Economic Kung Fu

Image Kung Fu Economy

In the animated film Kung Fu Panda, a villainous snow leopard named Tai Lung desperately wants to obtain the secret Dragon Scroll that is said to hold the secret to limitless power. The scroll is protected by a group of kung fu masters who are joined by a hapless panda bear named Po.

At the end of the movie (spoiler alert!), Po has mastered kung fu and successfully fends off Tai Lung… sort of. Before getting trounced and sat upon by a fat panda, Tai Lung gets a peak at the contents of the Dragon Scroll and finds nothing but a reflective surface.

Po, who has already looked at the scroll, points out that the secret of limitless power is what lies inside of us.

The theory of Keynesian economics, which for six long years has stolen money from savers, pushed investors to take on ever more risk, and worked desperately to tilt the economy in favor of borrowers, is based on the same premise.

In the early 1930s, the world was in the grips of the Great Depression.

Up until that time most governments had taken a hands-off approach to business, allowing the overall business cycle of growth-boom-bust-recovery to play out on its own schedule.

But the depths of the depression caused leaders to rethink this policy. They went searching for tools that would allow them to tame the business cycle, erasing or at least greatly reducing the effects of its downside.

Enter Keynesian Economics

They found their answer in the British economist John Maynard Keynes.

The typical business cycle involves rising demand, which calls for businesses to produce more goods and services. As businesses increase their output, they hire more people and/or increase wages, as well as buy more inputs from other businesses (raw materials, components, etc.).

These moves give workers and other companies even more capital with which to buy stuff, leading to even higher demand. The virtuous circle of growth is born!

Unfortunately, all of this money sloshing around encourages consumers and businesses to take on excessive risk. Counting on ever-rising incomes, consumers take on debt to buy more things.

Businesses, counting on more orders, use credit to expand their operations. Bankers are part of the cycle; they seek to lend out as much as they can.

At first the rising use of credit serves as a supercharger to the business cycle, which simply reinforces the aggressive behavior of consumers and business owners. But as demand for credit increases, money becomes more expensive in the form of higher interest rates.

Eventually the marginal borrowers, both consumers and businesses, fail under the weight of their debt payments. Their income and orders don’t grow sufficiently to cover their mounting debt payments.

The demand for goods and services slows down a bit. As lenders incur losses, they tighten their lending standards and lend less in order to rebuild their reserves. The decrease in available credit slows demand even further, leading to more losses, which aggravates the losses at banks.

So non-payment on debts leads to shrinking credit, which leads to falling demand, causing businesses to fire workers and order less, which causes even more bad debts. This is the vicious cycle.

The old way of dealing with this was to allow the liquidation of over-borrowing and over-spending. Assets would be sold to pay debts. The excessive risk-taking on the part of consumers, businesses, and banks would be “cured” through the pain of retrenchment.

During the 1930s, the magnitude of the economic downturn caused people to demand action from their politicians. Surely there must be something they could do to alleviate the suffering of everyday people. Enter John Maynard Keynes.

In the example above, the vicious cycle plays out as long as there are bad debts to be settled and a general sense of apprehension about the future. To Keynes, this is where governments can be of help.

Instead of allowing the sell-off to continue until an economy reached some base level, which could put millions out of work and idle assets for years, the government could borrow money and spend it on… well, on anything — as long as it employed people and ordered goods and services from business.

In this way, the government would supplant the private sector in demanding goods and services and eventually jump-start the virtuous cycle.

Nice Theory

The problem is that the business cycle is based on the psychology of consumers and business owners. On the way up, they take on more risk through purchasing and the use of debt, while on the way down; they trim their buying and shed debt as best they can.

Nothing in the Keynes model addresses this psychological state.

In fact, the model itself states that governments should continue with the deficit spending meant to bolster aggregate demand until the “animal spirits” of consumers and entrepreneurs have returned.

In the world of economics, The Economist magazine tells us that: “Animal spirits are the colorful name that Keynes gave to one of the essential ingredients of economic prosperity: confidence.

According to Keynes, animal spirits are a particular sort of confidence — “naive optimism”. He meant this in the sense that, for entrepreneurs in particular, “the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.”

Where these animal spirits come from is something of a mystery. Certainly, attempts by politicians and others to talk up confidence by making optimistic noises about economic prospects have rarely done much good.”

This is the basic building block of the economic theory behind the printing of more than four trillion dollars, and the reason that it doesn’t do much to rebuild our economy. At the end of the day, we’re told to look into the Dragon Scroll and realize that the power to reinvigorate the economy lies within us.

If only we would throw caution to the wind and once again take on debt with abandon, buy stuff we don’t need, and live like there’s no tomorrow… then all would be right with the world.

At this point you might wonder how such an approach could work. Wouldn’t bankers, business owners, and consumers recognize that government borrowing is fueling the demand, and as citizens they are responsible for that debt?

Wouldn’t people know that as soon as the government withdrew from the markets that they would simply be back where they were before, albeit having traveled through a government redistribution program that taxes everyone in order to funnel income to a few?

Maybe.

But if you’re asking these questions, then clearly you’ve not stared into the Dragon Scroll of economics long enough, since you have not regained that economic confidence known as animal spirits.

Excuse me as I go back to staring at the scroll.

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Rodney

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Categories: Business Cycle

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.