When I over the last couple of days have looked at my twitter account nine of ten tweets have been about the “fiscal cliff” and the financial media all over the world have been all about that horrible “cliff”. Commentators from left to right in the US have issued warnings about the horrors of the fiscal cliff. Yes, it has felt very much like we indeed have been heading for an economic meltdown. Economic slowdown in China or the euro crisis is not important – the only thing important is the fiscal cliff (blah, blah…)
Just take a look at what Google Trends is telling us. The graph below shows searches for “fiscal cliff” over the last 90 days.
Since mid-November the searches for “fiscal cliff” has clearly picked up and really spiked in the last couple of weeks.
However, despite the desperate efforts of pundits and the financial media the fiscal cliff has never really become a serious market theme. The best way to illustrate this is to look at the US stock market – and more specifically on two sets of stocks – defense stocks and “consumer discretionaries”. Both sectors should be expected to be impacted heavily in the event of a full-blown fiscal cliff event as a result of tax hikes and cuts in US defend spending. I have looked the two sectors’ performance during 2012 relative to the overall stock market performance (S&P500).
If the market really had been worried about the fiscal cliff we should have seen defense stocks and consumer discretionaries plummet. However, as the graph below shows that has certainly not been the case.
In fact both consumer discretionaries and defence stocks have outperformed the overall US stock market since August-September. Therefore if anything the performance of these two sub-indices have been positively correlated with the fiscal cliff “worries”.
In fact I would argue that the markets have paid little substantial attention to the ongoing political noise from Washington. It is for example notable that defence stocks have continued to do well despite Obama’s reelection.
This of course do not prove that fiscal policy is not important – far from it, but other things are certainly much more important and the markets are a lot more forward-looking than it seems to be the “normal” perception in the financial media. The discussion of the fiscal cliff has not been (a market moving) surprise to the markets and neither has been the political “show” that we have seen in recent weeks. Yes, the US political system is dysfunctional, but that is really no surprise to the markets. Nor is it likely to be a surprise to US corporations and consumers. As consequence it hard to believe that the fiscal cliff can be classified as an “shock” to the economic system.
A the fiscal cliff as a textbook take-it-or-leave-it game
As my good friend professor Peter Kurrild-Klitgaard has noted the negotiations about the fiscal cliff has been a complete textbook example of a take-it-or-leave-it game. Even though pundits on the left and the right of US politics have bashed both the GOP and the Democrats for failing in the negotiations there is really nothing surprising about how the negotiations have played out. Any student of game theory would tell you that and apparently the markets understand game theory better than pundits and the financial media reporters.
There is no reason to play the blame game here – both the GOP and the Democrats (including the President) have so far pretty much behaved rationally (in a game theoretical sense) – that of course do not mean that what they are doing is nice to look at or for that matter in the interest of the American people, but game theorists would not be surprised – neither has the markets been.
For good discussion of the game theoretical aspects of the fiscal cliff negotiation see this excellent post by John Patty on the “The Math of Politics” blog from December 14 2012.
The real market mover is monetary policy
Finally let me just repeat the Market Monetarist position (see more previous posts on the issue here, here, here and here). Monetary policy dominates fiscal policy – the Fed will be able to counteract any negative shock to aggregate demand (or nominal GDP). The performance of consumer discretionary stocks pretty well illustrates this. As the market started to price in QE3 in August and later was positively surprised by the implicit announcement of the Bernanke-Evans rule in September consumer discretionaries have rallied. Hence, at least judging from the stock market performance monetary policy has dominated fiscal policy worries. I am not arguing that if the there had not been a “deal” on the fiscal cliff the markets would have not seen a set-back, but I am certainly arguing that this issue has gotten far to much attention compared to have relatively unimportant the issue is.
I am normally not making predictions here, but I today predict that “fiscal cliff” searches on Google has already peaked (but no I am not a betting man). From today the fiscal cliff is so much 2012. It is time to focus on something else…also for the financial media.
PS fiscal policy always have an impact of income distribution and as far and as I can see this is the real issue in the US, but that does not really make the discussion important from a macroeconomic perspective (unless it has supply side effects).