Keynes on Trial
Many of us suffered through Economics 101 while in search of a bachelor’s degree in business. The text, of course, was probably written by Paul Samuelson and the ideology behind the doctrine was clearly from the teachings of John Maynard Keynes. Keynes believed that government and its Central Bank (the Federal Reserve) could gently steer, or guide, a free economy into consistent-growth without inflation.
Over the years, advocates for “guiding” the economy were increasingly tempted to influence growth through more government spending and social programs. Gradually the American economy became a large, bureaucratic, indebted economy in which government’s role changed from gentle guidance to strict control, imposing more restrictions on business and the lives of Americans.
Today’s obvious political divide reflects the pushback from more Americans who dislike government control. Supreme Court decisions are now most often about restricting the role of government in American lives. This struggle and the uncertainty surrounding it is very destabilizing for the stock market. The market does not like uncertainty. Nevertheless, we know that this struggle will continue for at least four more months until the election helps decide the future direction of our country.
Meanwhile, the Federal Reserve is left with the task of fighting inflation, using interest rates and the maturity “run-off” from its balance sheet as its weapons. In reality, the Federal Reserve can only affect the demand side of the supply and demand equation that ultimately determines prices.
Supply changes, or distortions, are typically affected by policy decisions, or other causes like pandemics, war, trade quotas, taxes, etc. Where there are supply disruptions, the supply/demand equation falls out of balance and prices rise, exacerbating the existing inflation problem. The Fed, in response, can only raise rates and literally take money out of the economy to curtail demand. In short, we can only shrink our economy and in so doing risk recession or worse. How far the Fed is willing to go is the current big question investors need answered.
Meanwhile, the Administration is attempting to pass legislation featuring tax increases, price caps, and regulation which will likely shrink supply even further. So far policy initiatives seem to be heading in the wrong direction. Hence, we are stuck in a Keynesian trap, and this is the reason our portfolios are still defensively structured, holding much cash waiting to go to work!
Over the last few weeks, we have seen the prices of commodities drop sharply as buyers of these commodities are believing that a recession is imminent and a resulting decline in demand for these commodities will weaken prices. Metals such as copper, nickel, aluminum, and iron ore have been weak across the board. We think that this will translate into favorable inflation numbers that may signal tomany that inflation is headed back down. We believe that this is likely to trigger a relief rally in stocks and bonds over the shorter term.
We have bought a few things including long-term treasury bonds that we expect to trade. We could easily see a 2–3,000-point stock market rally as investors begin to believe the inflation fight is over. If the Fed Chairman believes this, it could start a large up leg in the market…but we will then be living with a worsening long term inflationary problem. We’re back to the big unanswered question: How far is the Fed willing to go in its fight against inflation? Frankly, we believe that Chairman Powell will be a long-term fighter, so we can see another concerted effort at raising rates before he gives up. We believe we’re not done with the correction yet, but may be in an interlude allowing us to catch our breath, enjoying some price relief, and consolidating our plans for the next dip.
After all, the Fed Chairman has set the objective at a 2% endemic inflation rate. That’s a long way from 8–9%, and for interest rates to be effective as a weapon, they should be above the real inflation rate. Today’s 3% is a far cry from the 6–7% that may be needed.
During the last financial crisis, then Fed Chairman Ben Bernanke forced interest rates down in his “zero- interest rate” policy put in place to prevent a collapse of the financial system. Janet Yellen succeeded Bernanke and implemented her quantitative easing (QE) policies for years. Together these accommodative policy believers printed money endlessly, much of which is hiding in excess bank reserves or in the Fed’s balance sheet. The Fed’s balance sheet grew from $600 billion to a present $9+ trillion, as the Fed, itself, financed the annual treasury deficit. According to Chairman Powell, it will no longer be doing that, so we know the long road back to normalcy is still stretched out before us.
The coming election gives us some hope that we could be anticipating some good policy which will stimulate production, increase supply, and break the back of that part of inflation resulting from bad policy. We might also see some good results from the Federal Reserve interest rate policy. Growth policies, like tax cuts, and the growth that comes from these policies can go a long way toward defeating the inflation at hand. On the other hand, more Keynesian policies attempting to control our economy through government regulation and austere Federal Reserve actions will be detrimental to a good, profitable future for America.
Frankly, we are strategically prepared to take advantage of any growth opportunity in America. In the meantime, we will likely be tactical in nature, attempting to take advantage of shorter-term opportunities and other inefficiencies in the markets between now and the elections. We hope Americans reject large government and the Keynesian economic policies that go with it. Frankly, we don’t think anyone can really control and shape America. Free people in a free economy will always outperform any managed economy. We’re anxious to witness and be a part of this positive turn we see coming.