Keynesian economics grew out of the Great Depression of the 1930s. The fundamental premise is that government should act at times to adjust the economy. With the economy contracting at the time, it proved an intellectual justification for far more government interference already underway.
While many market-oriented economists and political figures from Milton Friedman to former President Ronald Reagan and former U.K. Prime Minister Margaret Thatcher did much to crush Keynesianism later in the 20th century, its fatal conceit still lies with us. That conceit? The notion that the government must act, because doing nothing is somehow worse.
Often, the government will act by lending a helping hand to the private sector. What happened when the stock market suffered its worst one-day crash in October 1987? Newly-minted Federal Reserve Chairman Alan Greenspan stated that the Fed stood ready to act as a lender of last resort. But why? The high-flying stock market and economy of the late 1980s didn’t need the help.
A decade later, in 1997, Greenspan’s Fed did step in to help a consortium bail out Long Term Capital Management. Loaded with some of the smartest men in finance, LTCM made heavily leveraged bets on rarely traded assets. Naturally, the fund couldn’t quickly unwind when trouble invariably emerged.
The high-flying market of the time, just getting into the tech bubble stage, didn’t need the help either. The financial sector would have been dealt a blow, but a limited one. And it would have recovered quickly. In short, the government could have sent a message that would have curbed speculation: You do so at your own risk.
The government decided to send the opposite message instead. Some traders called it the Greenspan Put, updating the name when later Fed Chairs came into power.
Another decade later, the entire financial sector collapsed in a matter of months as credit froze and highly leveraged financial firms started going under. Government guarantees, implicit or explicit, couldn’t act fast enough.
However, a few trillion dollars of government money, stimulus programs, and nearly a decade of interest rates at zero percent did a lot to smooth out the aftermath. We’re still recovering from that.
It’s no wonder this economic recovery has set a far slower pace than other recoveries in the past. It’s simple to see why. If you throw enough money at a problem, you bury the problem with money. What you don’t do is resolve it.
Now, market players have been conditioned to expect the government to step in. Comments from someone at the Fed every time the stock market makes a 10 percent pullback from all-time highs in recent years have only reinforced the message.
There’s a second part to Keynesian economics. At least, as originally envisioned by John Maynard Keynes. While the first part was that government should run deficits to stimulate the economy during a recession, the second part was the opposite.
Specifically, governments should run a surplus during economic good times.
There were plenty of good reasons for doing this.
First, doing so would act as a brake on the economy so it may not get a chance to overheat in the first place. Second, surpluses would provide the funds to pay for deficit spending during the next downturn. This would avoid permanently growing deficits.
Even Keynes recognized that too much debt could tank an economy just as much as printing too much currency.
Unlike socialists who claim we’ve never tried “Real Socialism”, we’ve never tried this second part of Keynesianism.
Arguably, at this stage in the recovery from the financial sector’s implosion a decade ago, government should already be running surpluses to pay off the last series of bailouts and to prepare for the next downturn. The massive expansion of government power over the economy should be gradually contracting.
It isn’t. Instead, we’ve gotten a few interest rate hikes with the nebulous plan of being able to cut them right back to zero again during the next recession. And a government budget deficit over $1 trillion dollars despite the current boom.
That’s not fiscal responsibility. It’s not even Keynesianism either. It’s the politics of a willfully economically blind political class.
This fatal conceit of economics leaves a few takeaway messages for investors.
First, even if the government says it’s going to bail you out, you may get your wish. But don’t bet on it. You may go bankrupt while the check is still in the mail. Just ask Bear Stearns.
So keep some cash on hand, and don’t go too crazy with leverage. Don’t let any single position build up to be too large a part of my portfolio. It’s better to take some profits than try and get another 10 percent out of a trade and watch all the gains disappear. And it’s better to buy a call option on a company likely to rally rather than buy a stock on margin.
Second, the time to start preparing for a rainy day is when the sun is shining and there isn’t a cloud in the sky. That’s the cheapest time to buy umbrellas — or in the case of the markets looking to safeguard your portfolio.
Insurance can come in many flavors.
You could buy put options against the S&P 500 Index to bet against a broad market decline. If you expect more volatility like we’ve been seeing lately, selling covered call options against stock positions you own can improve your returns there without adding to your risk.
Or you could even buy gold, which has been out of favor in recent weeks but saw a large rally earlier in the year when markets were first tanking.
Some combination of those defensive investments should provide solid profits against the next market shock, whatever it is.
The economy is in a pretty strong place right now. But it’s been in a strong place before only to see events rapidly overtake a rally and crush it. I wouldn’t expect a recession for another year at the least. But the fatal conceit you can make as an investor is to assume the current status quo will continue forever.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.
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