It’s the Economy, Stupid.

I have been mulling over how policy makers’ reactions often are more damaging than the crisis they are dealing with.
It will be the subject of my next report.
But first, i suggest to revisit a report I wrote 18 months ago.
It dealt with the fundamental change in economic thinking we were going through.
Here it is.

Tuesday September 22, 2009

It’s the economy, stupid.
We have all become economists now.

Investors, over the last six months, have been solely focused on macroeconomic data.
Every day, at 8:30 am, CNBC broadcasts the day’s economic news that will determine the day’s market moves.
It varies from unemployment numbers to housing starts to productivity figures and so on.
Whenever the day’s news is “better than expected”, traders buy stocks with the highest beta.
When the news is not so good, well, traders wait for the next day to find reasons to be excited.

So, Paul Krugman’s article on the evolution of the economic debate in academia published in the New York Times a couple of weeks ago was timely.
Krugman does a great job of explaining in simple terms the major issues economists have been debating since Adam Smith.
The only caveat, as I see it, is that the story is a bit too US centric.
Not once does Krugman mention Hayek, the very influential Austrian thinker.
It is a bit like writing about the history of psychology and not mentioning Sigmund Freud.

Nonetheless, for a non-economist, the debate looks to be quite simple:
how much should government get involved in the economy.
This should be a rational debate.
However, it is a highly emotional one.

Over the centuries, academia and governments have been going back and forth between more or less government intervention.
The motivations may vary.
Reasonable people may agree on better regulation.
Others want politicians to use governmental power to increase social cohesion.
Some people, especially in a downturn, think governments should stimulate the economy.
Some others, especially the French, believe the government has a major role to play in promoting certain industries.

Whatever the motivations for more governmental intervention, it is obvious we have turned a corner.
Neo-cons are out, Keynesians are in.
In a symbolic gesture, the father of the neo-conservative movement, Irving Kristol, died last week.

In the US, Krugman explains, the two schools of thought are separated geographically as well as ideologically.
Coastal universities tend to have a more or less Keynesian vision.
They are the so-called saltwater economists.
By contrast, the freshwater economists are teaching in the inland schools and reject Keynesian economics.

It was the stagflation of the 1970’s that gave the neo-cons their day in the sun.
Logically, the Lehman debacle has given the Keynesians an opportunity to rise back from the dead.
Unfortunately, as I see it, the debate has not evolved much.
The pendulum just swings back and forth, whatever new names we use to define the school of thought.
Call them neo-cons, supply-siders, monetarists, freshwater economists or Keynesians, liberals, saltwater or socialists.

At the end of the day, the only difference is the degree of (de)regulation.
Excesses in one direction always brings the opposite dogma to power.

How else can one define the “efficient market” theory?
It is a the ultimate excess in dogmatic belief.
Only professors come up with such nonsense!
The theory was teaching us, mere MBA students in the 1980’s, that financial markets always get asset prices right given the available information.
Anybody who has spent one day in a trading room or at a momentum shop knows better.

Keynes, who is now back in fashion, had a very different view of the markets.
He compared them to casinos.
And he had a problem with it:
“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”
And Keynes wrote this before Japan imploded.
Neither did he ever spend a day in a Chinese brokerage firm.
Larry Summers puts it differently:
“There are idiots. Look around.”

Unfortunately when theories become popular, they end up affecting important decisions.
How else can we explain Greenspan’s “shocked disbelief” because the “whole intellectual edifice” had “collapsed”?
True to his belief, Greenspan rejected calls to rein in subprime lending or the ensuing housing bubble.
Nor was he alone.
His succesor, Ben Bernanke, was also convinced in 2005 that home price increases “largely reflect strong economic fundamentals.”

Those were the days when few people questioned the Fed’s wisdom.
There was another nearly universal belief, even among economists across the spectrum.
It was the belief that the Fed can take care of things.

Indeed, every time the economy hit a bump on the road, the Fed would respond with monetary stimulus.
Recessions had to be avoided at all cost.
Hence, the Fed was accredited with the virtually uninterrupted economic growth experienced since the early 1980’s.

Obviously, rapid wealth had instilled some complacency even among the pure supply-siders.
Historically, they belonged to a school of thought that believed recessions to be inevitable and even healthy.
But growth had become the new Holly Grail.
We were, after all, living in the age of instant gratification.

Now, after the global financial meltdown, the Fed is no longer viewed as the only solution.
Like in Japan’s lost decade, near zero-interest rates is no longer enough to get us out of today’s major slump.
Keynesians are moving in.
Dixit Krugman: “When monetary policy is ineffective and the private sector can’t be persuaded to spend more, the public sector must take its place in supporting the economy.”
Maybe.
I wonder why solving excess spending by consumers – financed with excessive leverage – should be remedied by excessive public spending.
The latter too is financed by – you guessed it – leverage.
At the end of the day, the US consumer will be shown the bill.
He and she knows it, which means consumption is going down even further.
Thus to avoid a slowdown, governments will have to come up with more stimulus packages.
Which in turn…

Public debt above total GDP do mortgage the future.
Ask Japan.
Ask Italy.

In the meantime, whatever one’s position on the debate, we have undeniably entered a new economy.
Winners and losers in the stock market will be those that will adapt to the new reality.
Now more than ever, investors cannot look at the recent past for guidance.
Yet, this exactly what is going on today.
Markets can stay irrational longer than you can stay solvent Keynes famously declared.
And that is our immediate challenge.
Fundamentals will catch up.
But when?

As everybody is rediscovering Keynes, my contrarian instincts lead me to Hayek’s teachings.
Hayek did not like the fact that Keynes argued against the moral tradition of the “virtue of savings”.
“This in turn led (Keynes) to devote his formidable intellectual powers to develop his General Theory of Economics – to which we owe the unique world-wide inflation of the third quarter of our century and the inevitable consequence of severe unemployment that has followed it.” (dixit Hayek)

Kristol wrote a long time ago: “once the idea gets around that we are in a profound crisis and that only “drastic action” by Washington can save us – then it will be time to head for the storm cellars.”
An example of drastic action would be, for example, to put the IMF in charge of the new world order.
The IMF, of course, is headed by a socialist.
Not just any socialist.
A French socialist.

Let’s at least agree with Popper that our aim must be to make our successive mistakes as quickly as possible.

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