The Problem with Keynesian Economics

Includes: DIA, QQQ, SPY
by: Arnbjorn Ingimundarson, CFA

The president’s weekly address from August 1 contained the following statement:

Now, I realize that none of this is much comfort for Americans who are still out of work or struggling to make ends meet. And when we receive our monthly job report next week, it is likely to show that we are continuing to lose far too many jobs in this country. As far as I’m concerned, we will not have a recovery as long as we keep losing jobs. And I won’t rest until every American who wants a job can find one.

Apparently, the president is aiming for 0% unemployment. This absurdly unrealistic goal can be attributed to ignorance of economics, demagoguery or delusions of grandeur. Whichever it is, the president’s economic advisors must have cringed.

The problem with Keynesian economics

While we can only hope that empty rhetoric is at work here, there is not much to inspire confidence in a new era of fiscal responsibility in 2010 or anytime soon. At the heart of the problem is what I consider the main flaw in Keynesian economics: it only seems to work in one direction. Politicians who seek re-election have an incentive to give their voters instant gratification. Since people do not feel the pain of fiscal deficits as immediately as they feel reductions in government benefits or a general slack in the economy, it makes political sense to roll the problems forward and let someone else deal with them. When times are good, there is rarely much talk of reducing government expenditures to cool the economy down and reduce the public debt.

Looking at recent administrations, a clear pattern emerges. The Clinton Administration, while it had the decency to return a budget surplus when tax receipts were growing handily, was benefitting from one of the great stock market booms in history. The Bush Administration, inheriting a popping bubble, was quick to patch up the bubble and reflate it with a little help from its friends at the Federal Reserve. In that instance, a budget surplus was not even attained during a boom.

The Obama Administration faces the same problem as the Bush Administration did, except both the problem and the solution are on a larger scale. A continuation of this pattern can only lead to declining wealth and influence in the long run for the U.S. and other countries going down the same road. Unfortunately, there is nothing to suggest that this cycle will be broken in the coming years. For things to change, the U.S. government will most likely have to max out on its credit limit in the bond market. It is hard to live beyond your means when you can no longer borrow more money.

To be fair, it is not only politicians who have an unhealthy interest in fiscal stimuli. Some economists think that increased government spending is the solution to most problems; this 2002 article from Paul Krugman is an embarrassing case in point.

What does this mean for your portfolio?

It is not clear what this means for the stock market – it rarely is. There are two counteracting forces at work here: the first is that higher taxes and slow growth are on the horizon, which does not bode well for corporate profits and stock prices; secondly, people are increasingly realizing that cash, which has no inherent value, is not all that safe under inflationary circumstances.

The best thing an investor can do in terms of reducing risk in a portfolio might be to increase the weight of emerging market assets over the token 5-10% mark. Investors are often reluctant to invest large amounts in emerging markets due to political risk, even though it is quite easy to invest in a diversified portfolio of emerging market stocks spread out over the world. Many less-developed countries have shown fiscal discipline and have significant budget and current account surpluses. As things stand, political risk in the Western world should not be overlooked.