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Politicians are Playing with Fire

Politicians have the ability to screw up the economy. Investors remain focused on three major concerns: the debt ceiling imbroglio, default risk in Europe and the pace of economic recovery in the U.S. All three may be disruptive and damaging to markets and the economy, although the first two are matters of policy and should be overcome with sensible policy judgments. Instead, the markets remain hostage to the political game of chicken underway, waiting to see who blinks and whether the U.S. will default on its debt. This will not happen if common sense prevails. Unfortunately, investors lack confidence that politicians will make good decisions.

Some banks in Europe are inadequately capitalized to absorb the losses that would result from a default by Greece or any of the peripheral nations of the eurozone. The latest stress tests did little to calm these concerns, since bank capital were not stressed for the possibility of a sovereign default, even though the market perceives such as event as the most immediate risk. So, European nations have collectively loaned Greece money to defer the day of reckoning and will surely require weaker banks all across Europe to raise more capital. At some future point, Greece’s debt will be restructured. Critics call this “kicking the can down the road”, but it is actually a sensible way to allow the restructuring to occur when the banks are better able to handle it.

In the U.S., the debt ceiling limit that might force the U.S. to default is entirely a self-inflicted wound and need not occur at all. However, democrats and republicans are using the debt ceiling as an opportunity to play chicken with each other, by threatening default unless the other side makes concessions with regard to fiscal policy. Republicans have been focused on spending cuts, while democrats are demanding some tax increases as part of the package. The devil’s in the details, of course, insofar as whose programs get cut and whose taxes go up. Moreover, the arguments and public posturing are highly politicized. There are some obvious ways to compromise and politics is the art of compromise. But it says much about the current state of U.S. politics that the two sides seem unable to work a deal without a looming deadline to force them to face the abyss.

Most likely, a deal will be struck at the very last minute. And yet, Congress needed a meltdown in the markets in 2008 after they had voted down TARP the first time to convince them that a sizable program was necessary. We don’t need a second impasse to demonstrate total lunacy. But this fiscal battle has turned into a bare knuckle brawl that places the economy at risk. The markets have already signaled to the politicians they should not do this. Will the politicians listen? A few of the more extreme politicians are willing to play with default to force major concessions, a rather dangerous tactic. But, Treasury Secretary Geithner has stated publicly that the republican leadership has taken default off the table and he believes a debt ceiling increase will be approved. But we will all breathe a sigh of relief when the agreement is actually reached.

So as investors, what are we to do? Past performance suggests that it may be dangerous to place our welfare in the hands of politicians. While they should prevent a crisis, instead they may cause one needlessly. So, we raised some cash about a week ago. And by the time you receive this commentary, we will have raised a bit more. We think a deal must happen, although the timing is uncertain and the posturing provokes fear among investors. The scary headlines will continue while the two sides posture as they negotiate. The cash we’ve raised will provide some ballast during this choppy period for the market, but we expect this will be a temporary circumstance. And we will continue to monitor the situation carefully.