The Holy Grail of investments – Part 2

In an earlier post, I outlined the conventional wisdom on what drives the business cycle, and how stock and bond markets react to the cycle.

What if the stock market can by itself induce the business cycle?  In this case, the conventional wisdom no longer holds.  The business cycle now depends on stock market sentiment, and the stock markets will have lives of their own.  Stock markets could be spooked by the same animal spirits that Keynes claimed would drive the business cycle.

Suppose that for whatever reason the fear of a double-dip gets even bigger.  Then, the stock market will lead the economy into recession in a self-fulfilling prophecy.  Bond markets will, however, do well because typically a recession weakens inflationary pressures, and besides, the Fed will have to chase interest rates down in an effort to revive the economy.  Thus, contrary to the conventional wisdom, we now have a situation where the stock market leads the bond market.

Eventually, even the double-dip will move into recovery.  As bond prices become too high, stocks begin to look good again, and the stock market could then lead the cycle, as noted above, but into an upswing.  Independently, business may also pick up because of Schumpeter’s creative destruction (i.e., “fundamentals” would now continue to support the economy), though it can also be helped by a Keynesian stimulus. In this light, the Great Depression can be seen as one extended double dip that had to wait for the Schumpeter effect and the fiscal stimulus from a world war.

What happens to inflation?  Well, it will still depend on the monetary policies of central banks [1].  Expansionary policies eventually generate self-fulfilling inflationary pressures as consumers, producers, and labor anticipate that too much money would chase too few goods.  (After all, if money is a matter of belief, so can prices and expected inflation.)  A rise in inflation will raise bond yields as bond holders demand an inflation premium. Keynesian economics would warn that this rise in interest rates should stall the economic recovery, but a contrary outcome can be had if the recovery is based on fundamentals.  (Hyperinflation is something else, and that can co-exist with economic stagnation; but it seems unlikely that the major central banks will get together to print money like there was no tomorrow!)

So, there you are.  An alternative scenario suggests a follow-on stock market decline or crash that ensures a double dip and a continuing bond rally. The bond rally would eventually lead to another stock market recovery which would end the double dip.  With somewhat greater uncertainty, the economy could also recover on its own with the stock market “catching up” with it instead of anticipating it.  But eventually, the bond rally would end when inflationary expectations take hold.  And the rise in interest rates would not necessarily stall the economic recovery if other factors, such as Schumpeter’s creative destruction, were to come into play.

The moral of this alternative story is this.  Keynesian policies are not a sufficient cure for a recession that was the natural outcome of fundamental imbalances and excesses that had been built up in the prior boom period.  This alternative story explains the length of the Great Depression, and does not depend on Friedman’s thesis that the Fed had been too tight in the 1930s.  This alternative story can also support the likelihood of a double dip following the 2008-09 recession, even as practically the whole world pursued conventional Keynesian fiscal policies along with easy monetary policy.  Indeed, if the Austrian School were to be proved correct, the conventional medicine of stimulative fiscal and monetary policies can even backfire if they create a new set of excesses and imbalances, thereby prolonging sub-par economic performance.  (A die-hard Keynesian would never see this because for him a recession or depression results only from inadequate aggregate demand.)

Instead of relying on Keynes, economic policy makers should perhaps consider that the correct way “out of the woods” would seem to be to encourage Schumpeterian creative destruction and to promote greater wage and price flexibility.  Keynesian economics was never the magic bullet for dealing with a recession or depression.  However, the related idea of maintaining social safety nets as the economy adjusts is a good one, and it is something that the IMF’s economists painfully learned when they originally muddled through the Asian crisis of the late 1990s.  Indeed, safety nets are to some extent public goods, so it is a fair object of Keynesian government spending (within reason of course).

*****

[1] The Keynesian model assumes price rigidity downward, but not upward.

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