deal was; what exactly did Boehner promise Obama in return? Was there possibly a deal struck behind closed doors? Another stimulus? More universal health care? Anything else? While its possible no such deal was made, one should at least think about it. If the GOP had to concede something, that “something” will almost certainly be bad for the economy.

Summary

I was one of those who supported raising the debt ceiling, simply because of the uncertain, potentially lethal effects of not doing so. I still think this deal was good and much better than anything I expected. Getting a deficit reduction through 100 % cuts was more than I thought congress Republicans capable of. I know that defense spending will be cut, but lets get real; Pentagon is wasting a lot of money, and wasting money is never conservative. Ever.

Since the market obviously didn’t think a US default was imminent (like I said, investors figured the risk was about 1/2000), the fact that it’s now been avoided probably won’t affect the market very much. However, the way the government has handled this, not being able to get a deal until the very last minute, has shown investors and employers again how clueless the current administration is and how lightly they handle serious issues like these.

There are some positive and some negative effects. I supported raising the debt ceiling and I still do, but the increase was too large. Another thing that disappoints me is the back-loading that is taking place with regards to the spending cuts. Instead of getting serious with them now, our leaders have decided to postpone them as much as they can.

Overall, I think the effect on the stock market will be ambiguous. The market reacted initially positive today, but then weak numbers from the manufacturing sector (the ISM factory index) ended the rally.

There’s a lot of talk of who won; Obama or the Republicans. While that’s an interesting debate, I think what’s most obvious is that the people of America lost. Their government again showed itself clueless when it comes to economic issues. This mess should have been solved months ago, but as usual, congress demonstrated just how slow it can be when it really matters.

Every average Joe in the country lost when political leaders were running a chicken race, refusing to compromise and talk until the last minute.

Hopefully after the next election we will finally have statesmen in the US congress and White House. Anything is better than the greasers we have now.

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