At the not so tender age of 91, retired economics professor Herb Hoover still loves to rage against the stock market machine. You see, throughout his stock picking life, Professor Hoover has always managed to be at exactly the wrong place at the worst possible time.
It started in 1931 when Herb’s namesake President Hoover raised interest rates to protect the gold standard. Just the right classical economic medicine, thought graduate student Herb at the time. So he bought his first 100 shares of stock and then watched his certificates turn worthless as President Hoover’s tight money policies shoved the country off the precipice of recession into the Great Depression.
Nor did Herb do any better on his next market foray. That was a few years later after Franklin Roosevelt had replaced Hoover and started listening to that radical English economist John Maynard Keynes. It just made no sense to run a huge budget deficit to save the country—or so his professors at Harvard told him. So this time, Herb plunged. He shorted 1000 shares of General Motors—and then watched in dismay as the economy recovered and the stock zoomed in price.
These two stock market experiences pretty much cured Herb of wanting to take any more risks for the next 40 years. So Herb stayed out of the market until 1979. That’s when the Federal Reserve embraced the philosophy of one of Herb’s great idols in life, the monetarist guru Milton Friedman. Herb was so sure that the economy would boom under the Fed’s newfound monetarism that he took all his retirement money out of bonds and put the cash into a high-growth mutual fund. Three years later, after the Fed’s monetarist experiment had caused the worst recession since the Great Depression, the fund was as broke as Herb.
Too bad, because Herb missed out on the great bull market that took off when Ronald Reagan started all that supply side nonsense. Cut taxes to increase budget revenues? Herb knew that was smoke and mirrors. But boy did the stock market love it.
For Herb, the last straw came in the early 1990s. Herb was sure there would be a presidential election stock market rally because there always had been. So he tried the market one last time—this time with some very heavy margin buying. He was going for broke—and he got just that. But how was Herb to know that some new branch of economists calling themselves “new classicals” had taken over the George Bush White House and were refusing to prime the economic pump. The resulting economic slump not only cost Bush the election, it wiped Herb out for the fourth and final time.
As Herb Hoover learned the very hardest of ways, if you are going to trade or invest successfully, it is essential that you understand the basic differences between the warring schools of macroeconomics. These five schools include: classical economics, Keynesianism, monetarism, supply side economics, and new classical economics. Understanding the differences between these schools of thought is essential for at least two reasons.
First, each school has important insights that the macrowave investor can use to sharpen his or her perspective on the financial markets. For example, classical economics teaches us about how economies and markets naturally adjust, while Keynesian economics explains the conditions under which those adjustments are unlikely to take place. Similarly, monetarism reveals the all-important link between money and prices, while supply side economics explains how an economy can use tools such as tax cuts and deregulation to grow without worry of inflation. And, of course, new classical economics shines an absolutely brilliant light on the role of expectations in the stock market and the broader macroeconomy.
Second, and more important, each of the different schools of macroeconomics will prescribe a very different policy cure for whatever macro ills may be ailing us. This is of a very real practical importance because, at any given time, one of these schools of macroeconomics may have the ear of the President or the Congress or even the Federal Reserve. For example, both Presidents Herbert Hoover in the 1920s and Dwight Eisenhower in the 1950s were strongly influenced by classical economics, while Presidents Franklin Roosevelt in the 1930s and John F. Kennedy in the 1960s were surrounded by Keynesian advisors.
In contrast, during the late 1970s when stagflation was raging, monetarists quite literally took over the Federal Reserve, and the Fed under Chairman Paul Volcker stopped trying to control interest rates and instead established monetary growth targets. The result was a sharp spike in interest rates that wreaked havoc with the bond and currency markets and sent interest-sensitive stocks reeling.
The broader point here is that it is not just the macroeconomic problems that we discussed in the first chapter that the macrowave investor has to worry about. It’s also how Congress and the President and the Federal Reserve are likely to react to the problems. Will Congress cut taxes? Will the Fed raise interest rates? Will the President support an increase in government spending? And the punch line here is that the answers to all of these questions will be very dependent on which political party is in control of the White House and Congress and which of the warring schools of macroeconomics that party is currently listening to.
In this regard, it is fair to say that the Democrats are generally Keynesians who favor an activist fiscal and monetary policy. In contrast, the Republicans are generally divided among the monetarist, supply side, new classical, and even classical camps—all of which discourage an activist fiscal and monetary policy in some degree.
With this, then, as background, let’s dive into a quick, capsule history of the warring schools. This history begins with classical economics and moves, during the Great Depression, to Keynesian economics. Then, during the 1970s era of stagflation, we witness the triumph of monetarism, which is then quickly eclipsed in the 1980s by supply side economics. However, after a brief reign of the new classical economists in the 1990s, the nation’s policymakers like Alan Greenspan return in the 2000s to an eclectic form of Keynesian macroeconomic policy which appears to incorporate, in some small or large way, the wisdom of all of the schools.
“The truly savage and frenetic part of New York is not Harlem,” the Spanish poet [Federico] Garcia Lorca told a Madrid lecture audience in 1932. “In Harlem, there is human warmth and the noise of children, and there are homes and grass, and sorrow finds consolation and the wound finds its sweet bandage.” “The terrible, cold, cruel part,” he declared, “is Wall Street.” Wandering through its “limestone canyons” in October, 1929, Lorca observed the great stock-market crash that would help usher in the Great Depression. “A rabble of dead money went sliding off into the sea. Ambulances collected suicides whose hands were full of rings.”
THE NATIONAL POST
The irony of the Great Depression is that Herbert Hoover was one of the brightest men to ever occupy the White House. His problem, however, is that he had become a pitiful and much ridiculed prisoner of the prevailing economic doctrine of his time—classical economics.
Classical economics dates back to the late 1700s and has its roots in the laissez faire writings of free market economists like Adam Smith, David Ricardo, and Jean-Baptiste Say. These classical economists believed that the problem of unemployment was a natural part of the business cycle, that it was self-correcting, and, most important, that there was no need for the government to intervene in the free market to correct it.
Between the Civil War and the Roaring Twenties, America sustained periodic booms and busts—recording no less than five official depressions. However, after every bust, the economy always bounced back—exactly as the classical economists predicted. That was true until these classical economists met their match in the Great Depression of the 1930s. With the stock market crash of 1929, the economy fell into first a recession and then a deep depression. The gross domestic product fell by almost a third and by 1933, 25 percent of the work force was unemployed. At the same time, business investment virtually disappeared, from about $16 billion in 1929 to $1 billion by 1933.
While President Herbert Hoover kept promising that “the worst is over” and “prosperity is just around the corner,” and the classical economists kept waiting for what they viewed as the inevitable recovery, two key figures walked onto the macroeconomic stage—economist John Maynard Keynes and Hoover’s presidential successor, Franklin Roosevelt.
We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.
JOHN MAYNARD KEYNES
John Maynard Keynes flatly rejected the classical notion of a self-correcting economy. He warned that patiently waiting for the eventual recovery was fruitless because, as his most famous utterance informs us, “in the long run, we’re all dead.”
Keynes believed that under certain circumstances, the economy would not naturally rebound but simply stagnate or, even worse, fall into a death spiral. To Keynes, the only way to get the economy moving again was to prime the economic pump with increased government expenditures. Thus, fiscal policy was born and the Keynesian prescription became the underlying, if unstated philosophy, of Franklin Roosevelt’s New Deal. Fiscal policy uses increased government expenditures or, alternatively, tax cuts to stimulate or expand the economy. Fiscal policy can also be used to contract the economy and fight inflation by reducing government expenditures or raising taxes.
Roosevelt’s ambitious public works programs in the 1930s, together with the 1940s boom of World War II, were enough to lift the American economy—and the stock market—out of the Great Depression and up to unparalleled heights. In the early 1950s, the Keynesian prescription of large-scale government expenditures worked again—this time when the heavy spending associated with the Korean War helped pull the economy out of a slump. A decade later, pure Keynesianism reached its zenith with the much heralded Kennedy tax cut of 1964 passed in honor of the slain president.
In President John F. Kennedy’s Camelot, the Council of Economic Advisors Chairman Walter Heller popularized the term “fine tuning,” and Heller firmly believed that through the careful mechanistic application of Keynesian principles, the nation’s macroeconomy could be held very close to full employment with minimal inflation. In 1962, Heller recommended to Kennedy that the President advocate a large tax cut to stimulate the sluggish economy. The Congress eventually agreed, and this Keynesian tax cut helped make the 1960s one of the most prosperous decades in America. However, this fiscal stimulus also laid the foundation for the emergence of a new and ugly macroeconomic phenomenon known as stagflation—simultaneous high inflation and high unemployment.
I knew from the start that if I left a woman I really loved—the Great Society—in order to fight that bitch of a [Vietnam] war…then I would lose everything at home. My hopes…[and] my dreams.
LYNDON B. JOHNSON
The stagflation problem had its roots in President Lyndon Johnson’s stubbornness. In the late 1960s, against the strong advice of his economic advisors, Johnson increased expenditures on the Vietnam War but refused to cut spending on his Great Society social welfare programs. This refusal helped spawn a virulent demand-pull inflation.
The essence of demand-pull inflation is too much money chasing too few goods, and that’s exactly what happened when the U.S. tried to finance both guns and butter—both the Vietnam War and the Great Society. The result not only was a roaring economy and a very low unemployment rate, but rapidly increasing inflation as well. In this sense, demand-pull inflation is a very bullish phenomenon in that it emerges when times are too good.
In 1972, President Richard Nixon imposed price and wage controls and gained the nation a brief respite from the Johnson-era demand-pull inflation. However, once the controls were lifted in 1973, inflation jumped back up to double digits—helped in large part by a different, much more bearish kind of inflation then emerging. This inflation was known as cost-push inflation.
Cost-push inflation occurs as a result of so-called “supply shocks” such as those experienced in the early 1970s. During this period, such shocks included crop failures, a worldwide drought, and a quadrupling of the world price of crude oil. Over time, cost-push inflation can lead to a longer-term stagflation. This is simply recession or economic stagnation combined with inflation. In this situation, and unlike with demand-pull inflation, the economy suffers the double whammy of both higher unemployment and higher prices.
What’s most interesting about stagflation is that prior to the 1970s, economists didn’t believe you could even have both high inflation and high unemployment at the same time. If one went up, the other had to go down. But the 1970s proved economists wrong on this point and likewise exposed Keynesian economics as being incapable of solving the new stagnation problem. The Keynesian dilemma was simply this: Using expansionary policies to reduce unemployment simply created more inflation, while using contractionary policies to curb inflation only deepened the recession. That meant that the traditional Keynesian tools that worked so well getting the nation out of the Great Depression could solve only half of the stagflation problem at any one time—and only by making the other half worse.
It was this inability of Keynesian economics to cope with stagflation that set the stage for Professor Milton Friedman’s monetarist challenge to what had become the Keynesian orthodoxy.
Federal Reserve Chairman Paul Volcker’s war on inflation strangled the economy—and the stock market.
USA TODAY
Milton Friedman’s monetarist school argues that the problems of both inflation and recession may be traced to one thing—the rate of growth of the money supply. To the monetarists, inflation happens when the government prints too much money, and recessions happen when it prints too little.
From this monetarist perspective, stagflation is the inevitable result of government mischief—namely, the repeated use of activist fiscal and monetary policies to try to push the economy beyond its growth limits. In the somewhat tortured parlance of monetarism, these limits are referred to as the economy’s “natural rate of unemployment”—although most of us probably believe that there is nothing natural about unemployment.
Be that as it may, according to the monetarists, expansionary attempts to exceed the economy’s natural limits may result in short-run spurts of growth. However, after each growth spurt, prices and wages inevitably rise and drag the economy back to its natural rate of unemployment—albeit at a higher rate of inflation.
Over time, these repeated and futile attempts to push the economy beyond its limits eventually lead to an ugly upward inflationary spiral. In this situation, monetarists believe that the only way to wring inflation and inflationary expectations out of the economy is to have the actual unemployment rate rise above the natural rate and that means only one thing: inducing a recession.
This is at least one interpretation of what the Federal Reserve did beginning in 1979 under the monetarist banner of setting monetary growth targets. Under Chairman Paul Volcker, the Fed adopted a sharply contractionary monetary policy and interest rates soared to over 20 percent. Particularly hard-hit were the bond and currency markets, along with interest-sensitive sectors of the economy like housing construction, automobile purchases, and business investment.
While the Fed’s bitter medicine worked, three years of hard economic times left a bad taste in the mouths of the American people now hungry for a sweeter macroeconomic cure than either the Keynesians or monetarists could offer. Enter stage right: supply side economics.
They say the U.S. has had its day in the sun; that our nation has passed its zenith. They expect you to tell your children…that the future will be one of sacrifice and few opportunities. My fellow Americans, I utterly reject that view.
RONALD REAGAN
In the 1980 presidential election, Ronald Reagan ran on a supply side platform that his then-rival George Bush branded as “voodoo economics.” Voodoo or not, Reagan cast a wonderful spell over both the general public and the stock market as he promised to simultaneously cut taxes, increase government tax revenues, and accelerate the rate of economic growth without inducing inflation. This was a promise of a very sweet macroeconomic cure indeed.
On the surface, the supply side approach looks very similar to the kind of Keynesian tax cut prescribed in the 1960s to stimulate a sluggish economy. However, the supply-siders of Reagan’s time viewed such tax cuts from a very different behavioral perspective. Unlike the Keynesians, they did not agree that such a tax cut would necessarily cause inflation. Instead, the supply-siders believed that the American people would actually work much harder and invest much more if they were allowed to keep more of the fruits of their labor. The end result would be to increase the amount of goods and services our economy could actually produce by pushing out the economy’s supply curve—hence, “supply side” economics.
Most important, the supply-siders promised that by cutting taxes and thereby spurring rapid growth, the loss in tax revenues from the tax cut would be more than offset by the increase in tax revenues from increased economic growth. Thus, under supply side economics, the budget deficit would actually be reduced.
Unfortunately, that didn’t happen. While the economy and stock market boomed, so too did America’s budget deficit. And as the budget deficit soared, America’s trade deficit soared with it.
President Bush, thrown on the defensive by continued national economic problems…, plans to try to regain political momentum by accelerating the formation of his official reelection campaign.… “It’s falling apart,” one GOP activist said of the once well-oiled White House political and message machinery.… “We’re getting the crap beat out of us. The Democrats have pulled George Bush right into their playing field and they’re punching him out.”
THE WASHINGTON POST
How a president with a sky-high approval rating right after winning the war with Iraq fell so far and so fast in the polls is one of the great political stories of all time. But it is a story that hinges purely on economics.
At the time of the Gulf War, President George Bush was deeply concerned about a lot more than Saddam Hussein. Indeed, the budget deficit had already jumped to over $200 billion, and the economy was sliding into a serious recession. To any red-blooded Keynesian, this onset of recession would have been a clear signal to engage in expansionary policy. However, in the Bush White House, Ronald Reagan’s supply side advisors had been supplanted not by Keynesians but rather by a new breed of macroeconomic thinkers—the so-called “new classicals.”
New classical economics is based on the theory of rational expectations. This theory says that if you form your expectations rationally, you will take into account all available information including the future effects of activist fiscal and monetary policies.
The idea behind rational expectations is that activist policies might be able to fool people for a while. However, after a while, people will learn from their experiences, and then you can’t fool them at all. The central policy implication of this idea is, of course, profound: Rational expectations render activist fiscal and monetary policies completely ineffective, so they should be abandoned.
For example, suppose the Federal Reserve undertakes an expansionary monetary policy to close a recessionary gap. Repeated experiences with such activist policy have taught people that increases in the money supply fuel inflation. To protect themselves in a world of rational expectations, businesses will immediately respond to the Fed’s expansion by raising prices, workers will demand higher wages, and the attempted stimulus will be completely offset by the contractionary effects of inflation.
In fact, we observe global financial markets acting with such rational expectations all the time, and it is precisely this kind of forward thinking that this book is trying to cultivate. One small example is offered up by how the financial markets reacted in the first part of the year 2000. During that turbulent time, as demand-pull inflationary pressures continued to mount, the Federal Reserve steadily raised interest rates—six times over an 11-month period. However, the financial markets never waited for the Fed to actually raise the rates. Instead, adjustments took place well prior to the events on the expectation that the Fed would do what it actually did. Bond yields rose while bond prices fell; the dollar strengthened; the commodity market emerged as an inflation hedge; and the stock market reversed into bear territory. Of course, any microtrader who ignored all of these macrowave signals consistently wound up on the wrong side of any trade.
But let’s get back to President Bush’s plight back in the early 1990s. While Bush’s new classical advisors may have been giving him some very good economic advice, it was absolutely horrible political advice. Indeed, these new classical advisors flatly rejected any Keynesian quick fix to the deepening recession. Instead, they called for more stable and systematic policies based on long-term goals instead of continuing to rely on shortsighted discretionary reactions.
Bush took this new classical advice to heart, the economy limped into the 1992 presidential election and, like Richard Nixon in 1960, Bush lost to a Democrat promising to get the economy moving again. What is perhaps most interesting about this transition of power is that Bill Clinton actually did very little to stimulate the economy. The mere fact, however, that Clinton promised a more activist approach helped restore business and consumer confidence.
Today, the nation’s macroeconomic magicians appear to be able to keep severe recessions and depressions at bay. This is the real triumph of modern macroeconomics; it is great news for investors and is illustrated in Fig. 2-1. Note how the amplitude of the business cycle has been considerably reduced since the wide-scale application of macroeconomic policies after World War II.
FIGURE 2-1 The triumph of macroeconomics.
This figure would appear to provide strong testimony to the argument that activist fiscal and monetary policies can reduce the volatility of the business cycle and, by implication, the volatility of the stock market cycle. In the next two chapters, we will delve more deeply into the mysteries of fiscal and monetary policy. In the meantime, however, the broader points we want to take away from this chapter are simply these:
• The warring schools of macroeconomics will always disagree about how to fight the problems of recession, inflation, and stagflation.
• At any given point in time, the Federal government’s solutions to these problems will be shaped by whichever of the warring schools has the ear of the President and the Congress and the Federal Reserve.
• Depending on which solutions are adopted, the stock market will react in different ways and in different degrees.
For example, in the event of a recession, a Keynesian president may opt for an increase in government spending to stimulate the economy. This may provide a short-run boost to the stock market as well as a stimulus to specific sectors of the market like defense and housing that rely heavily on the government for business. But the bond market may react negatively for fear that the resultant budget deficits will drive up interest rates.
In contrast, a supply side president may favor a large tax cut for consumers coupled with a cutback in the regulation of certain businesses to jump-start the recessionary economy. This, too, may boost the stock market. But the consumer tax cut may also give a particular boost to the stock prices of companies in consumer-dependent sectors like retailing and automobiles. In addition, the companies in those industries most likely to benefit from the deregulation—perhaps chemicals or telecommunications—may likewise get a share price boost.