EFF/KRF: Even in good times, economic systems are often changed dramatically by political decisions. (Think about South America over the last 30 years.) Capitalism is always under threat in the U.S., and the threat is higher when the legislative and executive branches are both in the control of liberal Democrats, who seem to be big admirers of the European system of high social welfare expenditures and "managed" (or better, mismanaged) capitalism. Unfortunately, the current political period may result in stagnation of the sort that other managed capitalist economies (Japan and most of Europe) have experienced. But we hope the pioneering free enterprise spirit of the U.S. can quickly reassert itself.
The current recession aside, the big long-term problems of the country are a bankrupt social security system (thanks FDR) and bankrupt Medicare and Medicaid systems (thanks LBJ). The Republicans are not faultless. When they had joint control of the legislative and executive branches, they gave us the prescription drug care program for seniors (who vote, mostly Republican).
In general, it is dangerous to have the legislative and executive branches firmly under the control of the same party, whether Democrat or Republican. Politicians like power and spending generates power. Democrats and Republicans like to spend; they just disagree on where the expenditures should go. Democrats like social programs. Republicans like defense expenditures, energy, and farm subsidies, and in the past eight years they honed pork barrel spending (earmarks) to a level not seen before. The current stimulus plan is likely to fail, but are the eventual costs likely to be more or less than those associated with the Iraq War?
What are the investment implications of these challenges? The huge drop in the value of public corporations since President Obama's inauguration suggests the market shares our pessimism. But for investors the damage is already done. Although the economy is likely to suffer from high unemployment and low profits for quite a while, the market has already incorporated all this bad news into prices. In the real economy the pain of a recession may be spread out over several years, but investors bear the full expected impact as soon as the market sees it coming.
This means there is no reason to be gloomy about our current investment prospects. Prices may continue to fall, but only if the news turns out to be even worse than the market expects. We are equally likely to be surprised by good news that pushes prices back up. It is impossible to forecast how prices will evolve, but we believe the market is currently offering investors unusually high expected returns as compensation for this uncertainty.
Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.