• In 1933, President Franklin Roosevelt began to dramatically increase government expenditures on a whole slew of Keynesian-inspired New Deal programs, and the U.S. economy began what would be its very long journey out of the depths of the Great Depression. Over the next four years, the Dow Jones stock market average would rise by 240 percent.
• In 1954, the U.S. economy fell into its deepest recession since the Great Depression. President Dwight D. Eisenhower responded with a call for major tax cuts and increased public spending, bears turned to bulls, and the stock market rallied more than 80 percent over the next 15 months.
• In 1964, Congress passed the famous Kennedy Tax Cut in honor of the slain president. This textbook Keynesian remedy shook the U.S. economy out of its doldrums, and the Dow Jones Industrial Average raced up over 40 percent over the next two and a half years.
• In 1982, President Ronald Reagan dramatically cut taxes, the economy broke free of its chains of monetarist restraint, and the stock market took off on a five-year bull run, rising over 200 percent. This would not be the longest bull run in history, however. That happened during the long and often tumultuous reign of William Jefferson Clinton.
• At the beginning of his first term in the 1990s, Bill Clinton raised taxes and cut spending to help balance the Federal budget. This calmed Wall Street’s fears over the burgeoning budget deficit, the economy prospered, and the bulls on Wall Street went on rampaging right into the new century.
• At the beginning of his term in 2001, President George W. Bush engaged in a very subtle war with Fed Chairman Alan Greenspan over whether a flagging economy should be revived by Bush’s tax cut or Greenspan’s interest rate cuts. The ensuing uncertainty heightened inflationary concerns, while a policy gridlock made it much more difficult for either Bush or Greenspan to take the appropriate steps needed to restore the nation’s economic health. In the process, the stock market’s recovery was stalled.
All of these examples illustrate how fiscal policy can have a profound effect on the movements of the stock market—where fiscal policy is simply increasing government spending or cutting taxes to stimulate the economy, or decreasing government expenditures or raising taxes to contract an overheated economy. What we want to do in this chapter is to first understand how fiscal policy works and then use our macrowave logic to figure out how the effects of fiscal policy are likely to ripple through the stock and bond markets.
To really understand the essence of fiscal policy, we need to start with a little national income accounting. To total a nation’s gross domestic product (GDP), all we have to do is add up consumption spending, investment spending, government spending, and net exports, where net exports are simply exports minus imports. In terms of understanding fiscal policy, this GDP calculation is important for two reasons.
First, it gives us an idea of the relative importance of each of the components that make up the GDP. For example, consumption represents almost 70 percent of the GDP. That’s why the savvy macrowave investor will pay particular attention to consumption indicators like consumer confidence, retail sales, and personal income. Changes in these major indicators can all be early warning signs that the largest component of the GDP is about to tank and trigger a recession—or perhaps overheat and ignite inflation.
The second and perhaps even more important reason that the GDP formula is important is that it helps us work through the macrowave logic that motivates discretionary fiscal policy actions to begin with. For example, suppose the macroeconomy suffers some kind of negative shock like a war in the Middle East or a worldwide drought triggered by an El Niño condition. This might cause consumers to save more out of worry and therefore consume less. While consumption starts to go down in our GDP formula, this is just the beginning of the story.
The next thing that happens is that inventories begin to pile up at businesses because consumers are spending less. Businesses not only respond by reducing their investment, they also begin to lay people off. And what do you think the newly laid off people do—or don’t do, as the case may be? That’s right. They spend less, so consumption falls some more. This leads to more inventory accumulations, even less investment, and more layoffs. And so the downward recessionary spiral goes until it reaches some kind of bottom.
Now, the whole idea behind fiscal policy is to first stop, and then reverse, this recessionary slide. It does so by offsetting the declines in consumption and investment in one of two ways.
The first Keynesian option is to simply increase government spending. In fact, this is exactly what the government did to get us out of the Great Depression in the 1930s, as it spent large sums on New Deal public works projects to offset the massive declines in consumption and investment brought about by the 1929 stock market crash. Such a Keynesian stimulus was also used very successfully in the 1950s to pull the economy out of a recession. However, since that time—more than 50 years ago—this kind of fiscal policy has rarely been used as an antirecessionary tool.
Not so for the second fiscal policy option. This second Keynesian option, which has obvious political appeal, involves cutting taxes to stimulate economic growth. For example, the most famous Keynesian tax cut ever administered was in 1964 during Lyndon Johnson’s presidency. This was the broad-based tax cut noted earlier that was passed in honor of the recently assassinated President Kennedy, who had originally proposed it. This tax cut helped drive the Dow Jones Industrial Average up by more than 40 percent over two and half years. The irony of this tax cut, of course, is that just five years later, the Johnson Administration had to impose a tax increase to cool down an economy overheated by a combination of the original Kennedy tax cut, the war in Vietnam, and expenditures on President Johnson’s Great Society programs. Essentially, this tax hike was fiscal policy in reverse.
A second historic example of a tax cut which stimulated the economy occurred in the Reagan years in the 1980s. While this cut was marketed as a supply side tax cut by the Republican president, at least some have argued that the effects of the Reagan tax cuts were primarily on aggregate demand and that it really was a classic Keynesian example of fiscal policy rather than true supply side economics. Here is how Business Week put it:
The Reagan Administration was launched with a flurry of economic experimentation. Citing supply-side economics, the President proposed to cut taxes, boost defense spending, and still balance the budget. But the 1981 tax cut failed to produce a surge in revenues. Many economists now believe that growth under Reagan was stimulated by deficits and that supply side [economics] is nothing more than Keynesianism on steroids.
That assessment is a harsh one—and perhaps inaccurate. But regardless of who is right about whether the Reagan tax cuts were new-fangled supply-side or old-style Keynesianism, the effects of these cuts on both the economy and the stock market were dramatic.
As for how and why the effects of fiscal policy are likely to ripple through the stock market, this is where fiscal policy really gets interesting from the macrowave investor’s point of view. This is because to increase government expenditures or cut taxes, the government typically has to increase the budget deficit. The important question for the macrowave investor to ask here, then, is this: How will the government finance a budget deficit that results from expansionary fiscal policy?
As a practical matter, there are two ways to finance a deficit. The government can either sell bonds or print money. And the point we want to make here is that these two options present both very different dangers and very different profit-making opportunities for the macrowave investor.
As an undergraduate in the 1970s, I was taught that…one of the important features of a successful economy was the use of budget deficits as a stimulus to economic growth. This idea, which had its roots in Keynes’s writings…still captures a very important truth about certain economies at certain times.… Since the time when I studied these theories, however, …we have come to understand that we must place much greater emphasis on the importance of supply factors for long-term growth and be much more cognizant of the danger that by crowding out investments, budget deficits can slow productivity growth and lead to a vicious cycle of higher public borrowing at higher interest rates, leading to still lower investment and economic growth, which in turn leads to even larger budget deficits.
TREASURY SECRETARY LAWRENCE SUMMERS
With bond financing, the U.S. Treasury goes directly to the private financial markets and sells the bonds it needs to finance its deficit. The big danger of this option is that the sale of these government bonds will raise interest rates and thereby crowd out private investment—as former Treasury Secretary Larry Summers eloquently warns above. This crowding out can happen because in order to sell its bonds, the Treasury may have to raise interest rates. But higher rates will make corporate bonds less attractive, and the result will be a lower level of private investment. You can see, then, why budget deficits make both the stock and bond markets very, very nervous.
And note the irony here. The government is increasing government spending to offset declines of consumption and investment during a recession. However, when the government sells bonds to finance its expenditures, this can raise interest rates, and that, in turn, can drive down investment in the GDP formula even further. To the extent, then, that private investment falls as government spending rises, there is crowding out of the private sector even as fiscal policy becomes a much less effective tool.
At the beginning of 1970, [President Richard] Nixon had installed his old friend Arthur Burns as chairman of the Federal Reserve.… Burns had more or less promised Nixon that he would, if appointed, flood the economy with whatever liquidity it took to elect Republicans in 1970 and ‘72. Once he got the job, however, he hesitated. Burns understood perfectly well how inflationary Nixon’s monetary policy would be. He would only proceed, he decided, if Nixon restrained prices directly.… On August 15, 1971, Nixon announced the most stunning turnabout in American economic policy since 1933. He froze wages and prices for ninety days, imposed a 10 percent surcharge on all imports, and refused any longer to exchange gold for dollars at the $35 rate.
In the short term, the plan worked. A delighted Arthur Burns started the printing presses rolling at the Mint, and Nixon got his 1972 boom—and 61 percent of the vote. What he also got, however, was double-digit inflation in 1973–74, an energy shortage, the collapse of the international monetary system, and the worst economic slump since 1940.
THE WEEKLY STANDARD
Here, I might add one important item to the Weekly Standard’s list of financial disasters wrought by the Fed’s unrestrained printing of money in the Arthur Burns era. That item, of course, was the second worst bear market in American history. In 1973 and 1974, this bear market ripped the Dow Jones Industrial Average almost in half. Only the bear market of the Great Depression, which saw the Dow drop by 89 percent, was worse.
Clearly, then, the government’s printing press can pose a grave threat to your portfolio—or perhaps a wonderful shorting opportunity. But how, you may ask, does the Federal Reserve actually print money to finance a budget deficit?
Well, this happens when the Fed purchases the U.S. Treasury bonds before they hit the open market. In this case, the Fed is said to be “accommodating” the government’s fiscal policy because it is buying the bonds rather than letting those bonds go out on the open market to compete with corporate bonds. And that’s why this method of financing the budget deficit is equivalent to “printing money.” The Fed simply pays for the Treasury bonds with a check that increases bank reserves.
Historically, there have been some very interesting battles over the Fed’s accommodation, or lack thereof, of discretionary fiscal policy. For example, during the Vietnam War, Federal Reserve Chairman William McChesney Martin steadfastly refused to accommodate the budget deficit being run by the Johnson Administration to finance the Vietnam War and Great Society, and the result was a double-digit spike in interest rates. On the other hand, as our news clip from the Weekly Standard notes above, the Fed under Arthur Burns accommodated the Treasury when the U.S. tried to use fiscal policy to get out of the recession. However, the result of this easy money policy was a disaster as well.
More broadly, the savvy macrowave investor should clearly understand that the two different ways of financing a budget deficit—bond financing and printing money—can have very different impacts on the financial markets. In the case of bond financing, higher interest rates are likely to drive the stock and bond markets down and the value of the dollar up. This is a recipe for short selling and currency speculation. In contrast, with the print money option and lower interest rates, bond prices will tend to fall along with the value of the currency while the stock market will tend to rise; that’s very bullish for stocks—at least in the short run. However, if the easy money policy ignites inflation, as it did in the Arthur Burns era, just about everyone on Wall Street will be running for the exits. In this kind of situation, only the bears and nimble short sellers are going to be making a buck.
You can see, then, how complicated the impact of an application of fiscal policy is on the financial markets. In the next chapter, we will see that the same is true for monetary policy.