Why Markets Won’t Crash — Yet

Recent Global Economic News comes with a strong sense of déjà vu. Consider where we are today: markets are surging–on March 5 the Dow reached a record high–yet investors are nervous, fretting that budget battles in Washington and the implementation of the sequester will eventually cause growth to tank. Yet as deep as political dysfunction is inside the Beltway, it’s deeper still in Europe. Thanks to the muddled results of recent Italian elections involving at least two comedians–one a satirist turned activist, the other Silvio Berlusconi–the euro-zone crisis is back on the front burner. The rate Italy has to pay to borrow money is rising as lenders worry that the country will ultimately need a bailout. On both sides of the Atlantic, the threat of more sovereign downgrades looms–unless leaders can get their acts together and put sound policy before ideology.

If that sounds a lot like the summer of 2011 to you, you’re right. We’re almost exactly where we were back then, when we had the debt-ceiling battle that led to the sequester–a series of cuts so poorly conceived that they were never supposed to happen. But there is good news: just as things didn’t end in tears then, they won’t now, at least not yet. Here’s why:

1. As messy as things are in the U.S., they are worse in Europe. Most European nations have entrenched debt problems. The U.S. doesn’t. One important point lost in the sequester debate is that we’re actually very close to reaching the “grand bargain” goal set in the summer of 2011 by President Obama and House Speaker John Boehner of trimming $4 trillion from the deficit in the next decade. In fact, if you combine the cuts previously agreed to as part of the Budget Control Act of 2011 with the tax increases secured by Obama at the end of last year, and add to that things like the associated interest savings and shifts in deficit expectations by the Congressional Budget Office, we’re already two-thirds of the way there–and that’s without including the sequester.

Princeton professor Alan Blinder, a former vice chair of the Fed and the author of the new book After the Music Stopped: The Financial Crisis, the Response and the Work Ahead, recently did the math. He sums up America’s debt issues this way: “In the long run, we don’t have a European-style generalized deficit problem in this country. We have a health-care-cost problem.” It is mainly health care that will drive up U.S. debt over the next few years; spending on everything else, including Social Security, defense and social programs, is projected to decrease.

We will have to deal with health care costs eventually. But in the short term, the fact that our underlying fiscal issues aren’t as bad as Europe’s and our projected growth rate is much higher–somewhere just below 2% this year, compared with a likely recession in a number of European countries–means we’ll still be the prettiest house on an ugly block, as we were back in 2011 when the euro-zone crisis diverted attention from our debt downgrade. That should keep our borrowing rates low and our best blue-chip stocks high.

2. Housing is back. This is a new and powerful factor offsetting some of the growth-dampening effects of the sequester. New-home sales jumped 15.6% in January, the highest rate since the summer of 2008. The number of private residential projects launched was up a stunning 82% annualized in the fourth quarter of last year, which means this rebound has legs. All those houses being built and sold will fuel construction and manufacturing as consumers buy furniture and appliances to fill them. That’s why stock prices of home-improvement companies like Lowe’s and Home Depot are up. What’s more, rising home prices boost growth. Research co-authored by housing guru Bob Shiller estimates that a $1 rise in housing wealth generates 10¢ in consumer spending, compared with a 2¢ consumption boost from an equivalent bump in equity wealth. If that’s true, the $1 trillion rise in housing wealth last year boosted spending by $100 billion. Capital Economics predicts that further increases in equity and home prices will likely boost GDP by about 0.7% this year, which would be enough to offset the 0.5% hit from the sequester.

3. The fed is still throwing money around. Much of the record rise in stock prices is due to a government buying spree. For the past four years, the Fed has spent billions buying bonds and mortgage-backed securities, which helps lift stock prices by forcing investors to search for higher returns in the equity markets. Many smart investors have started to worry that the Fed’s actions are creating a stock bubble and stoking longer-term inflation. For now, Fed Chairman Ben Bernanke believes the benefits outweigh the risks, and he has hinted that the Fed may keep the money spigots flowing into 2014. We can only hope that the déjà vu–as well as the reality of government dysfunction–will be over by then.