The Exchange

Why Investors Should Brush Up on Their Political Science and Economics

The Exchange

By Douglas J. Elliott

Newspapers have been reporting the possible misuse by hedge funds of confidential information about proposed government actions. Whatever the truth of these particular allegations, it is a sign of the intense interest that much of the “smart money” displays in the specifics of government policy.

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This runs counter to the misconception, still held by many investors, that we will eventually return to the “good old days” when they can focus again on businesses and ignore governments. They believe that the current need to actively scrutinize the likely actions of the U.S. and other governments is a fluke resulting from the financial crisis and the ensuing severe recession. This seems very unlikely. Governments should always matter a great deal to investors: they establish the framework of laws and regulations that rule business transactions, set taxes, establish monetary policies, decide government spending levels, choose among infrastructure projects, etc.

A return to the norm

The truth is that the 20 or so years preceding the financial crisis was the aberration and we are returning to more normal conditions. In the U.S., we went through a couple of decades in which governments were relatively laissez faire, intervening less than usual in business operations and continuing a trend of deregulation.

Further, the Fed, in line with central banks in other advanced economies, began to believe that a “Great Moderation” had occurred in business cycle conditions as a result of better central bank operations based on an accumulation of understanding of monetary policy over the years. Financial markets operated fairly freely, as the government held the reins with a light hand.

Do not expect these conditions to recur anytime soon. In the short to medium term, the memory of the terrible economic and political damage from the financial crisis will certainly keep the level of government intervention in the U.S. at high levels. Further, the need to resolve our fiscal problems will involve major decisions about what the government does and how it pays for it. This will have knock-on effects throughout the economy, both by affecting general conditions and by hitting particular industries, such as defense contractors or hospitals. This will come on top of activist monetary policies at the Fed that will bring years of critical decisions about the level of purchases of bonds by the Fed, their eventual disposition as the inventories are worked down, and, of course, an eventual rise in interest rates that will need to be carefully managed.

World markets increasingly important

Beyond our shores, the global economy is increasingly influenced by emerging market countries that believe in much more active government policies and even state ownership of major businesses. These nations will also make key decisions about where to invest public funds, and where to encourage the investment of private money, as they continue to develop rapidly. The choices of their governments, and the reactions of our own, will have a major impact on U.S.-based companies and on our own stock markets and interest rates, as well as the value of the dollar in foreign currencies, and therefore our trade balances.

Europe, for its part, is going through a prolonged set of inter-related political crises that aggravate economic problems, in turn worsening the political difficulties. The impacts on businesses and the overall economy have had, and will have, substantial effects on America and the rest of the world. Europe is likely to remain in political turmoil for years, even if the potential short-term disasters are overcome. If things work out on the positive side, reshaping their joint political institutions will still take years and will have major effects on their economies and therefore ours.

Government actions matter

This pattern, where government decisions have determining effects on business choices and investor returns, is typical of preceding decades and even centuries. Sometimes this has been vividly demonstrated by decisions about war or the trade equivalent -- trade wars or competitive devaluations of exchange rates. Other times, the big impacts have come from tax and regulatory policies that differ greatly from that of neighbors and trading partners. Other times it has been massive infrastructure projects such as the creation of the transcontinental railroads and the federal give-aways of free land to homesteaders. Even the abolition of slavery had massive economic impacts. Government actions going forward may be less dramatic than these examples, but there is no doubt that what happens here and abroad will be profoundly influenced by political decisions and the implementation of these decisions by bureaucracies.

So, pay attention to politics here and around the world and the intersection of those politics with underlying economic issues. Government decisions may sometimes prove to be more important than the intricacies of business strategies in determining the fate of investments.

Elliott is a fellow in the Initiative on Business and Public Policy at The Brookings Institution.

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