Saturday, February 12, 2011

The deficit and the stock market

Is the deficit choking the stock market? The answer is Yes. In this article, I’ll explain how a deficit helps to reduce investment in the stock market and also reduce long-term growth.

First, we need to understand that the government is competing for the same money as the private sector. When the government runs a deficit, it must find people who are willing to buy the country’s bonds. The money that was spent on those bonds could have been invested in the private sector, where it would most likely have been used better. This is how the government can crowd out private investment.

The consequences, however, doesn’t stop there.

The interest rate on government bonds is called the risk-free rate. This si the rate of return which you can get without taking on any risk, since governments, in particular in western countries, do not default (lately we’ve seen a few examples of countries which may default, but so far they haven’t).

Shares have to give a better return than government bonds, simply because they are risky. Investors are, as we say, risk-averse – if they have to choose between 10 % certain return and 10 % risky return, they choose the certain return. Why wouldn’t they?

A high-risk share has to give a higher return than a low-risk share. If you have a 50 % risk of losing all your money (which is what happens when a company goes bankrupt), you would certainly demand a really high return, while if you only have a 5 % risk of losing all your money, the return you demand would be a lot lower.

There is a model called CAPM, which predicts how much return every share must give based on how risky is it. The risk associated with a share is called Beta. Beta means how well a share follows the market. If a share has a beta of 1.0, that means that every time the stock market goes up 1 %, this share goes up 1 %. If it has a beta of -1.0, that means that every time the stock market goes up 1 %, it falls 1 % (and vice versa of course). If it has a beta of 2.0, that means that every time the stock market goes up 1 %, the share goes up 2 % (that’s a risky share).

A share with a high beta is more volatile – it has bigger swings than the average share – and so it must give a higher return, or no-one will invest in it. Let’s say the average stock market return is 10 %, and the return from government bonds is 4 %. Then, the “risk premium” is 6 % – this is the extra return that you get from taking on risk (which you do if you invest in the stock market).

If a share has a beta of 2.0, it must then give 4 + 6×2 = 16 % return. Since it is twice as risky, it must provide twice the risk premium (which we already established was 6 %, the difference between stock market and bond return). Similarly, a share with a beta of 0.5 would only have to provide 4 + 6×0.5 = 7 % return, since a low beta indicates smoother movements in the share price and so a lower risk.

Now let’s imagine the return on government bonds double. As the government keeps borrowing money each year, investors demand a higher and higher return, so this is bound to happen. Suddenly, investors will demand 8 + 6 = 14 % from the stock market (assuming the risk premium is the same, and there is no reason why it would change).

This means that companies must provide higher returns, which equals higher dividends, than before (the stock price depends largely on the size and growth rate of the dividends). This means that the company has to plow back less money than before – if it used to pay 30 % of its earnings in dividends, now it may have to pay 40 %.

This ensures that the company cannot grow as fast in the long run. The worst thing is that it has to spend less money on Research and Development (R&D). If all companies has to do this, that means that there will be less research, and less development. Technological progress slows down as companies cannot afford to invest in it, having to pay more and more money to their shareholders. Many investments which used to provide a good enough return won’t do so anymore; the rate of return required will be higher.

Technological progress is the only thing that can lead to growth in the long term. Increasing savings, or printing money, can both cause short-term growth, but in the long run, you must get more and more efficient if you want to grow. If companies cannot get more efficient, the economy won’t get more efficient and so it cannot grow.

The companies which cannot provide this new, higher rate of return will lose their investors and go bankrupt, or at least suffer severe cuts in their stock prices. Needless to say, this is not good and causes the stock market to fall, making the average american poorer.

If the US were to pass a balanced budget amendment, more companies would spring to life, and more companies would go public (why go public if you’re not sure what rate of return you’ll have to provide?). It would significantly lower the return the government had to pay on american bonds – US government bonds are already being described as the next bubble – and so lower the risk-free rate. Why hasn’t this been done already?

Thanks for reading. Please leave a comment

John Gustavsson


Right Wingnut said...

Good post. I would also add that higher deficits usually means higher taxes and interest rates. Both are profit killers.

carlo said...

What RWN said!

John said...

Yep, that's what I meant by the risk-free rate going up - that is the interest rate you get when you lend money to the government. This post focused on the stock market, but you are right about taxes as well.

Ann said...

I really don't know much about this topic but your piece is very well written.

credit cards said...

There are times during which the government incurs higher expenses than its revenues. In such a case we observe a government deficit. This means that the government spends more than it gets from taxes and other types of income.