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We are all Keynesians now...

September 23, 2019
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“We are all Keynesians now,” is what is now being espoused as the new economics. While we won’t explain the entire theory of economics proposed by John Maynard Keynes, it was a “demand-side” belief system. A key tenet was using government spending, budget deficits, and loose money to let bureaucrats exert control over the economy. After its failure in the 1970s, Ronald Reagan and Margaret Thatcher changed the world by moving it back toward a supply side, small government mentality.

The U.S. and U.K. moved from high inflation, high unemployment, and slow growth to low inflation, low unemployment, and strong growth. But, since the crisis of 2008, the commanding heights of economic control have once again shifted toward big government. Quantitative easing, zero percent interest rate policy (ZIRP), negative interest rate policy (NIRP), TARP, infrastructure spending, minimum wages, and new ideas for wealth taxes, free healthcare,…etc., have all been either proposed or tried. The result? Ever since government assumed the high ground, global growth has slowed. Especially when compared to what it was in the 1980s and 1990s when government was reducing its role in the economy.

Does the consistent failure to create growth matter to those who are proposing bigger government? Absolutely not. They ignore it and call for even more government intervention. Just this past week, Mario Draghi, in his last act as head of the European Central Bank, cut the interest rate it pays on excess reserves to -0.5% from -0.4%. But negative interest rates have been little short of a disaster. European and Japanese banks are suffering. Their loans and economic activity haven’t budged. There is zero evidence that negative interest rates help economic activity, but plenty of evidence they hurt. Draghi, himself, called for “fiscal” policy help for the economy, but he wasn’t suggesting tax cuts and regulatory relief, he meant more government spending – a purely Keynesian prescription.

Here’s the problem. Demand-side, Keynesian policies don’t work. Growth comes from the supply-side – from inventions, innovation, and entrepreneurship. In fact, between 2009 and 2016, without the tremendous tailwinds from the likes of fracking, smartphones, apps, and 3-D printing, it is easy to believe that two major tax hikes, increases in regulation and spending, and massive fines on financial institutions would have pushed real GDP growth negative.

Government is bigger and tax rates and regulation more burdensome in Europe. That’s why it’s lagged U.S. growth for decades. What the world learned in the 1980s was quickly forgotten by Europe, and now it’s being forgotten by thought leaders in the U.S. These old ideas have also transfixed investors, who cannot think about the economy without coming at it from a government policy point of view. How much new QE will the ECB propose? And what about President Trump’s tweet that the U.S. should have negative interest rates? This is all dangerous for long-term economic growth in both the U.S. and abroad. People will suffer to the extent these policies are followed.

The good news is that, in the near-term, corporate tax cuts in the U.S. and a continued reduction in regulation are positives for the supply-side, more than offsetting the cost of trying to bring China in line with global norms. Thanks to these supply-side policies, the U.S. does not face a recession. New technology is continuing to lower costs, increase profit margins, and boost earnings. None of this positive news is from government spending. In fact, government spending only crowds out the private sector and reduces investment and opportunity. If the U.S. does not change course and follows Europe through the Keynesian looking-glass, it will eventually pay a price. A damaging price. But for now, it’s just words and fear. Profits and growth beat out words and fear every day.

The markets were focused on developments in the trade war between the US and China. China moved first last week, announcing a list of 17 products from the US that would be exempt from import tariffs. President Trump jumped on the olive branch move from China, announcing that he would be delaying the 5 percent tariffs increase that was set to go into place on October 1st until October 15th. China took the move to be a meaningful concession and, on Friday last week, announced it would not be adding tariffs to imported US agricultural products, including soybeans and pork. At the same time, the government in China said it would be “encouraging” Chinese companies to buy US agriculture products.

This move caused prices here in the US for all agricultural products to jump higher, on the hope of increased Chinese demand. While the markets were initially excited about the movement on the trade front last week, it was evident that there lacked some oomph behind the movement of the markets as "this is just talk". The low-level meetings scheduled to take place this month and the director level meetings in early October will be the true test of whether this latest round of positive developments on the trade front will hold or if it is just more smoke being blown around.

Equities: US markets last week saw a very bifurcated performance as the small-cap stocks moved significantly higher, leaving all the other major indexes behind. There were several reasons for the difference in performance, with the single largest factor being the regional bank weighting in the small-cap space and the strong performance from that specific sector. Volume remained low on both the Dow and the NASDAQ, while both the Russell 2000 and the S&P 500 made it up to average annual levels.

○ Russell 2000 (4.85%) – Average volume
○ Dow (1.58%) – Below Average volume
○ S&P 500 (0.96%) – Average volume
○ NASDAQ (0.91%) – Below Average volume

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