WE ARE ALL KEYNESIANS NOW - Roger Arnold

Apr 07, 2003

"WE ARE ALL KEYNESIANS NOW!"

This is the famous quote attributed to President Richard Nixon when he ended the international gold standard in the early 1970's.

What he should have said is that we are all "MONETARISTS" now; which is clearly what he meant.

In other words, it was a vote for and acknowledgment of the benefits of having a fiat currency system over a fixed or quasi-fixed system. The implication being that central banks can control the business cycle through manipulation of currencies and rates.

Given the current equity run this is exactly what the markets believe today as well.

However, the divergence of the worlds financial markets and economies is rarely as wide as they are today. The war rally is causing extended gains in stock and bond markets all over the world while simultaneously causing losses in Treasury and gold markets all over the world.

This is the reversal of the flight to safety that ensued prior to the beginning of the war in Iraq.

Be careful however and makes sure you understand the arguments for and against each view of the future.

The momentum is right now behind the equity run and could cause it to extend even further as markets begin to move from a war rally to war euphoria mode, and then to expectations of renewed economic activity.

There is nothing wrong with a war rally or war euphoria, a reversal, at the margin, of the flight to safety that ensued before the war began. But, the war euphoria is now running headlong into a full blown prediction of an increase in economic activity this year; which according to wall street and the worlds central bankers will be the result of cheap money being made available to the market by the central banks.

This is the principal behind monetarists philosophy. Don't worry, the FED will always be there to mitigate the slow down with cheaper and cheaper money as necessary, until the economy rebounds.

This is where the rubber hits the road.

So far, over the past three years, the worlds central bankers have been unable to ignite an economic resurgence. They are insisting however that the resurgence was beginning prior to the war and that the war then postponed the resurgence. Now that the war is drawing to a conclusion the resurgence in economic activity will begin anew is the mantra upon which equity markets all over the world are beginning to trade.

The markets are beginning to anticipate and predict the increase in capital borrowing, spending and investing that should, as promised, occur after the war has been successfully concluded. At least this is what the monetary leaders all over the world have been telling us.

The capital spending slow down has been blamed squarely on the war. Now that the war is over the markets are expecting the economic pick up to be apparent within 6 months.

Perhaps they are right and perhaps it will occur. I am however hesitant to concur.

This is the clashing of economic philosophies playing out right now. The monetarists insist that the slow down can be mitigated by the central banks. The Austrian school economists believe the exact opposite, that monetary manipulation can not supercede the economic cycle and can only effect it at the margin. They caution that the worlds economies will continue to slow and contract as a normal part of the economic cycle due to the necessity to work off the excesses of the late 1990's, regardless of what the worlds central banks do and that ultimately the stock markets will come to realize this, reverse their current trend, go to new lows and drag treasury yields to new record lows as well.

I believe the Austrian view, although not popular, is the more probable outcome for the future. However, the markets right now are not interested in this view of the economy. You should at least be cognizant of it.

Economic Activity

The economic reports from all over the world have been horrendous recently. But they also represent past or current situations, are not necessarily indicative of future potential, and are being blamed on the war by most. In other words, the markets consider them to be irrelevant right now. They are however falling very quickly, all over the world.

The markets are trying to catch a falling knife. And although it is likely that there will be a marginal increase in both capital and consumer spending following the conclusion of the majority of tensions in Iraq it is less probable that these increases will result in a secular economic resurgence.

For now the markets don't care about this and that is OK. Just make sure you understand them.

This is the equivalent of the markets predicting that the thin economic ice they are standing on that is actually melting more quickly now, solidifying underneath them and providing the foundation and justification for their preemptive increase in value.

All of this is occurring at the same time most wall street economists now predict that the FED and ECB will have to lower rates further in the US and Europe and Morgan Stanley is now predicting another world wide recession, becoming apparent this year.

So the economists are telling us that the economies of the US, Europe and Japan are likely to continue to slow or contract. Business leaders are telling us they have no substantial plans for expansion and instead are marginally tilted toward further job cuts and internal consolidation. Both of these views validate the Austrian model and concerns.

On the other hand, the monetary and fiscal authorities are saying that rate and tax cuts are not necessary right now and that they will take a wait to see what happens after the war attitude. Wall street is almost unanimously predicting increasing rates of return in equities and economic activity which will then justify the speculative increase in equities ahead of it. Both of these views are supported by monetarist economic theory.

I don't know which philosophy will prove to be most right. I know that so far, over the past three years, the economy has played out exactly as the Austrians have been predicting and exactly not the way the monetarists have been promising.

Why then are the markets putting so much faith in the monetarists view versus the Austrians view of the future? To put it bluntly, it best represents their business needs. Whether it is logical or rational has taken a back seat to hope and business need. No wall street firm is going to increase its sales of stocks and bonds by warning of the potential for continued economic contraction. So, for the most part, it is not discussed.

But, remember, markets are not self validating.

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