Priming The Pump: Keynesian Economics Revisited

Since 1978 monetary policy has dominated the United States economic landscape. Former Chairman Alan Greenspan made monetary policy famous and it’s this economic school of thought that most Americans have not only embraced, but also given credit for the good times of the past few decades.

In June 2004 the monetarists at the Federal Reserve decided to raise interest rates and they have been raised incrementally, 14 times since then. Normally, rising rates stymie economic growth and stock markets fall. Yet, since June of 2004 all major U.S. stock indexes are up over 20%, with the small-cap Russell 2000 Index (adversely susceptible to rising rates) up a whopping 37%. After almost three years, shouldn’t the higher cost of money be detrimental to America’s markets and the economy?

The answer would have been “yes” if we were in a period similar to what we saw from the early 1960’s to the early 1980’s. Rising rates kept a lid on rising market indexes during those 20 years. Conversely, for the 20 years between 1980 and 2000, lower interest rates gave stock indexes a boost. For forty years, the conclusion was interest rates and stock indexes moved in the opposite direction to one another.

What has changed in the past few years? Perhaps the reason is that current United States economic policy is really a stimulative Keynesian fiscal policy and rising rates may actually be helpful, not a hindrance, to economic growth, productivity and a rising market. The short-term effects of a Keynesian fiscal policy, especially its component called “deficit spending,” can produce spectacular results. Keynesian stimuli result in rising U.S. equity indexes. The questions that needs answering is how long can this policy be sustained and what, if anything, will lead the indexes lower?

Presently, the United States is running a “deficit spending program” to which no one seems to seriously care about. Not the media, nor our elected official on Capital Hill. In a monetary environment, why would they?

Lately, there has been much talk about cutting interest rates to spur America’s economy on to greater heights. America has enough wind in its sails. There is no need for the Federal Reserve to cut interest rates. John Maynard Keynes General Theory (1936) explains why.

To keep an economy “cooking” the U.S. Government can, according to the Keynesian General Theory, increase government spending through:

  1. Cutting Taxes
  2. Printing Money
  3. Borrowing

1. The Bush Administration is not taxing. Our country saw a tax cut ($1.2 Trillion) early in his administration. Many would argue, including Keynes, that tax cuts are more effective than collecting money from taxes. Cutting taxes, certainly, not raising them, will give people more money to spend. Along with printing more money, government, business and consumers spend more and people all receive more. Incomes increase, consumption increases and Americans prosper!

2. The printing of money has already occurred. From 1987 to his departure, Alan Greenspan printed more dollars than all other Fed Chairmen combined. The rate of change to which money supply (MZM) has increased has ended for now. During the Greenspan tenure and especially after the Internet/Equity crash of 2000, money was printed to prop up the economy and stave off a potential recession. Increasing MZM gave real assets “value” once again allowing equity investors to accept 40% losses in their portfolios in return for 40+% gains in their real estate portfolios.

3. Borrowing; “priming the pump;” deficit spending. Here we come to a central catalyst allowing interest rates to rise in tandem with a rise in stock indexes. Presently, “priming the pump” is the reason both interest rates and the equity indexes are moving in the same direction. The United States borrows money by issuing debt through the selling of U.S. Treasuries Bills, Notes and Bonds. Rising rates keeps treasuries attractive for borrowers.

Foreign held U.S. assets have grown from approximately $600 Billion in 1981 to $12,600 Billion in 2005; a 20- fold increase. The Dow Jones Industrial Average has increased 10 times, thanks in large part to foreign capital inflows.

Our deficit spending catalyst, funded by foreign capital inflows from China and Japan, gives the United States economy and its consumers many benefits: inflows keep inflation low and drive interest rates lower, leading to government, consumer and business purchases. The Keynesian “multiplier” effect leads to even more purchases while boosting the asset value of equity, real estate and other asset. Tax hikes are avoided, keeping Americans happy. Our happiness manifests itself through “irrationally exuberant” purchases of real estate, big screen televisions and other “stuff”. As a result, manufacturing and service sectors grow, employment rises, global jobs and the global economies prosper. Everyone around the world is happy.

Global oil transactions are predominantly consummated in U.S. dollars and foreign nations continue to use the U.S. dollar as their primary cash reserve. This creates a continual demand for our currency. The dollar appears solid and will continue to remain strong as long as foreign governments purchase the U.S dollar and it is perceived as THE primary default currency around the world. Many believe that countries like China will continue, indefinitely, to purchase U.S. dollars. A strong U.S. dollar means strong trade. China exports to the U.S. keep Chinese workers employed and productive. A strong dollar keeps the value of previously purchased dollars residing outside the U.S. stable, giving foreign purchasers reason to hold these dollars. A strong dollar keeps foreign exports profitable since the U.S. is not purchasing foreign merchandise with “cheaper” dollars, should the dollar fall in value. Since the Chinese Yuan is “pegged” to the U.S. dollar, a strong dollar means a strong Yuan. In return for a strong dollar, the United States receives “borrowing power” since our outgoing consumption dollars to China eventually find their way back home in the form of government issued treasury debt. In other words, it is in neither country’s best interest to alter their spending patterns and upset the apple cart.

Rising interest rates support the U.S. dollar. Steady to rising interest rates in the United States keeps the symbiotic relationship with our foreign trading partners strong. The “good times” will continue with steady to even slightly higher interest rates, NOT low interest rates, thanks to the U.S. dollar underpinning global exchange. Greater liquidity is available for us as a country because of a strong dollar. Not only do we get to keep borrowing “other people’s money,” with a strong dollar, but the availability of that money creates liquidity to grease the wheels of American business. This process is wonderful economic news for the United States of America, in the short run.

But looking forward, which is always difficult in good economic times, there will come a point when our foreign trading partners will either run out of money or just decide to slow down purchases of U.S. government debt. Logically, China and our other trading partners cannot keep financing our deficit. On the American side of the ledger, there will come a time when the United States consumer runs out of discretionary income to keep up the current rate of purchase for foreign goods, leading our trading partners to slow down their purchases of our debt because they have less of our money to lend to us. With our inability to spend comes an end to our ability to borrow. At this time our lawmakers and consumers will have some tough decisions to make. Look for the markets to head lower before this eventuality hits the headline news. For the savvy investor, don’t wait for the headlines. It will be too late. Watch for those financial instruments that signal a weakening dollar, especially gold.

Carl Perthel

March 27, 2007