Friday, August 20, 2010

Keynesian End Game – Fooled By Stimulus.

Nassim Nicholas Taleb wrote a fabulous book called Fooled By Randomness. It’s a treasured part of my library and will stay so to the day I die. Everyone should read it and then read it again. I won’t go into too much specifics, but it’s all about how investors as well as humans in general often are unaware of the existence of randomness. We tend to explain random events as non-random. Often from this we over analyze and over estimate causality. We tend to make the simple complicated and the complicated simple. When in fact the random happens all of the time and that most are unprepared for it because our belief systems are so out of whack. We have years of ingrown cognitive biases that distort our view of the world and its surroundings.
My point here is not to talk about randomness per say but to talk about being fooled. World markets are currently being fooled into thinking that Keynesianism is going to save us all. In fact, it’s the opposite. Keynesianism will be the hammer to the nail to the coffin to what Neo Classical Economics started. Policy makers and central bankers around the world have been indeed “Fooled By Stimulus.” The idea that exponential increases in debt and leverage will eliminate debt and leverage is at the foremost zeitgeist of Central Bank circles. This one single toxic theme has permeated almost all policy circles. Cheap debt begets more cheap debt. Bankers get drunk off of cheap debt because they can always invest somewhere to gain the spread.

Most central bankers call the Keynesian Theory of Economics the “Beautiful Theory.” This was the most influential economic theory of the early 20th Century. It saved us from the depths of the Great Depression. It is also currently the preeminent theory that is housed today. Keynes was an exceptional thinker who alerted all that financial markets are inherently unstable, Hyman Minsky said similar things in greater detail decades later but it was Keynes who mentioned it first. Keynes also had this Gem, “In the long run we are all dead.” Western democracies needed an approach to balance free market capitalism with government initiatives. Keynesianism was the approach. But all “beautiful” things inherently hide some ugly truths. Like the super model who has an eating disorder, and the gorgeous porn star who comes from a broken home. At the end of the day it all comes out on the wash.

I believe that the Keynesian miracle is dead. The game is over. The stimulus programs have not reduced unemployment and not spurred the real economy. America is currently running two economies and it’s the financial economy that Keynesianism has greatly helped at the expense of the real economy. This is the great divide in our country. It’s not Democrats V. Republicans. That’s too easy. It’s the Have V. Have Not’s. The debt costs used to prop up the financial economy has a direct consequence to the real economy for generations to come.
Keynesian economics was born with the publishing of John Maynard Keynes’ "The General Theory of Employment, Interest and Money.” This theory states or advocates a mixed economy, predominantly driven by the private sector, but with significant intervention by government and the public sector. Keynes argued that private sector decisions often lead to inefficient macroeconomic outcomes, and advocated active public sector policy responses to stabilize output according to the business cycle. Keynesian economics served as the primary economic model from its birth to 1973. It lost some of its luster during the high inflation and subsequent stagflation in the 70’s, but made a comeback during the credit crisis of 2007-2008.

This crisis rejuvenated Keynesian policy and we then received the following from government:
-American Recovery/Reinvestment Act
-Cash For Clunkers

Most of these programs were indeed geared to bailout the financial economy. It had very little effect on stabilizing the real economy but the financial economy just reloaded on the cheap debt.

This type of policy basically makes the point that we can have debt and credit expansion if the economy also grows with it. A rising tide lifts all boats. The rising tide really is a debt tsunami that is going to drown us all. Deflation will be the prevailing theme for developed economies for the foreseeable future. This is why the Fed is obsessed with a busted QE policy. Deflation is poisonous to levered risk assets. What typically happens after we have deflation is mass monetization of bad debt which undoubtedly leads to hyper inflation or general destruction of all Fiat currencies. Hyper inflation is not prices spiraling upwardly out of control, it’s the loss of confidence in ones currency. The Keynesian End Game is total and complete debt monetization which will lead most investors to give up on fiat paper currencies. Any wonder that gold and silver are all in rally mode? What should be happening is debt restructuring and outright default. This would cleanse economies and make lending much more responsible.

The prevailing wisdom of ever expanding debt loads being offset with stronger economies have been around for a long time. It worked all through the 1960’s. The debt loads were high but world economies were just getting in line and economies were able to grow. This made the debt load manageable. Many were worried about corporate debt loads, deficits, and personal debt burdens, but world economies powered higher. The critics were all wrong and looked like idiots.

Statistics on almost all types of debt showed a high correlation between their increases and increases in measures of economic health like the GDP, average personal net worth, and the country’s standard of living. This marched on for decades, but underneath the beauty was a sleeping slug. Over the years, the dollar increase in debt necessary to generate a dollar increase in GDP kept growing. In the late 1940’s and 1950’s, it took about a one dollar increase in debt to generate a one dollar increase in growth, but in each succeeding decade the amount of debt necessary to generate a dollar increase in GDP kept growing. Through the most recent decade, it seems to have taken more than five dollars of debt to produce one dollar of growth, and over the last few years the numbers might have gone into reverse, or perhaps only toward infinity, as all the increase in debt does not seem to create any growth.

Debt used to be the answer but it is increasingly becoming the wrong answer for our current ills. What are the alternatives? Painful ones I presume, that is why that they still alternatives. The easy thing to do is print and monetize debt. The world has not seen a reduction in debt levels since the Great Depression and it is painful obvious that debt reduction is what is needed but will not be implemented until all is lost.

Going back to the correlations of debt and GDP. We see that global GDP especially US Economic growth was 100% credit generated. The 2000-2007 boom was all about residential construction and homeowners using their homes as ATM machines. When the credit boom collapsed, we saw both economic and credit contract. From this policy makers instituted a ZIRP to try and reinflate past bubbles via animal spirits. In the past this worked but presently most Americans are experiencing a balance sheet recession, and no matter where short rates are most are in secular deleveraging mode. Expansionary monetary policy is failing because the debt levels are enormous, as an expansion of credit has lost its power to stimulate growth. As such a reduction in debt levels coupled via restructuring and outright default of debt will have a devastating effect on economic output. What we are experiencing and seeing before our own eyes is the Keynesian End Game. A dead end for Risk Markets .

Just from this logic I can deduce: Forget a double dip recession. The vast amount of Americans never fully recovered from the 2007-2008 credit crisis. A new depression has begun. There will be massive amounts of new debt issued around the world by Central Bankers, this only delays the process of recovery as new debt will not stimulate growth but only keep alive zombie financial institutions. Eventually there is no other option than to restructure/default the debt load. Global debt loads need to shrink and shrink fast. Only after this catharsis where the debt is purged can we can realistically think of growth via reflation.

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