The mess we're in

Everyone should read today's WSJ op-ed by Shultz, Boskin, Cogan, Meltzer and Taylor: "The Magnitude of the Mess We're In." To their credit, they make no attempt to pin the blame for the mess on any party or politician. It should be clear that this is a bi-partisan mess we're in, and the Fed, presumably independent, is potentially a big part of the problem. It's just the facts, ma'am.

They also note that all is not yet lost, and the solutions are straightforward:

The fixes are blindingly obvious. Economic theory, empirical studies and historical experience teach that the solutions are the lowest possible tax rates on the broadest base, sufficient to fund the necessary functions of government on balance over the business cycle; sound monetary policy; trade liberalization; spending control and entitlement reform; and regulatory, litigation and education reform.

Both parties need to know this.

A friend asked me how it was possible for the market to be near all-time highs when the problems, as described in the article, are so big, so obvious and so potentially disruptive. My answer included the chart below.

Corporate profits are very close to all-time highs, both nominally and relative to GDP, yet PE ratios are below their long-term average. The market is not at all optimistic based on this metric. Indeed, I would argue that the market is priced to lots of bad news, at the very least to a big decline in profits in coming years. The article says the same thing in another way:

When businesses and households confront large-scale uncertainty, they tend to wait for more clarity to emerge before making major commitments to spend, invest and hire. Right now, they confront a mountain of regulatory uncertainty and a fiscal cliff that, if unattended, means a sharp increase in taxes and a sharp decline in spending bound to have adverse effect on the economy. Are you surprised that so much cash is waiting on the sidelines?

If the market is at all optimistic, it would be to the extent that it is not yet priced to death and destruction. The market assumes that somehow we will avoid a calamity. There is still time to fix things, and I would agree.