“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”
John Maynard Keynes, The General Theory of Employment Interest and Money (1935)
I am not generally a fan of Keynes in terms of macro-economic policy. The idea that we can jump-start economic growth by paying folks to dig holes and then fill them up again has always seemed foolish to me. I remember the dismal 1970s, back when President Richard Nixon said, “We are all Keynesians now.” What followed was a theoretically-improbable combination of inflation and slow growth – stagflation.
Personally, I would think that the experience of Japan over the last two decades would have cured even the New York Times editorial page of Keynesian fantasies. That small nation has covered a very large part of its landscape with steel and concrete, borrowing 200% of GDP to finance the construction thereof, without ever getting its economy out of first gear.
But one aspect of Keynes’ thought seems to me more persuasive all the time. Back during the Depression, Keynes wrote some powerful and elegant prose about the role of emotion in the functioning of equity markets and the real economy.
My own Cliff Notes version of the General Theory is that Keynes believed that much capitalist activity came not from a dispassionate, uber-rational calculation of economic cause and consequence, but rather from what he called “animal spirits” — a willingness to ignore the counsels of prudence in pursuit of profit. Whether you translate “animal spirits” as optimism, over-confidence or an excess of testosterone, his formulation seems powerful to me.
In our investment practice, we spend a good bit of energy pondering the insights of behavioral economics, the emerging discipline at the intersection of economics and psychology. One of the key insights of behavioral economics is that most human beings are over-confident about almost everything, almost all the time. In investing, that typical human over-confidence usually leads to bad results — to systematically under-estimating risk and over-estimating the ability to pick winners. But in the real economy, the role of confidence is more complex. Consider two generally-accepted facts about the American economy:
80% of new businesses fail within five years and
Most new jobs are created by small businesses
Given the known failure rate of new businesses, it surely takes over-confidence, desperation or even stupidity to start a new enterprise, even in a strong economy. So how hard must it be to ccontemplate setting up a new business in an economy like the current one, or hiring new employees for an existing company? We suspect that a lack of confidence is restraining capitalists of all types, existing business owners just as much as potential entrepreneurs and investors in publicly-traded equities.
Our national crisis of confidence has many causes, but surely one is the bitterness of the debate in Washington D.C. The inability of Congress to work with the President (and vice versa), the brinksmanship over the debt ceiling, not to mention the lack of seriousness about spending restraint, all have taken the approval ratings for Congress to new lows.
Easy to miss amid the current uproar about Washington’s bad behavior is the fact that, for almost two decades ending early this century, there was very substantial agreement about the basics of economic policy, and that agreement helped to drive positive results for both investors and the real economy.
Between 1982 and 2000, American investors enjoyed the greatest equity bull market in human history. The good news on stocks reflected similar good news on economic growth. During this period, we enjoyed the two longest peacetime expansions in American history, one principally under Republican President Ronald Reagan, the second, even-longer expansion mostly during the two terms of Democrat Bill Clinton.
Much of the confidence underlying the expansion came from a benign consensus in American politics about the role of government and the policies it should follow. The elements of that consensus were:
- Sound money
- Low to moderate rates of taxation
- Free trade
- At a minimum, at least lip service to the idea of low deficits.
There were two other elements of the consensus that turned out to be considerably less benign:
- A faith in the ability of the Federal Reserve to fine-tune economic policy
- A willingness, built through the 1990s and into the 2000s, to use rising levels of debt to drive economic growth.
Without getting into the gruesome details about the role of the Fed in driving the real estate and stock market bubbles, or that of Fannie Mae and Freddie Mac in both the real estate bubble and the sub-prime debt debacle, suffice it to say that not all bipartisan ideas are good ones.
In the period since the Great Panic of 2008-2009, that benign bipartisan consensus has fundamentally broken down. In the absence of consensus, amid the near-constant barragge of bad news, both parties have returned to their most basic premises. Democrats want more government, higher taxes and more aggressive regulation of business. Republicans want less government, lower taxes and a rollback of regulation.
Both parties have indulged themselves in speculations that wander far from once-agreed principles. Read left-wing publications like The Nation, Mother Jones or The American Prospect and you see a remarkable nostalgia for the public policies of the 1950s, a period of strong unions, higher tariffs and marginal tax rates above 90%. On the right, you see opposition to new taxes in any form, a loathing of Wall Street and even a desire to just plain abolish the Federal Reserve. (As though having a central bank was the problem, as opposed to the policies of that central bank.)
Each party looks at the other’s proposals and comes to the same conclusion — “Those people are nuts.” Meanwhile investors, without understanding all of the details, recognize that the prior underlying unity about policy is gone, and that its disappearance has profound consequences.
In our internal discussions about investment policy, we have debated the implications of this new, more-contentious political landscape. Absent insane ideas being translated into actual policy (90% marginal tax rates, an abolition of fractional-reserve central banking, starting a trade war), our view is that the general lack of investor confidence translates into higher volatility rather than structurally-discounted equity prices. When any hiccup in quarterly growth immediately becomes fear of a double-dip recession, expect a higher VIX number and devil take the hindmost.
Will things ever return to normal? Will we get back to those halcyon days in the late 1990s, when markets went up 20% per year and all we worried about was what the meaning of is, was?
I suspect that we won’t get a new consensus without a transformational election, one that puts one party or the other firmly in charge of economic policy. The last two such elections were 1896 and 1932. In some ways, 2008 looked like that kind of election, with the Democrats taking control of the White House and both houses of Congress. In reality, the voters did not really want European-style social democracy, they were just sick of Bush and unhappy with the direction of the economy. (And of course, recently we have watched the European model begin to fail in real time, complete with both threatened credit defaults and actual riots.
Until a new consensus about policy emerges, we will need to supply our own internal confidence, one based on maintaining an even keel despite higher volatility and lower structural returns.
Easier said than done. I’ll have some more thoughts about this in a future post.
 Keep in mind that “small business” by this definition includes companies employing over 100 people and generating tens of millions in annual revenues.