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By Mark Bern, CPA CFA

Economic theory is considered an inexact science, and so it should be. But it is definitely not a natural science, nor is it, strictly speaking, a social science. There are certain rules that do apply that are difficult, if not impossible, to ignore. Today's theories are based upon those rules and, for the most part, ignore the multitude of phenomena that can influence the expected economic outcomes. That was my position on the subject of economics in 1976 when this budding young economist elected to take a less tortuous path in life.

Imagine if you will a national economy and all the disparate, independent decisions that are made by the many different groups that make up the economy that can affect each individual or other entity: consumers, government leaders, investors, large corporations, entrepreneurs, local and regional businesses, unions, distribution networks, raw materials suppliers, transportation companies, communications networks, and mother nature (to name a few). Then consider the psychologies and other influences that motivate each of these different groups: savings, quality, re-election, profits, accumulation of power, reliability, consistency, supply restraints, input costs, environmental concerns, infrastructure, technological advances, supply shortages or oversupplies, natural disasters, etc.

Now add into the mix all the possibilities of those same sets of entities and influences that are external to the national economy existing throughout the entire global economy along with all the disparate, conflicting economic, social and political agendas that still have the capabilities of influencing the decisions of corporate and government leaders as well as the individuals of our one economy and you begin to see the complexity of economics. The possible number of outcomes may be infinite or unimaginable to the human mind, and thus, bordering on what I term as practical infinity.

What modern economic theory does is try to include only the most significant influences and decision maker options, ignoring those things that are outside of human control such as natural disasters, and ignoring many of the multitudes of possible smaller influences that can impact one or more industries but do not fit nicely into an econometric model; the combined effect of all that is left out in today's world of economics has become far more significant relative to what it was in the past, thus making the science of economics less accurate as the complexity of our world expands. In other words, all the things we don't completely understand or are unable to quantify within a specific range of inputs over specific periods of time are not included.

As the world has become more and more globally interdependent in recent decades, the complexity of economics has not kept pace. We are still working, by and large, with much the same major theoretical foundations established more than 60 years ago. These theoretical foundational theories were not created to make sense out of the complex global socio-economic world we live in today. Thus, the predictive accuracy and effectiveness of application on a portion of the world economy, such as one nation, are becoming less and less useful.

That is not to say that a nation such as Sweden cannot successful apply fiscal and monetary policies to improve that nation's economy and the welfare and quality of life of its citizenry. It is doing so very successfully. Sweden is large enough to engage in and benefit from the global interconnectedness of the world economy while, at the same time, is small enough to remain less dependent internally upon the success or failure of the world economy.

If the world economy slows, it will negatively affect Sweden, but its partial insulation from world affairs mitigates the effects of the same global slowdown. Part of what I call Sweden's insulation factor stems from the country's decision to not follow but to lead. It has not chosen, strictly speaking, either the Austrian or Keynesian economic model. It also has the advantage of starting from a state that has leaned more toward socialist political policies and high taxation.

The nation has always taken good care of its citizenry but the old policies leave a great deal of room for improvement. It is swimming against the global currents and moving toward greater individual freedoms, less restrictive regulations, and lower tax rates. It has become a magnate for new investment by multinationals in an era when most highly developed nations, like much of Continental Europe and the United States are creating higher regulatory barriers that act to repulse new capital investments. So, Sweden is creating jobs more rapidly while the U.S. tread water and Europe is shedding jobs.

China is still in a favorable position in terms of growth prospects for the short-, intermediate-, and long-terms. It has hundreds of millions of people who are still living at the subsistence level. The priority in China is not to create profits, but to create jobs. There are profits to be made in China; no doubt. But central government policy has been focused on job creation to move millions of people from subsistence to higher levels of consumption. It is somewhat similar to the economic bonanza experienced by the U.S. when Europeans migrated to the U.S. with little in their pockets but willingness to work hard and realize their dreams. The Chinese people have dreams, too. But the wave of new consumers being created domestically in China is an event that has never happened on this scale before in history.

China has advantages in fostering growth that developed countries do not such as no balance of power or restrictive, opposing political or social agendas. The system is designed to be more fluid because if the Party makes a mistake it can correct its policies relatively quickly without a drawn out public debate by opposing sides of each issue. I'm not lobbying for communism as a preferred form of government. I'm just trying to point out that the hybrid system of communist government and controlled capitalist economy are working well for a nation in China's current stage of development. I believe that will change in the future and that something will necessarily have to give way for the nation to continue to flourish. This isn't an essay on China, so I'll leave this topic for another discussion.

My point in these two illustrations is that there is no single, appropriate economic system for all times for all nations. I suppose that the global economies might work better together if all were applying one for of economic system, but only if all nations were also close in development and all peoples of the world exhibited the same work ethic. That world will never exist. Due to the wide disparity between the developmental levels of nations from each other, I would contend that there are probably better economic systems for different nations at different points of development. Some, probably most, would be hybrid systems that could adapt to the changing economic forces that transform the economic environment around them over time.

I would also posit that what is often called Keynesian economics being applied around the world today is a very dissimilar bastardization of what Keynes had in mind when he originally proposed his economic theory. That brings me to a quote from another article: "We are over four years into this, and right back where we started, only far worse for the wear. Stop the Keynesian attempts. They've never worked. Which is likely why Keynes himself came to understand this in the week or two prior to his death in 1946, explaining to Henry Clay of the Bank of England: "I find myself more and more relying for a solution of our problems on the invisible hand which I tried to eject from economic thinking 20 years ago." In other words, Keynes himself was worried about the effects of the theory he had unleashed upon the world. From "Commentary: Here's The Thing About Deflation" by Five Thousand Over Libor.

But I take exception to the part about "being four years into this." I would contend that we are several decades into the Keynesian experiment, having given up on the concept of balancing the nation's budget during the good times, which is something with which I believe even Keynes would have agreed. His original theory was to use fiscal stimulus during economic troughs, allowing the budget to go into deficit temporarily, to prevent downturns from being as bad or deep as they otherwise might.

We have wandered far afield from that original idea. He later modified his theory to allow more regular deficits as sustainable as long as the deficits were within a certain tolerable level and that when the economy grew abnormally fast; the surpluses would be applied to reducing the deficits that had been built up over the years. That change of direction caused modern economist to take the next seemingly obvious step: to assume that the federal budget can always run at a deficit as long as the total debt to gross domestic product (GDP) remains below what are considered to be tolerable levels.

With the United States in the advantageous position of minting and controlling the world's reserve currency, some economists have taken the theory even further. Now there is speculation by the far left that as long as ours is the reserve currency and investors around the world seek safety in U.S. Treasury debt securities during times of uncertainty and fear, we can print and spend as much fiat money (electronically, of course) as we want without worrying about the debt to GDP levels because we can just pay off our accumulated debt in future, inflated dollars. Unfortunately, this scheme only works for so long. I call it a scheme instead of theory because no matter how one looks at it the end results are devastating based upon all other existing theory.

While those theories may be flawed by lack of complexity to compensate for the changes that have occurred over the past 50 years, the same theories are correct in this case. The U.S. has not always controlled the world's reserve currency. That prestigious position has changed several times over the course of history and unless we, as a nation, change course soon, it will undoubtedly change again, possibly in our lifetime. Such a change would likely cause tremendous economic upheaval both here in the U.S. and around the globe.

Such an event today would likely be felt more deeply around the globe than in the past due to the interconnectedness of the world's economies. The chart below should begin with the Athenian Drachma issued beginning in the 5th century B.C.E. There were come overlaps, of course, but this seems to be a good representation of the historical timeline of "reserve currencies."

The U.S. dollar usurped the British pound sterling as the world's reserve currency, gradually increasing its role from about 1914 on until it became the recognized reserve currency in 1944 under the Bretton Woods Agreement. Thus, the U.S. has benefited to some extent, at least, for nearly a century. It is interesting to note that the changing of the world reserve currency has generally occurred as a result one or two precedents: war or inflation caused by excessive budget deficits (spending) by the issuer of the reserve currency. Of course, if I had to choose between the two I'd rather experience the later and it appears, if nothing changes, that it is exactly what we will experience.

What I expect will happen is that eventually our counterparties will have watched their dollar-denominated assets debased by our unilateral policies to the extent that those same "partners" will substantially change the rules of the game to the extent that the U.S. will effectively lose the advantage of controlling the world's reserve currency. Actions taken by China and others, especially oil-rich nations in the Middle East and other countries rich in natural resources (most notably Russia), are moving away from using the US dollar for trade wherever possible.

Many of the countries that have invested in U.S. Treasuries have begun to reduce additional purchases due to the manipulated, low rates of return being below inflation and the growing risks of rising inflation in the future. The Federal Reserve has surpassed China as holder of the most U.S. Treasury issued securities. Doesn't that seem like taking money out of one pocket and putting it into the other pocket and saying, "Now I have twice as much money"?

But all is not lost if we can change the course in which the country is headed over the next couple of years. I believe that one of the greatest advantages of our system is its malleability, or its ability to evolve economically to meet the demands placed upon it. I may be asking for too much to expect our government leaders to wake up and make the hard choices necessary, but that is the only way I suspect we can avoid my expectations outlined in the previous paragraph.

But I haven't lost hope nor given up just yet. Politicians are taking us to the brink, in my opinion. The question that I raise as an investor is whether or not they'll be able to see the cliff and decide not avoid it in time? Our fortunes literally may depend upon the decisions coming out of Washington, D.C. over the next few years. How does that make you feel? Welcome to the era of uncertainty and volatile markets.

If you own quality stocks such as those reported on in my two series entitled, "The Dividend Investors' Guide to Successful Investing," and "My Long-Term, Enhanced Investing-for-Income Strategy," there are four primary things you need to remember at times like this.

1) Hold on and collect the dividends. This is the part of the roller coaster ride that scares us all.

2) Only by selling do you ensure taking a loss on your assets. This is why you chose quality, dividend-paying stocks in the first place.

2) In the end quality companies will recover and once again the associated stock prices rise to new highs at some point in the future.

3) Be prepared to make new purchases when you sense capitulation in the markets and valuations seem absurdly low relative to the long-term. When I sense capitulation I will write about what I see and why I think it has arrived. I may be a little early or a little late (probably the later), but a few days in this sort of matter does not matter that much.

Thanks for reading and, as always I enjoy your comments so keep them coming. Only through sharing our ideas, experiences and perspectives can we all learn to be better investors together. I wish you all a successful investing future.

Source: Welcome To The Era Of Uncertainty And Volatility