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Mark's Market Blog

1-9-09: Economic Theories and Depressions

By Mark Lawrence

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The stock market continues its bear market run-up, staying within the channel that was established in late November. The red line is a 15 day moving average, the green line is a 45 day, the gold line is a 150 day moving average. Normally it's thought that trading below the 150 day average is a bearish sign, people are not enthusiastic about stocks. I know, you think you already knew that without drawing funny colored lines. But coloring is one of the few affordable entertainments left to us these days. The purple lines are a suggestion of the "price channel" in which we're currently swimming. Stepping over the purple lines would be a sign that something had changed and the market is now going to move in a new direction.

You can see that the lower purple line has a different slope if you draw it from November 24 to December 12. The Dow dropped below that purple line, and established a different one, drawn above. This shift was what I was talking about in my 12-12-08 blog when I said there would be a breakout day. You may find this a bit dissatisfying, more than a little after-the-fact. Unfortunately technical analysis, as drawing these funny colored lines is called, is somewhere between an inexact science and voodoo.

Oil had a brief rally over the last couple of weeks, but the reality of a world where no one has any money to travel set back in and brought the price back down to around $40. It appears we've found a price range for oil for the next several months, about $37 to $50, meaning gasoline should hover between about $1.75 and $2.00 per gallon. The December jobs number came in, 525,000 people lost their jobs last month bringing unemployment up to 7.2%, a 16 year high. The Congressional Budget Office (CBO) announced that they project unemployment will top out about a year from now at 9.5%.In my 1-6-09 blog, we saw that history predicts that unemployment should top out at 9.5% to 16.5%, which is 15 million to 25 million unemployed.

Obama continues to sell his $800B stimulus package. Thursday he announced "In short, a bad situation could become dramatically worse" if his package isn't passed. "The very fact that this crisis is largely of our own making means that it is not beyond our ability to solve."

This is an interesting perspective: we screwed it up, we can fix it. It's worth trying to decide if it's correct. Let's consider the Great Depression. This was a similar era - in the 1920s there was a huge inflow of foreign capital, leading to a huge run-up in stock and housing prices. The bubble famously burst. Many think that on Black Thursday of '29 the market dropped a million points, everyone on Wall Street jumped out of their windows, and the rest of us took to selling apples and standing in soup lines. The reality was more like having a leg amputated by ants gnawing on it for three years. Below we see a chart of the Dow from October 1928, a year before the crash, to July of 1933, a year after the bottom. We see that on two occasions, April of 1930 and March of 1931 the Dow traded above its 150 day average (gold line), which is normally taken as a signal that all is forgiven and the bull market can resume. In fact, we now see clearly that these were "dead cat bounces." The true top to this market was September 3rd, 1929 at a Dow of 381, and the true bottom to this crash was nearly three years later on July 8th, 1932 at a Dow of 41, a loss of almost 90% of value.

In 1929, there were basically no useful economic theories of how to manage an economy. The Great Depression set everyone to work on new theories, and eventually three theories were developed. Lord John Maynard Keynes developed the idea that the level of government spending managed the economy. If the government spends more, especially more than it takes in in revenues, the economy will speed up. If the government spends less, especially less than it takes in in taxes, the economy will slow down. A second theory is Monetarism. If the Federal Reserve raises interest rates, people will borrow less money, the money supply will contract, and the economy will slow down. If the Fed lowers interest rates, people will borrow more money, the money supply will expand, and the economy will speed up. Finally, Marx claimed that Capitalism is inherently unstable, a few people will wind up with all the money, and then there won't be an economy because most people won't have any money to spend. Marx's theory had the unique property of at least correctly describing the depression situation.

Today we know all three theories are successful in one area and deeply flawed in others. When the economy is at full employment and full production, like 2006, if the government spends more then all you get is inflation: there is no slack in the economy to make more stuff, so you just get more dollars chasing the same goods. If the government spends less we're happy, that's just more Cadillac Escalades and bigger houses for us. Keynesianism cannot manage an overheating economy. When the economy is in deep recession, like perhaps now, if the Fed lowers interest rates nothing happens because there's no one to whom the banks are willing to lend. If the Fed raises interest rates, again no big change, there's no one to whom the banks will lend. Monetarism cannot manage the deep unemployment of a depression. Finally, Marx was right that capitalism is inherently unstable and for the economy to function most everyone needs to be involved. But his cure, central economic planning and no private accumulations of wealth, is worse than the disease. By managing everything Marxism destroys all growth, not to mention hope.

Today the US is discussing a "huge" government stimulus package, which at $400 billion per year is about 3% of our $14 trillion GDP. Roosevelt was elected in 1932 to end the depression. He immediately "put America to work" with a whole bunch of programs like the WPA, but nothing he did worked until 1942 when he got us into WWII. Roosevelt shipped a couple million unemployed men overseas to smoke free cigarettes, hired another couple million to build tanks and airplanes and watch war newsreels, and raised government spending to over half of GDP. In 1943, 1944 and 1945, military spending alone was 37% percent of GDP. That finally worked, after thirteen years of depression our economy started growing again.

So there is a big debate going on between economists: are we headed for a depression, and if so is there anything we can do about it? One side thinks that Marxism is unacceptable, Monetarism (the Fed) is currently shut down by the liquidity trap - no credit worthy bank customers - and Keynesianism seems to require we spend $4T on a stimulus, ten times the amount Obama is considering. The other side thinks those guys should go home, get drunk, and shut up, and everything will look better in the morning.

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