A Requiem for Supply-Side Economics

It was Nixon who remarked after taking the US off the gold standard that “we are all Keynesians now.” That was the high water mark for Keynesian economic theory. Keynes’ proposal that government ought to step up during times of economic contraction and be the consumer of last resort was the lasting idea of his teachings. His ideas have been adopted by virtually every democratic government in the world since 1936 when he published his “General Theory of Employment, Interest and Money”. The principal contribution of the ‘General Theory’ was the idea that the government had an obligation to do something during times of economic contraction to maintain aggregate demand by being the aforementioned consumer of last resort. This demand management seemed to strike a chord with politicians who could promise more, actually deliver some small fraction of that and none the less slop around in the economy a lot more than they were accustomed to.

We do Keynes and all those who ascribe to his General Theory a disservice when we forget that Keynes also argued that the government ought to ‘lean against the wind’ during boom times by raising taxes and curbing government spending when demand begins to get out of control. It seems that most politicians forget to read those chapters in the book or at least forget to apply them to real life situations.

Art Laffer, Robert Mundell and several other notable economists led a reaction to Keynes’ theories. Rather than manage the demand side of the equation, they argued that the supply side was far more important. Also, Keynes’s prescription had run upon the rocks when the wild inflation of the 1970s brought the world to the edge of another horrific economic debacle (the worst since the Great Depression). Having the government sector push more consumption seemed out of step with the situation. The supply-siders thought that providing incentives to produce more goods by relieving them of excessive taxation and needless regulation would help.

During the presidential terms of Ronald Reagan supply-side economics got its first big test and seemed to be providing the spark to get the economy moving again. But, supply-side was never truly embraced by the government sector. Keynes theory made the government sector a key actor in the economic landscape. It was loath to give up its critical role in the economy. Government never really receded from the large segment of the economy it had become during the New Deal and Great Society epochs.

Now, supply-side is all but dead. We hope that this eulogy is being delivered much too early. Perhaps supply-side can make a come-back. But Keynesianism is in the ascendancy again. The current administration is bent on several initiatives to increase government’s role in the economy (healthcare, energy, education). Sooner or later, taxes will rise to help pay for the huge increase in spending that is foreseen. Likely, inflationary tactics will be permitted to allow the nominal economy to grow faster to lessen the apparent burden of taxes. And, once again, we will tax the rich to give to the poor. This side of things would likely make Keynes roll over in his grave. Keynes was no friend to the downtrodden. He made little special effort in his treatise to lift up those in poverty.

But, Keynes was embraced by social democrats because his version of economics allows them a middle ground between true socialism, where government is the arbiter of what gets produced and who gets to consume it, and a free market. Keynes provided a framework that would allow for a lot of government interference in the economy without the responsibility to run everything.

Good News

New home sales, as opposed to existing homes (not that people buy non-existent homes, but homes that have just recently been built) rose. It is about time that people started taking advantage of the new home market. Prices are down and the number of new homes sold rose 11% from May. After revising the May numbers, the Commerce Department now argues that sales of new homes have risen three months in a row. The overall pace is still pathetic, but pathetic is probably better than dismal. And, you see what the outcome was from buying a brand-spanking new home when just about everybody else was doing it.

The Case-Shiller Home Price Index rose for May. That comes as something of a surprise as most guesses were for it to drop a little bit. But, rising prices in 13 of the 20 cities in their broader index overwhelmed declines in the other 7. This is by far the best report that the Case-Shiller index has produced in a long time. The improvement is likely due to improved financing opportunities, bargain hunting by buyers and the receding of a wave of foreclosure sales that were depressing prices in many markets. Foreclosure sales will be ongoing, but the first big wave hit prices particularly hard. We may not be out of the woods yet on the home price declines, but at least it isn’t as universal and as virulent as it has been. That is improvement, isn’t it?

Other Economic Numbers

Consumer Confidence fell again this month. Almost surprisingly, the confidence number again slipped, to 46.6 from 49.3 last month. With all the indications that the economy is bottoming and that growth is just around the corner, you’d expect as did most economists that the focus of most consumers would be getting back to normal. But, for whatever reason, consumers are once again freaked-out by the outlook. Go figure.

2Q 2009 GDP – the guesses were for a modest decline, something on the order of 1% to 1.5% to the bad. They were close. The first blush guess on GDP were that the US economy fell by a mere 1% in the second quarter. As previously stated many times, we now have a good idea of what happened in April, and some good data for May and June. But, there are still big areas of the economy that haven’t reported in or are preliminary. There is still a lot of room for revision in these numbers. We will get revisions of the second quarter GDP every month until October and each one will get better. By the time we’re done, either the recession will be ongoing or it will be over.

Speaking of revisions, the first quarter revisions increased the drop from the 5.5% fall reported earlier to a 6.4% fall. Ouch!

Weekly Stuff

At a time of the year when the summer doldrums are supposed to be setting in, we are still having bouts of surprisingly good performance. Last week was a tug of war between pure, unadulterated boredom and a burst of enthusiasm for stocks. Monday, Tuesday, Wednesday and Friday were uninspired, actually negative on balance and boring. Thursday was a sudden summer storm of good feeling that turned the week into a gainer.

The major indexes were higher by between two-thirds of a percent and seven-eights of a percent. The Russell 2000 gained one-and-a-half percent. Foreign stocks were higher by a lot more with a dollar tailwind and surges in many Asian markets.

An upgrade of once and maybe again market leader General Electric along with better earnings from several other market bell cows helped the stymied market get moving last Thursday. The pop came from essentially out of nowhere and was over almost as soon as it began. But, we haven’t yet given it up so the trend continues to be higher until the trend stops.

We are embarking on August, the second worst month of the year historically. Even with its history of not making any money, August can be a quite fruitful period when the trend is your friend. Don’t give up hope.

Bonds had a good week last Friday. After another round of Treasury offerings, the bond market celebrated getting another monthly issuance under its collective belt. A couple of issues have begun to come to the fore recently in bonds. First and foremost, the sheer girth of the Treasury demand for money is beginning to weigh on the market. Last month it was a quarter of a trillion dollars all told, amazing, simply amazing. Most of that was refinancing, but it included a lot of new cash as well. And, we haven’t started spending the stimulus money yet, so there will be more and more on the horizon. So far, the bond market has been able to absorb the supply mainly because so few alternatives are out and about. But, the corporate calendar is heating up as many high grade issuers are trying to extend maturities in what is still a low rate environment historically. As that issuance begins to enter the market, the Treasury will have some competition.

Also, the sheer size of the Treasury demand is shifting many of the statistics on how well the market reacts to the supply. The bid to cover ratio, or the size of the bids for the Treasury’s bonds versus the bonds being sold, has come under pressure. We have fewer primary dealers these days and those dealers have had their capital accounts squeezed in the bear market. There is less free capital to be invested in the new Treasury offerings while the Treasury offerings are getting bigger and bigger. So, where a bid to cover of 3 to 1 used to be common, the last of the Treasury offerings last week didn’t even get to 2 to 1. So, we may have to rewrite the rules on what a good auction is in this new era.

Then, there is the outlook of our primary creditors, the foreign central banks, foreign wealth funds and the public. Each is different. The foreign central banks are awash in dollars and Treasury bonds and most of them are saying they want to diversify away from dollar holdings and into Euros, Yen, Yuan and other stronger currencies. The foreign wealth funds can buy just about anything they want and as other asset classes recover, they will likely shift to stocks, real estate and corporate bonds. The public will also weigh its options and may opt to put less in Treasuries at the margin. All in all, the outlook for Treasury debt (and bonds in general) may be getting tougher.

Real estate securities had a good week with gains several times those of stocks. After the latest round of nay-saying on the forecast for commercial real estate, we may have hit bottom on bearishness for the time being. US real estate securities gained nearly 4% last week while foreign properties were ahead about as much.

Commodities were higher last week with broad gains in metals, both precious and industrial, in energy and agricultural commodities. The recent news on energy demand would have caused oil more of a problem had not the news out of China been supportive. Crude oil is back to $70 and seems to be surviving the summer despite rising inventories and slow actual demand. We’ve gone from having roughly 2 million barrels in excess demand on a daily basis to having almost 4 million and the price holds at these levels. That is almost amazing.

Au revoir

Have a really great week.

Karl Schroeder, RFC
Investment Advisor Representative
Schroeder Financial Services, Inc.