Monday Morning Blues

Originally I thought that today would be a sleepy summer day, perhaps a day off. But Wall Street seems to be roiled and has begun to reverse the steady march it had been on since the early part of the year.

I wonder why?

Here’s what I see going on.

As we all know Wall Street is perennially optimistic. Investment is inherently an act of optimism about the future, just as savings are a cautionary statement. In an economy that is growing, and where confidence is high, investors are happy to pile their money into assets like stocks, businesses buy new machinery and build factories, and consumers put their money into more expensive and longer term goods like new homes and cars.

Conversely, in a recession the opposite occurs: money tends to be stockpiled in liquid assets – things that can easily be disposed of to provide a cushion against difficult times.

So in a recession savings rise, and in a period of growth investment goes up.

As you can see this is a profoundly psychological process. If people start to feel good, if personal financial security is high, then they start to spend more. This process becomes self-sustaining and the economy booms.

The Depression gave us two great phrases to summarize this: FDR’s ‘We have nothing to fear but fear itself’; and John Maynard Keynes description of ‘animal spirits’ being the driver of a modern economy.

Both insights are something to dwell on this week.

Fear is what is now holding the economy back.

As the fear of collapse melted away early this year Wall Street started to seek ways to make money again. It sought to take its cash out of safe storage assets like US Treasury bonds and put it to work in higher yielding assets like stocks. As the storm abated this investment attitude took hold even more, and the result was that stock prices rose from the depths they had fallen to over the winter, and US bond prices fell as cash flowed out of the bond market to seek those higher returns. As bond prices fall the interest rates on bonds rises.

Some people misinterpreted this rise in bond prices as a warning that the bond market was signaling rising inflation rates. It was no such thing. It was simply a recovery from the extraordinarily low ‘panic’ interest rates that prevailed at the height of the financial crisis last Fall. Bond rates are now back to more ‘normal levels’ and there seems to be no pressure from inflationary expectations to keep them rising much beyond where they are now.

The reduction in fear came from one source, the US government; and in two directions.

The first direction was aimed at settling the financial markets. This was the purpose of all those bailouts. It worked. In fact it worked really well. Risk spreads are back to normal ranges, rates are also in normal ranges, and bank profits are higher – albeit rigged by the accountants! So the first part of the government rescue plan worked like a charm.

The second part was the stimulus plan.

This part was more controversial because many people reacted to its cost and thought that the huge run up in debt it implies was too much a burden for the future.

As you know I thought the stimulus was too small.

But it is now flowing through the economy and seems to be doing exactly what we wanted it too: it is savings jobs – about 1 million so far.

I find it odd that many folks still argue that this part of the rescue plan was controversial. On the contrary, it is text book economics – as long as your text book has a chapter in it that talks about the Depression. If you are a right winger then I suppose you will be predisposed to see no value in government spending in a crisis. You may even agree with the Republican leadership who wanted to tighten the government’s belt and cut spending rather than increase it. But that position was totally demolished and discredited by the Depression: back then the economy was recovering until the government started to tighten up and the Fed raised interest rates prematurely thinking that the worst was over. Instead those actions plunged the economy into what we now call the Depression.

Which, presumably, is what we are trying to avoid now.

It is incredible that many people think that the ‘market’ will fix things and that the government should ‘just get out of the way’.

That’s ridiculous.

A recession is exactly the collapse of the private sector.

Let me repeat that: the private sector gives way and fails. So demand falls. That’s what a recession is. We can prolong a recession and turn into a depression by letting the private sector work things out by itself. Prior to the Great Depression the US suffered regular depressions, some lasting several years. The 1800’s had many. There was one at the turn of the twentieth century. The worst, though, was the one we now call the Great Depression, and it was during that one that we learned how to cope better so the damage to society was minimized.

That learning took two forms: better monetary policy in the form of aggressive interest rate management by the Fed, plus the development of ‘unorthodox’ monetary policy actions like bulking up the Fed’s own balance sheet. The second was Keynesian demand management: getting the government to fill the demand void created by the implosion of the private sector so as to put a floor under the collapse and re-instill investor and consumer confidence.

Both these lessons are being applied in spades now. Which is why it is precisely government action that is saving us from depression at the moment.

Put it another way: without government action, especially the stimulus plan and the bank bailouts, we would certainly, absolutely, be in depression and facing the prospect of unemployment levels way above those we have now, far greater loss of wealth, and a very long and arduous climb back.

We dodged a depression very narrowly, and the private sector is still contracting.

Which brings me back to this week and Keynsian ‘animal spirits’.

The stock market rose strongly this year based upon an ebullience about the future: we had survived and were now undoubtedly going to recover. That meant that the depths to which prices had fallen were viewed as too low, thus stocks represented ‘cheap bargains’ relative to the value implied by the future profits the recovery would generate. Money flowed out of bonds and into stocks. Hence the run up. Everything was based upon a new set of expectations about the economy in 2010 and beyond.

But the gloss has come off a bit.

As usual, the guys on Wall Street over-reacted. They always do. They over-estimate profits and they under-estimate losses in good times and then do the opposite in bad times. That’s why the stock market is a very imperfect predictor of the economy. Those ‘animal spirits’ dominate. Cold hard reasoning doesn’t.

Extending this argument, Keynes also taught us that the entire economy was unstable due to ‘animal spirits’ driving consumers too: they tend to take on too much debt in good times and save too much in bad times. Banks too: they lend too easily in good economies and not enough in recessions.

The Keynsian vision is thus that of an economic system with inbuilt tendencies to lurch off track periodically. Since the private sector was inherently unstable it was the role of government to help smooth things out and act counter-cyclically.

Since this flies in the face of right wing ideology, economists like Milton Friedman and Robert Lucas have worked tirelessly to ‘disprove’ the Keynsian vision and re-establish a view of markets as flawless machines best left to themselves. They failed, but they managed instead to influence politics and the public sufficiently to produce the backlash against the stimulus. Their economic theories have just taken a beating, but their failure has yet to be absorbed by non-economists.

We get a better read on why the stock market is pulling back somewhat when we look through a Keynsian lens. The animal spirits that drove the ebullience of spring has now turned into an overly cautious doubt that there will be growth. So the conclusion is that prices where driven too high – the likelihood is that profits will be hard to grown much for a year or two – and so the market has to back off those heights.

This calmer view suggests that the recovery was going to be weak all along: consumers have a long way to go to recover their own ‘animal spirits’! Confidence remains low – it has actually slipped this summer after building quite well earlier. To paraphrase FDR: we still have fear to fear.

The inventory build up that is currently going on will end the recession this quarter or next. But until consumers get back to buying and stop saving we run the risk of stalling again next year.

We cranked the handle once to get the private sector going. There was a cloud of black smoke as it coughed out its excesses. It turned over a bit. But we made need to crank it again this Fall to ensure that the engine springs back to life on its own.

Wall Street has suddenly realized this. Hence the Monday morning blues.

Addendum:

For those of you who want to get into the notion of unstable economies – no doubt you’ve been brought up on equilibrium economics – I highly recommend reading any of Hyman Minsky’s books. He took Keynes and extended it into finance and banking. The best start is his compendium of essays ‘Can ‘It’ Happen Again?’ [‘It’ being the Depression]; or perhaps his ‘Stabilizing an Unstable Economy’. Minsky is a ‘must read’ for anyone wanting to understand what’s just gone on and what we should do about it.