Fog of Uncertainty Lifts but We Don't Like What We See

Markets hate uncertainty. So the conventional wisdom goes. And it is true. But the reduction of uncertainty can be a mixed blessing, especially if what becomes more certain is likely to interfere with recovery from the recently ended recession.

Ben Bernanke has been confirmed for another term as chairman of the Federal Reserve Board. But confirmation came at a price — the further dilution of the Fed’s independence. The leader of the Senate Democrats, Harry Reid, says that in return for his support, Bernanke has promised to ease credit further. How that is possible with interest rates already effectively at zero, and printing presses working overtime to turn out dollars, is unclear. And it is unclear how the Fed chairman could have made such a promise while at the same time repeating his commitment to begin withdrawing central-bank support from the mortgage market.

My own guess is that Bernanke will move gingerly to tighten, a little bit and not right away, keeping a wary eye on the politicians upon whose support he is increasingly dependent. If he ignores them, he will encourage the drive for legislation that will limit the Fed’s freedom of action.

Another uncertainty that has been dispelled concerns the president’s reaction to his party’s loss of the Massachusetts Senate seat long occupied by Ted Kennedy. A similar setback prompted Bill Clinton to move from left to centre — the place on the political spectrum that is home to most voters. Not Barack Obama. In last week’s State of the Union message he repeated the themes of his campaign and inaugural — transformation of the healthcare and energy sectors, regulation of big banks, support for education, and economic stimulus, the latter relabelled as a jobs package. And he challenged his congressional colleagues to use their huge majorities in both Houses to pass his legislation. A display of political courage, or of deafness to the expressed wishes of the electorate, depending on which side of the aisle you sit.

So we know that the era of big government is not over, as Clinton claimed when he swung right after disastrous mid-term elections. Any doubts on that score were dispelled when the president announced his risible deficit reduction programme. The annual deficit was reported last week to be $1.3 trillion. And rising. The president proposes to attack this elephant with a pop-gun — a freeze on 17% of the budget. In the unlikely event that an unhappy Congress accepts such a plan, it will cut spending by only $25 billion a year.

Meanwhile, legislation requested by the president and already approved by the House of Representatives calls for new spending in excess of the projected savings. More spending on education subsidies, childcare benefits, infrastructure, subsidies for low-income mortgage holders and energy efficiency, funding of basic research in energy production, “a comprehensive energy and climate bill” certain to drive up energy costs — a list to warm the heart of Gordon Brown. Throw in a second stimulus and $30 billion for small, regional banks, and it is easy to see why Democrats who do not represent far-left constituencies fear they will have difficulty selling themselves as the guardians of the taxpayers’ purse at the mid-term elections in November. Little wonder that the non-partisan Congressional Budget Office says the US budget outlook is “bleak”.

So we now know that taxes will go up. Call it “fees” in the case of banks, or taxes on “the rich” in the case of income taxes, but up they will go. And swamp the tiny tax benefits the president plans to bestow on small businesses that “hire new workers or raise wages”, the latter not considered by most economists a sensible way to create jobs.

We know, too, that bank regulation will be tightened. The president, to the applause of Mervyn King, governor of the Bank of England, wants to adopt the plan proposed by Paul Volcker, former Fed chairman and inflation slayer. Banks that take customers’ deposits would be limited to plain vanilla lending, and their risk-taking subsidiaries spun off so they cannot again bring down the banking system. God is in the details, and since He has not been known to make His presence felt in Congress to preach sense to the sorts of politicians who seem to dominate the legislature these days, we will have to wait to see if this idea leads to sensible legislation.

All of which means we know that the future of the economy is now heavily dependent on what Congress does with the president’s proposal to expand government intervention. It does seem recovery is under way. The economy grew at an astonishing 5.7% annualised rate in the last quarter of 2009. Businesses are once again investing in software and equipment, the inventory drawdown has ended and stocks are being rebuilt, investors are increasingly confident that the Fed’s withdrawal from support of the mortgage market will not cause a significant rise in interest rates, unsold inventories of new homes are at their lowest level in 40 years, and consumer confidence has ticked up.

But the recovery is fragile, and it can be aborted by the slightest policy slip. Increased taxes on “the rich”, a group that includes most small businesses, will surely stifle expansion of the nation’s most important job-creating sector.

If the Fed waits too long to tighten while the federal government continues pouring red ink over the nation’s ledgers, interest rates will surely rise, taking steam out of the recovery. If bank reform takes an ugly, populist turn, credit might become even less available than it is now.

These are big “ifs”, obviously roiling stock markets. But at least we know that it is policy that will determine the course of the economy in the near term, that the federal government is set on a tax-spend-borrow course, and that the central bank’s independence has been compromised. We might wish those things were not true, but they are. Reduced uncertainty, you see, is not always a blessing.