New Keynesian Economics
July 26, 2010
Good morning. It was a very strong week for the market last week, despite a sell-off on Wednesday attributed to Federal Reserve Chairman Ben Bernanke’s testimony before Congress. In that testimony before the Senate Banking Committee the Fed Chairman referred to the economic outlook as “unusually uncertain,” and the market responded with a two percent sell-off into the close on Wednesday. The market recovered that amount and more on a big rally Thursday that continued into Friday. For one week, at least, the market focused on generally good earnings, increased revenues, and good guidance going forward, rather than the tepid Economic numbers. In that area the week was not as good, as Initial Jobless Claims and Leading Economic Indicators failed to impress jet again. It really is a tale of two markets, if you focus in on the Corporate news you could be downright bullish on stocks to the point on urgency, if you look at the numbers indicating general economic health (or lack thereof) you are probably more in the wait and see gear regarding new investment. In fact, if you were to look at the earnings numbers for a lot of companies reporting, check the P/E ratio, and assume the recovery will continue and gain steam, they look downright cheap. Even Microsoft is looking like their P/E is around 12-13 pushing towards 10 next year with the stock right here. The VIX took a 10% hit on the week, closing at 23.46.
Something seems confusing, or maybe a lot of things seem confusing. How are some of the increased revenue numbers, like Amazon up 41%, MSFT up 22.4%, Alcoa up 20%, etc. matching up with the best estimate of GDP growth somewhere in the 3% range? Granted, they are coming off a horrible quarter last year, but still the growth in revenue in many areas is eclipsing any number you might guess given the general economic numbers. I am in the camp that says at the end of the day the companies in the economy will not end up very far ahead of the economy, in total. What I mean by “in total” is that you might have some blips in some industries that have had consolidation (it would not surprise me to see Best Buy have good revenue numbers this year with Circuit City closed) but even with increased foreign sales I think the growth in companies is ultimately limited to just that, the economic growth. Maybe somewhere in the future we can forget about the U.S. but I do not think we are there yet.
Those listening to the radio show this morning know I am trying to understand the “New Keynesian Economics” put forth and supported by the current administration and their Economic Team. You also know that I am feeling, not just starting to feel, that it does not pass the smell test. It has been a while since I was in school and involved in the Keynesian vs. Monetarist debate (ND was probably more Keynesian while the University of Chicago was virtually pure Monetarist), but recently the subject is front and center. Actually, I ran into a fellow on Friday night that was real anxious to tell me that my misgivings about the current, call it New Keynesian Policy, was all wrong and I should become more of a believer. Here is my problem with that. What I remember about Keynes Theory (I will keep it short) is that people in society generally save to some extent (again, debatable today), say in the 20% range (some societies were that high). Even though saving is laudable (savings does end up equaling investment), in the short run government can increase demand by borrowing money and then (since government never saves) spending that money borrowed. For example, let’s say that citizen A makes $20,000 per year and normally saves $4,000 (not today’s world but for examples sake). If the government goes out and borrows, say through a bridge bond, some of that $4,000 and puts all of it to work the theory says that we pick up the 20% normally saved in current consumption and can effectively “jump-start” an economy in the doldrums. When the business cycle heats up we reverse the process, redeem the bonds, and act to “cool” the economy possibly about ready to over heat. Using this deficit/surplus tool we can effectively (the theory goes) fine-tune the economy and temper the business cycle.
There are several issues with this theory. The Monetarists say that if you increase the money supply to make the borrowing easier it is the action of the increased money that causes the expansion. Let’s leave that debate aside. The big question now, and not one I think Keynes addressed (mind you it has been a while since I was studying this), is whom are you borrowing the money from. I do remember in Dr. Milton Friedman’s class one day someone asking the question (problems do not really change, just grow) about his feelings about Federal deficits. Dr. Friedman’s response was (in 1975) that deficits did not really matter, in that if the U.S. Government was to borrow money from the citizenry the “balance” of the “U.S.” did not change, much the same as if a husband owed his wife $100 the equity of the “family” did not change. I would love to hear his response today, as the new situation is to trade with a partner with a 20% currency fake valuation (China), send bushels of dollars their way, then borrow it back to fund deficits. I do not think he would have the same response (or I suspect would Keynes). It is no longer internal, and the “no harm, it is all in the family thing” does not apply. There is an article on Bloomberg today by Daniel Kruger and Rebecca Christie entitled “Deficits Don’t Matter as Geithner Gets Lowest Yield.” It basically talks about the idea that as long as the borrowers do not have an issue with the strength of the debt and keep showing up at the auctions there is no problem; the “market” is essentially applauding the current approach. It is then OK to ignore totally the fact that our deficit numbers are approaching rapidly the same levels at which investor revolts occurred in Greece, Ireland, and Spain. I do not think Keynes had anything like this in mind.
Why do I feel like I am, along with my listeners and clients, in this test tube, and this is the biggest economic experiment I have witnessed or read about. We feel like that because it is and we are. The question is why? Why do these administrations feel (both the current and former) that they have to keep this pattern of wasteful spending (mostly to those that greased them into office) no matter what the cost? Anyone who read the three part series on security last week in the Washington Post should be horrified regarding he waste, inefficiency, and outright fraud involved in all this supposed “protection” we have benefited from since 9/11. What a drag on the economy all this useless security is, with every person with his finger in the right pie having some sort of contract to guard God knows what or to watch someone that maybe, repeat maybe, bears watching. The current group in office has their own set of “beneficiaries”, from every Community Action Program or so-called Education Program (with most funds intercepted on their way to the supposed poor or uneducated) to the lawyers and governmental employees being given lifetime jobs in the new Financial Reform bill (do not want to even talk about the Health Reform Bill). As just a little aside in the Health Reform Bill, how many people know that a clause in that Bill causes any firm doing more than $600 with any other firm to send them a 1099? So if PTI were to shop at Sam’s buying coffee and rolls for our seminars we have to send Wal-Mart a 1099, or if we have a Christmas Party for employees that is over $600 we need to send one to the restaurant? What exactly is Wal-Mart going to do with these millions of 1099’s?
So what happens? Do we continue to try to make New York in record time on flat seas until the iceberg gets hit? Would Bush, Geither, and Obama be right at home in the fancy uniform with the Titanic emblem toasting the full speed ahead until they hear the telltale sound of ice on metal (or through metal). Do we really want to put our fate in the hand of foreign people and governments most of us do not trust? It appears some do, and they are in power, but I do not, and I think most of those reading this do not (if you are on the dole and can get your piece and leave in time my hat is off to you). Somehow Bush’s trickle down thing, or now Obama’s trickle in some direction to his group thing, or the always flood towards big banks and multi-nationals thing never seemed to flood or trickle towards me, my listeners, or clients. Maybe we should drop our scruples and fight our way into the line where your butt is in the air because your nose is in the government trough. It just does not come easy for us to be in that line, it smells in there. I just know that some day the borrowing will stop going so smoothly, the people stealing will be gone, and the rest of us will be holding this enormous bag of “stuff.”
So how do we trade it? Do we get sneaky long in the hope that somehow the recovery is sustainable? Those in the more aggressive risk categories have seen us do some trading in the new weekly S&P options, as we have put on some spreads that get us bullish for at least that week. The market seems poised to maybe move higher in the short term, but I think we need to be short term oriented and/or well protected if we go out further. The drop in the last few months in the basic industries has me concerned, but not participating has me concerned as well. The drop in the VIX last week has us looking for ways to get a little more invested while protecting ourselves at a reasonable rate.