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January 12, 2004

Blame Keynes

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Einstein once said every theory should be made as simple as possible, but no simpler. I think about that a lot when I work on financial analysis. It's clear that making things very complicated can be dangerous – every extra element has the potential to interact with the others. While there is only one relationship to examine between two points, there are 15 relationships between 6 points. The possible relationships increase by nearly the square of the number of elements you have in your theory [n x (n-1)/2 to be exact].

An overly complicated model quickly becomes impossible to analyze, and as the geniuses at Long Term Capital Management found out, it can become completely unstable even if the relationships change a tiny bit.

At the same time, oversimplifying can be equally dangerous if you leave out important elements. There is probably no better example of this than the field of economics.

Apart from a tiny group of academic economists who write arcane mathematical articles intended for a tiny group of academic economists who write arcane mathematical articles, the popular view of how the economy works is broadly speaking, an entirely unrealistic caricature of reality (though I say this as a former academic economist who used to write arcane mathematical articles.)

As long-term readers of these comments know, I blame Keynes. It's no exaggeration that if college graduates remember anything of their economics courses, they escape with little but Keynes. During my years in academia, I was constantly amazed to see even brilliant colleagues reduced to Keynes-blubbering pod people when they were asked questions about the actual economy. See, most academic economists don't actually study the economy. They study economies in a very abstract sense, as in “consider an economy in which there are two islands, a turnpike, and five guys named Jack, one of whom is the government but nobody knows it…”

Garbage in, garbage out

The main problem with Keynes is that he assumes that the economy consists of a single good, that investment is fixed, and that even though there are investment goods, they effectively serve no purpose (there is no production function in standard Keynesian theory).

The basic idea goes something like this. The economy produces output Y which is equal to consumption C, plus investment I, and government spending G. People consume some fraction c of income Y, so C = cY. So we've got

Y = C + I + G

Y = cY + I + G

So Y = (I + G) / (1 – c)

Now assume that investment I is fixed, and people try to save more of their income (c declines, so the denominator gets larger). In that event, output falls. End of story. The reason this “recession” happens is that as a rule, saving has to equal investment, and by assuming that investment is fixed, the attempt to save cannot actually translate into more saving either, so income has to fall. And look, with investment I fixed, the only way to drive the economy higher is to a) increase government spending G, or b) spend more and save less, so c increases and (1-c) becomes as close to zero as possible. In Keynesian theory, the best outcome is for people to spend 99.999999% of their income.

And that, in a nutshell, is why people think saving is bad for the economy and makes recessions worse. The implicit assumption is that greater saving will not translate into greater investment. Anyway, investment is really just another kind of spending to Keynes. Since there is no production function in Keynesian theory, there's no reason to invest anyway. It's not like the investment is what produces the output, for gosh sakes, so the spending might as well be consumption.

Don't worry. Be happy.

In Keynes' view, recessions are essentially periods when individuals erroneously decide to save rather than consume. As a result, Keynesian theory offers a simple way to counteract recessions: get the government to spend money. Drop it from helicopters. Or as Keynes suggested in his General Theory, fill bottles with money and bury them at suitable depths for enterprising young men to dig up. Recent U.S. fiscal and monetary policy have been based on precisely these notions.

Unfortunately, the result of these policies is that U.S. households, businesses, the government, and the nation itself have developed the worst balance sheets in history.

Despite the so-called recovery in the U.S. economy, the American Bankers Association reports that credit card delinquencies and defaults have just reached a new record. There has been precious little improvement in corporate balance sheets – the reduction in default rates and the narrowing in credit spreads has much more to do with swap financing tied to unsustainably low short-term interest rates, along with improvements in equity prices that have reduced debt/equity ratios. The U.S. now faces the deepest current account deficit in the nation's history, meaning that even current levels of U.S. consumption and investment activity are dependent on the largest continuous inflows of foreign capital than we've ever required. Meanwhile, mainstream economists have completely ignored how cyclical productivity growth can be, and how unreliable rapid short-run productivity growth is as an indicator of long-term trends. Indeed, they've even fooled themselves into confusing the rapid expansion of imports and labor downsizing with beneficial growth in productivity (see the November 10th comment for more on the “productivity boom”).

Recessions imply a mismatch between what is demanded and what is supplied

If our nation is to improve its balance sheet and achieve sustainable economic growth, the first thing is to understand that the economy does not produce a single good. It is exactly the emergence of new goods, their associated scarcity and profitability, and expansion of those industries through new investment and competition that drives economic growth forward.

Recessions result when a mismatch develops between what is demanded versus what is supplied. Economic downturns are not simply periods where people reduce their consumption of some “representative good.” Rather, we see most industries virtually unaffected by recessions, with a few industries actually experiencing shortages, but with a handful of industries experiencing devastating drop-offs in demand. Turning this around is not as simple as “stimulating aggregate demand,” because quite literally, buyers don't want the stuff that those industries are producing.

So recessions are really periods of adjustment. As a result of overconsumption, overinvestment, competition from new substitutes, or changes in preferences, some industries simply fall out of favor. New industries may or may not emerge, and of course, there is no easy transition for workers from the industries in downturns to other industries that may or may not emerge to replace them. This is a painful process for some industries, as we've seen in technology and telecom during recent years. But it's hardly noticeable in others, as we've seen in retail and health care.

The implication is that policy cannot simply be geared to mindlessly stimulating demand, particularly in an economy that is precariously burdened with debt. The best and most seriously overlooked policy toward this economy would be tax incentives for research and development. In addition, to the extent that we've seen a Keynesian weakness in investment, the objective should not be to seek remedies through greater consumption, but instead to encourage productive investment through much more direct means than rebate checks and capital gains reductions.

Above all, the U.S. economy has a balance sheet problem. This will not be solved by spending more. Even here, increased saving would at least allow the U.S. to reduce its dependence on foreign capital and allow the nation to avert a dollar crisis that is otherwise likely at some point in the next few years.

If one thing is entirely clear, it is that this “expansion” is far different from those of the past. Capacity utilization remains low, employment growth has profoundly lagged typical patterns, consumption has been unusually and even recklessly stimulated as an alternative to balance sheet improvement, and rather than beginning from a current account surplus as all previous expansions have, this expansion began with the deepest current account deficit on record.

Call me a skeptic, but watching the panorama of bullish economists and Wall Street analysts is almost like walking into one of those 3-D movies where everybody is wearing those geeky glasses with the red and green lenses. Except that here, all the lenses seem rose colored.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and moderately favorable market action. That combination held us to a constructive position, with about half of our fully invested position in stocks hedged against the impact of market fluctuations, and a very small “contingent” put option position in place a few percent below current levels, sufficient to hedge an additional 25% or so of our market exposure in the event of an abrupt decline. For now, we remain positioned to gain primarily from market advances, and our position should not be considered highly defensive or bearish. Very simply, the market remains driven primarily by speculative merit (rather than investment merit), and we're willing to maintain at least a moderate exposure to market risk on that basis for now. Fundamentals are certainly unfavorable, particularly as they relate to valuations, but at present, those fundamentals are not sufficient to overwhelm investors' preference for speculation here.

In bonds, the Market Climate remained characterized by modestly unfavorable valuations and modestly unfavorable market action. The Strategic Total Return Fund currently holds a duration of about 2 years (meaning that a 100 basis point move in interest rates would be expected to affect the Fund by about 2% on account of bond price fluctuations).

As I noted last week, our precious metals position was one of the most subject to change. Last Monday, we liquidated our small position in precious metals shares on price strength. This isn't a “bearish call” on gold by any means, but at present, our own measures don't give us sufficient reason to hold these stocks. Though I do believe that the U.S. dollar faces more downward pressure on the basis of fundamentals, the weakness has been very profound lately, at the same time that some of the downward market pressures from inflation, interest rates, and economic weakness have subsided. For that reason, it would not be surprising to see an upward correction, possibly substantial, in the value of the U.S. dollar, despite continued poor fundamentals over the long term. As usual, we don't base investment positions on such opinions or forecasts, but the data are sufficient here to prevent us from extending new positions in precious metals or foreign currencies for now.

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New Research & Insight article by Bill Hester: Why Investment Strategists Have the Toughest Job on Wall Street


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