John Maynard Keynes (June 5, 1883 – April 21, 1946) is another master of economic theory that has relevance for the Wall Street Psychologist’s Gyroscope. More than a half century prior to the “Too-Big-to-Fail” bank bailouts of the US banking industry in the early 21st century, Keynes advocated interventionist economic policy, encouraging governments to leverage fiscal and monetary policies to allay the adverse consequences of downturns in business cycles, economic recessions, and depressions. His ideas are the basis for the school of thought known as Keynesian economics, and its derivatives.
Essentially, Keynes argued that decisions made by individuals and groups in the private sector at times produce negative macroeconomic results that can be mitigated by monetary measures and policy actions in the public sector.[1]
Whereas classical economists argue the validity of Say’s Law, that “supply creates its own demand,” as a market mechanism to avoid a “general glut,” Keynes response was that the collective demand for goods might be deficient in times of economic crisis, fueling high unemployment and damaging output. As such, Keynes contended that government policies should be applied to enhance the aggregate demand, thereby spurring economic growth and decreasing unemployment and deflation.
Keynes’ strategies for recovering from a depression were to stimulate the economy, advocating the reduction of interest rates and government investment in infrastructure. We have seen these tactics wielded, with varying success, in successive depressions and recessions ever since.
As with any economic theorist of substance, Keynes had his detractors, though his theories were widely embraced by Western economic powers in the wake of World War II.
Understanding Keynes also involves appreciating his emphasis on the creation and coordination of international economic institutions and how economic developments influence social events, such as war and peace. In his “The Economic Consequences of the Peace”, published in 1919, Keynes objected to the punitive reparation payments imposed on Germany by the Allied powers subsequent to World War I. He rightfully assessed that the amounts were so exorbitant, that Germany would remain perpetually poor and politically unstable. Unfortunately, his prescience was correct, ultimately producing the disaster that was the rise of the Nazi Party, culminating in World War II.
Studying Keynes, you gain an appreciation of the labyrinthine manner in which the economic strata intertwines with the political and social fabric. The markets do not operate in a vacuum and the savvy financial professional must be aware of the entire scope of the market’s influence, and how markets are subject to intervention.
When a broker adopts a particular strategy, he must think beyond the impact and survey the larger political and social stage and adjust his execution. For instance, sub-prime lending was facilitated, in part, by political ideology of home-ownership. Subsequently, many loans were originated than should not have been, putting thousands of Americans in homes they really could not afford. This was a set up for failure.
When those loans hit Wall Street, bundled up in pools of mortgage-backed securities, there were devised many different ways to trade their value, including complex derivative strategies that many traders simply did not understand.
In hindsight, the fallout was inevitable, but few actually managed to get out of the way. A better student of economic history would have looked beyond the balance sheet and analyzed trading in sub-prime lending more comprehensively. Applying Keynesian theory, they would have sense the inevitability of the government intervention, albeit applied selectively, as Lehman Brothers learned.
However, critics of Keynes would note the backlash now evident of the government bailouts and the increased scrutiny now places on public companies, especially in the area of compensation.
Ultimately, when incorporating Keynesian theory to the strategic engine of the Wall Street Psychologist’s Gyroscope, the value is in anticipating the inevitability of intervention. In common parlance, the divide between Wall Street and Main Street is symbolic. As Keynes knew, both physically and psychologically, they are both parts of the same thoroughfare.
[1] The theories forming the basis of Keynesian economics were first presented in The General Theory of Employment, Interest and Money, published in 1936.