Friday, July 29, 2011

The Dysfunctional U.S. Government

It's Friday afternoon and amazingly the U.S. Congress has yet to agree on a bill that raises the debt ceiling and reduces spending. This is forcing investors to deal with an unprecedented level of uncertainty. Stocks have been selling off despite recent financial reports that largely show strong revenue and earnings growth. Despite strong earnings, a number of CEOs have commented that increased macroeconomic uncertainty and political risk make it extremely difficult to plan for the future.

On top of all this, the latest GDP report was extremely disappointing. All of the increased spending by the government to try to save the economy appears to have been for naught. The Advance Estimate for Q1 showed extremely meager growth of just 1.3%. As disappointing as that figure is, the downward revisions for prior quarters were even worse. In fact, for the entire 2007-2010 period, the Commerce Department had previously estimated that the economy grew at an average annual rate of 0.1%. In other words, it hardly grew at all. Yet now the Commerce Department says the economy actually shrank at an average annual rate of 0.3%. Furthermore, the average annual rate of growth of real disposable income during the period was halved from 1.2% to 0.6%.

These revisions make it clear that the U.S. economy was doing much worse than the government’s already dismal statistics suggested. Of course, all those unemployed people who are still having trouble finding jobs already knew that. However, during the same period, most corporations have done an excellent job of getting their own houses in order. Although the Commerce Department revised corporate profits down by 1.1% for 2008, it revised profits up 8.3% in 2009 and 10.8% in 2010. Unlike the government, corporations don’t have the luxury of financing losses ad infinitum with indefinite amounts of borrowing. Corporations that can’t generate profits do not stay in business for very long. If there was any doubt, recent events in Washington confirm that the average corporation is much better run than the government is.

A last minute compromise between Republicans and Democrats is still possible. However, the dysfunctional manner in which an agreement is being hashed out makes it almost a certainty that America’s credit rating will eventually be lowered. While a downgrade would be unfortunate indeed, it does not necessarily mean that interest rates will skyrocket. While events in Washington make it clear that U.S. government securities are more risky than investors previously believed, there is little doubt that most investors would still prefer to own U.S. bonds than the bonds issued by almost any other nation. Even so, shares of well run companies would probably provide a safer haven.