Blogvesting

Nowadays, every stock seems to be trading not based on their fundamentals, but based on the fear that the economy will sink into a depression. If indeed this fear proves to be true, then buying stocks now would be a mistake. In the Great Depression of the 1930s, US GDP shrunk by 27%, pushing the unemployment rate up to 25%. Deflation rates of up to 27% caused consumers to defer consumption and conserve cash at all costs. The situation was aggravated by policy missteps by the federal government, including a call by Herbert Hoover for citizens to tighten their belts, and the passing of the protectionist Smoot-Hawley Tariff Act, which caused retaliatory measures by other countries causing US exports to drop by 66%. In the face of the deep economic malaise, the US stock market sunk by more than 80%, and remained at those levels for almost a decade, until the forced expenditures caused by World War 2 ended the Great Depression.

To find out where we’re headed, its important to see where we are today. The US economy has begun to shrink at an annual rate of 0.3%, and unemployment has edged up to 6.1%. Inflation is running at 4%, but will fall in the near future as the price of oil and other commodities have plunged in the face of weak global demand. Similarly, US exports, which had been growing by 15% until recently, will probably decline as world demand decreases. Government mistakes in the form of allowing Lehman to fail has sparked a financial crisis which is only now coming under control. The Fed has aggressively lowered interest rates down to 1%, and the Treasury has injected capital into banks, but banks are not lending at any price, since there is spare capacity in nearly every business sector, and banks do not know how high default rates will rise, and therefore prefer to keep the excess capital in case they need it in the future. Massive deleveraging and capital flight to cash on a global scale have sparked economic crises in multiple countries, further threatening global demand.

The key now is in boosting demand. Without adequate demand, there will be spare capacity in the economy, with excess resources going unused (spare land going unused, spare labor in the form of a high unemployment rate, and spare capital in the form of cash sitting in bank accounts and under mattresses). Monetary stimulus has reached its limit; it is time for the federal government to step up with fiscal stimulus to boost demand. This stimulus should be channeled towards productive purposes (e.g. building wind farms to wean the US off oil imports, building a national broadband system etc.) instead of more consumption (e.g. shopping vouchers for citizens). During the 1980s, the Japanese government issued multiple tax credits and started many “bridge-to-nowhere” infrastructure projects in trying to jump-start the Japanese economy from a deflationary spiral, but they failed because people saw that these measures all had a temporary effect which would fade once the extra one-time demand ceased, and resisted investing in new factories. Only when it is clear that the new measures will result in permanent new demand (e.g. by shifting demand for foreign oil into demand for domestic wind power, resulting in permanent new jobs in the US) will the private sector be willing to invest its own capital into the economy.

What will happen in the future? In the worst case scenario, the US may endure a Japan-style lost decade. The Fed cuts rates to zero without increasing lending, and deflation causes people to avoid taking on debt (which costs more to repay in a deflationary environment) and to defer consumption (goods get cheaper with time). The economy stabilizes at a level of lower consumption, with 15-20% unemployment rate and lower living standards, and the stock market stays depressed. In the best case scenario, the US government incurs large deficits to spur productive investments in infrastructure, education and technology. It pays for this deficit by issuing Treasury bonds on a large scale, and the Fed holds the interest rate of these bonds at a measly 1% by buying up excess bonds on the open market (i.e. by printing money). Foreigner creditors take a look at the deteriorating balance sheet of the US government and the burgeoning inflation, and decide that rather than hold Treasury bonds that are losing value, they would rather buy USD-denominated assets, such as stocks and real estate. The housing and stock markets recover, and US consumers feel richer again and start spending. The increasing inflation discourages people from holding cash, and demand recovers.

It may seem like heresy to advocate for higher inflation, since inflation works against savers and investors (like myself), and benefits debtors (like the idiots who took out loans they could not afford). However, on a macroeconomic basis, it is reality that the US is a country with a negative savings rate, and that we have depended on foreign countries to fund our consumption for nearly a decade. I see moderate inflation as a fair way to spread the pain between debtors and creditors, who share responsibility for past excesses and the current situation. Inflation erodes the value of the huge pile of Treasuries held by foreign creditors, causing them pain, and also makes future consumption more expensive, causing US consumers pain. In the short term, the US loses a chunk of its productive assets to the hands of foreign government as the price for past consumption, and in return the US economy regains its footing and continues to be the most innovative economy in the world, generating new productive assets (ideas, companies, technology) at a rapid clip.

The key to an economic recovery therefore now rests almost entirely upon government policy (as well as policies by foreign governments). This is the key reason why stock markets are so volatile at this time; the current administration is genetically opposed to government intervention and vaciliates from policy to policy, while the capabilities of the future government is not yet clear. At no time in recent history has government leadership been as important as it is today.