October 25, 2015
Last week we looked at two components of GDP as simple money flows. In an attempt to understand the severe economic under-performance during the 1930s Depression, John Maynard Keynes proposed a General Theory that studied the influences of monetary policy on the business cycle (History of macoeconomics). In his study of money flows, Keynes had a fundamental but counterintuitive insight into an aspect of savings that is still debated by economists and policymakers.
Families curtail their spending, or current consumption, for a variety of reasons. One group of reasons is planned future spending; today’s consumption is shifted into the future. Saving for college, a new home, a new car, are just some examples of this kind of delayed spending. The marketplace can not read minds. All it knows is that a family has cut back their spending. In “normal” times the number of families delaying spending balances out with those who have delayed spending in the past but are now spending their savings. However, sometimes people spend far more than they save or save far more than they spend, producing an imbalance in the economy.
When too many people are saving, sales decline and inventories build till sellers and producers notice the lack of demand. To make up for the lack of sales income, businesses go to their bank and withdraw the extra money that families deposited in their savings accounts. Note that there is no net savings under these circumstances. Businesses withdraw their savings while families deposit their savings. After a period of reduced sales, businesses begin laying off employees and ordering fewer goods to balance their inventories to the now reduced sales. Now those laid off employees withdraw their savings to make up for the lost income and businesses replace their savings by selling inventory without ordering replacement goods. As resources begin strained, families increasingly tap the several social insurance programs of state and federal governments which act as a communal savings bank, Having reduced their employees, businesses contribute less to government coffers for social insurance programs. Governments run deficits. To fund its growing debt, the Federal government sells its very low risk debt to banks who can buy this AAA debt with few cash reserves, according to the rules set up by the Federal Reserve. Money is being pumped into the economy.
As the economy continues to weaken, loans and bonds come under pressure. The value of less credit worthy debt instruments weakens. On the other side of the ledger are those assets which are claims to future profits – primarily stocks. Anticipating lower profit growth, the prices of stocks fall. Liquidity and concern for asset preservation rise as these other assets fall. Gold and fiat currencies may rise or fall in value depending on the perception of their liquidity.
Until Keynes first proposed the idea of persistent imbalances in an economy, it was thought that imbalances were temporary. Government intervention was not needed. A capitalist economy would naturally generate counterbalancing motivations that would auto-correct the economic disparities and eventually reach an equilibrium. Economists now debate how much government intervention. Few argue anymore for no intervention. What we take for granted now was at one time a radical idea.
While some economists and policymakers continue to focus on the sovereign debt amount of the U.S. and other developed economies, the money flow from the store of debt, and investor confidence in that flow, is probably more important than the debt itself. As long as investors trust a country’s ability to service its debt, they will continue to loan the country money at a reasonable interest rate. While the idea of money flow was not new in the 1930s, Keynes was the first to propose that the aggregate of these flows could have an effect on real economic activity.
A very good week for the market, up 2% for the week and over 8% for October. A surprising earnings report from Microsoft lifted the stock -finally – above its year 2000 price. China announced a lower interest rate to spur economic activity. ECB chair Mario Draghi announced more QE to fight deflation in the Eurozone. Moderating home prices and low mortgage rate have boosted existing home sales.
The large cap market, the SP500, is in a re-evaluation phase. The 10 month average, about 220 days of trading activity, peaked in July at 2067 and if it can hold onto this month’s gains, that average may climb above 2050 at month’s end.
The 10 month relative strength of the SP500 has declined to near zero. Long term bonds (VBLTX) are slightly below zero, meaning that investors are not committing money to either asset class. The last time there was a similar situation was in October 2000, as the market faltered after the dot-com run-up. In the months following, investors swung toward bonds, sending stocks down a third over the next two years. This time is different, of course, but we will be watching to see if investors indicate a commitment to one asset class or the other in the coming months.