Our president-elect is certainly facing a great deal of uncertainty. The CBOE Market Volatility (VIX), an index of stock option trading from the Chicago Board Options Exchange, is off its highs of nearly 90, but remains well above the low near 16 this past year. The index stood at 54 at the close of options trading on Monday.
The index reflects the cost of hedging risk through the sale or purchase of option contracts on the largest U.S. stocks. The high historical value reflects great uncertainty over what prices of financial assets will be in the future.
U.S. markets were relatively calm before Election Day, but global markets reflect continued pessimism. Oil prices declined Monday on news of slow auto sales and lower manufacturing activity. The president of the Organization of Petroleum Exporting Countries (OPEC) said on Sunday that demand for oil remains below their recently revised production levels.
Meanwhile, the Institute for Supply Management said its index of manufacturing activity in the U.S. fell to 38.9 in October. Any level below 50 indicates less production from U.S. manufacturers. In such a global market downturn we can usually expect active government policy. The current administration continues to implement the $700 billion bailout, but President-elect Barack Obama is likely to recommend more.
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As Nobel laureate Paul Krugman suggested in a New York Times essay, the U.S. needs “massive” fiscal stimulus. Fiscal policy is the setting of government spending and taxation by government policymakers. This could include heavy spending on such things as more unemployment benefits, or a cut in taxes, or both.
How well this fiscal policy works at helping the economy depends on the marginal propensity to consume. This propensity is the fraction of extra income that a household consumes rather than saves. If we spend, the desired effect may be achieved. If we save more, the effect on the economy from any stimulus plan is rather small.
Alternatively, or perhaps in conjunction with fiscal policy, we could see more active monetary policy. The Federal Reserve may continue efforts to influence the overall economy by reducing interest rates in the banking system. If it works, lower interest rates stimulate investment spending, which in turn spurs hiring and improves the employment situation.
In a recent report from the Federal Reserve Bank of San Francisco, Chief Economist Kevin Lansing provides evidence from John Taylor of Stanford University showing that monetary policy was inappropriate earlier this decade. Rates were too low for too long.
What is needed now are interest-rate adjustments by a rule whereby the money supply grows by the rate needed to match consumption behavior and the job market. Applying such a rule today calls for lower interest rates, but they work only if banks increase lending. This appears unlikely as continued tightening of credit standards were announced in Fed survey results reported on Monday. Finally, we could do nothing. In a recent article for The Wall Street Journal, economist Russell Roberts of George Mason University provides arguments for just such a "doing nothing" approach. Dr. Roberts points out that historically, government efforts to stimulate the economy have been less than stellar.
So, policymakers can play with government spending (fiscal policy), play with interest rates (monetary policy), or simply sit back and watch the game we call the U.S. economy.