‘The market is rational and the government is dumb’

The above quote is a favorite of former House Speaker Dick Armey (R-TX). He even used to write it on the blackboard on the first day of class when he was an economics professor. Armey has been out of government for years, but as a founding member of a Tea Party group, he’s been a big influence on that wing of the Republican Party. Not surprisingly, he seems pleased with the pounds of flesh they’ve extracted in the new Budget Control Act of 2011.

Armey and I have different ideas of “dumb.” He favors slashing government spending during our Little Depression and also favors a balanced budget amendment that would supposedly compel further slashing. I think those things are time-tested recipes (the times being 1932 and 1937) for worsening a depression. What do the markets think?

The stock market is on track for its eighth straight day of decline (as of 11:55 a.m., the S&P 500 is down 0.5%, and its biggest drop, 2.6%, was yesterday, when the Budget Control Act finally passed). 10-year Treasury bond prices have been rising, and T-bond interest rates falling, over the same span, now down to 2.57%. How to interpret those numbers?

Hard to do, because nobody (as far as I know) takes scientific polls of market participants to ask them why they did what they did. Armey would probably say, as some commentators have, that stocks have tanked because the $2.1 – 2.5 trillion in cuts over a decade aren’t enough. I would say, as have others, that the market is reacting to the dismal state of the economy and to the likelihood that, as basic macroeconomic theory tells us, the spending cuts will make it even more dismal.

What about bonds? The rosy view would be that T-bond prices have improved because the debt-ceiling vote means no default through 2012 and the spending cuts reduce the overall burden of debt. Armey and I might actually agree that the unrosy view is correct: T-bonds are in higher demand because of a worldwide “flight to safety,” as grim economic news causes people to move away from risky, cyclical assets like stocks and toward safe assets like T-bonds. Again, is the grimmer news the “failure” to slash spending more or the weakening economy?

I’m thinking Armey’s quote fits right now, except it’s the budget bloodletters who are dumb and the markets are rationally reacting by anticipating that they will cause further hemorrhaging of the economy.

P.S. At least one market participant agrees. From the Aug. 2 Financial Times:

‘Jim Reid, strategist at Deutsche Bank, . . . has warned the US could be approaching a “1937 moment” – when authorities removed post-Depression stimuli from still-fragile markets and triggered another recession. This risk, he says, has in fact only been magnified in the markets’ eyes by agreement on raising the US debt ceiling.’

(Hat tip: Brad DeLong)

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