Economic Fashions

By: Andrew Smithers | Wed, Jun 4, 2003
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Fashion, as much as theory, drives economic policy. The public debate is simplistic. Names are given to policies. Keynesians, monetarists and supply-siders are supported like football teams. Bees get into bonnets.

Alan Greenspan has one which buzzes loudly. When the economy was booming, the Fed was slow to raise interest rates, arguing that strong productivity held back inflation. Today's risk is deflation, but he's still backing productivity to support the economy. Standby for the next Fed meeting: can productivity cure the common cold?

We risk running into a liquidity trap, in which monetary policy ceases to be effective and, in Keynes's words, is like pushing on a string.

The Keynesian solution is to increase budget deficits. This is opposed, on the football supporters' basis, by those who think deficits are wrong in principle. (Those who think that massive unemployment is even more unprincipled support a different football club.)

The Fed encouraged the asset bubble. The mistake can't be undone. To pragmatists, large deficits and a return to inflation aren't good things, they are simply better than deflation and unemployment. Don't start from here.

Europe's "Growth and Stability Pact" calls for budget deficits to be kept below 3% of GDP. It's not much better in the US, where 43% of all government spending is at the state and local level, whose governments are required to balance their budgets.

It's likely that the recent tax cut is the last fiscal boost for some time ahead. There's a high chance that it's not sufficient to stop deflation. The other teams now have the ball. We will have to rely on the monetarists and the supply-siders.

Deflation in Japan has been a boom time for almost nobody. An exception has been for those who don't realise that we have shortage of demand, not of supply.

There are only two ways of stimulating demand. You can try fiscal or monetary policy. In Japan many claim that both have been tried and failed. So the retreat from economic reason has been dramatic. The most common form of nonsense is to claim that shutting down zombie companies will make the economy flourish.

This is supposed to reduce competition so that the survivors boom. It doesn't and they don't. Demand falls as unemployment rises and things just get worse. Cost cutting goes with falling not rising profits, as experience shows and theory explains.

It's rumoured that this is not understood by fund managers. According to David Bowers of Merrill Lynch, writing in the FT on 26th May, three-quarters of fund managers think that cost cutting will improve corporate earnings. If the supply-siders have the football, we can expect folly to be rampant. But I am hopeful that in Europe and America it will be recognised that the problem is not too much supply, but too little demand.

Demand must be stimulated. If politics makes further fiscal boosts unlikely, then we must rely on the monetarists. The question is whether they can push on a string.

The answer is probably yes, but it will be difficult. Short-term rates can't fall much more, so the Fed will have to bring down long-term ones. This means more than just letting them fall as they have in Japan. To stimulate an economy by cutting rates central banks must push them down, not just let them fall.

All of this looks great for bond markets. US bonds may be over-valued but they will go up if the economy is weak and go up even faster if the Fed buys them in. In Europe things are even better (for bonds not people), as yields are higher and deflation more entrenched.

Everybody knows this and the pros are up to their eyes in Euro denominated bonds. They will either all be wrong, or even more right than they dared dream.

In the US advertisements in the papers for gold are common. They may soon be overtaken by foreign bond funds. The pros are already invested, but the amateurs have the real money.


 

Andrew Smithers

Author: Andrew Smithers

Andrew Smithers
Smithers & Co.

Smithers & Co. Ltd. provides advice on international asset allocation to about 100 clients based mainly in Boston, London, New York and Tokyo. Our work is based on the fundamental belief that no one's judgement is better than their information. We believe that our clients' decisions will be helped if we can provide them with important information that is not otherwise available to them. We therefore concentrate on research which aims either to tackle issues in greater detail and thoroughness than is otherwise available or to tackle issues of importance which seem to have been generally overlooked. Examples of the former include our work on stock market valuation, the profit distortions arising from the use of employee stock options and the underlying secular problems of Japan's economy. Examples of research into areas which have otherwise been largely overlooked include our work on the Japanese life insurance industry.

Our approach to research is also different. The standard approach bases market projections on economic forecasts of major economic aggregates, such as GDP and inflation. Stock market, bond and currency forecasts are then derived from the way these estimates differ from the consensus. We consider this approach to be flawed in two ways. It places excessive reliance on the ability of any particular analyst to produce forecasts which are consistently better than average. It also ignores the evidence that stock markets tend to lead economies, rather than the other way around. In contrast, we put greater emphasis on "information arbitrage", in which we include identifying factors which have been overlooked, drawing on data and academic research which have not yet been exploited and pointing to inconsistencies in the implicit forecasts of different markets.

Andrew Smithers, founder of Smithers & Co., is also columnist for London's Evening Standard and the Tokyo Nikkei Kinnyu Shimbon's Market Eye, and is regularly quoted in the New York Times, Barron's, Forbes, The Economist, The Independent, and the Financial Times.

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