Like a journalist seeking the truth in writing a story, you have to ask and answer the questions: Who? What? When? Where? Why? and How? Answering these questions on a general, fundamental level is the province of economics. Answering them in particular for a specific market is the province of market forecasting. – Victor Sperandeo, Market Wizard
Many aspiring traders are either confounded or discouraged when confronting economics as applied to the markets. Economics is the study of the instruments, methods, and actions available to human beings for attaining their goals. Yet the intellectual community has taken axiomatic principles and expanded them into a hopelessly complex system of mathematical equations. It’s time to go back to basics. A huge part of successful speculation rests on anticipating the nature and effects of:
- fiscal policy
- monetary policy
on specific markets and on the general business cycle. Government creates the environment within which the economic machine operates. However, government can’t create prosperity with the stroke of a pen. Prosperity requires production & savings. Only if you understand the errors in the economic theory that motivate policymakers, managers, you can anticipate the effects and position yourself to act profitably.
Who are the PolicyMakers
I place economy among the first and most important virtues and public debt among the greatest of dangers; we must make our choice between economy and liberty; or profusion and servitude. If we can prevent the government from wasting the labors of the people under the pretense of caring for them, they will be happy. -Thomas Jefferson
Jefferson clearly stated that a careful and thrifty management of public revenue was (and remains) the most important thing. In saying “economy or liberty?” he was implying where the focus of government should be: expanding its purse and providing public services, or focusuing on protecting life, liberty, and property. The key here, that Jefferson understood, is that government “profusion” can only be paid by “the labors of the people.”
Understand this age-old economic principle: growing government budget and an extension of the services government offers “under the pretense of caring for [the people]” can only come at the expense of private property and individual liberty.
Refute the idea that only government, with it’s countless task forces, high-paid consultants, subcommittees and bureaucratic agencies can find the right set of “compromises” to manage the mixed bag of interests in our nation.
Refute the idea that Central Banks (which are still full of political figures and academics, rather than market professionals) should manage the economy by inflating the supply of money and credit to encourage production.
The most fundamental policy tools in use are:
- the level and method of funding deficit spending,
- monetary policy (i.e. the control of money and credit),
- specific legislation restricting production and/or trade.
So it should be logical now that market participants tune in every time
- the President of the United States (or other corresponding figures)
- Central Bank heads (Draghi, Carney, etc)
- Treasury Secretaries (Mnuchin, etc.)
- other key political leaders or groups (OPEC, etc.)
make a speech or announce something in public. They have the thick sticks. By understanding first what these figures can do, and then anticipating what they might do based on human nature (which has never changed through human history) you can position yourself to profit from future actions.
Taxation and the Business Cycle
Everyone hates taxes but let me say that not all taxes necessarily restrict business activity and growth. It is arguable that using taxes to pay for necessary services rendered by government (for example healthcare, sewage, etc.) is similar to an economic exchange, like other trades.
But market forces do not regulate government services & intervention. Politicians do that, and in order to make it “popular”, they usually hide their real intents behind slogans like “taxing the rich to help the poor”. However, what happens in reality is that the whole productive capacity of the nation suffers as government reach expands and ever more resources are absorbed.
Government does not produce anything. It’s purpose is to redistribute wealth and provide key services for taxpaying citizens. However, usual government spending programs financed by taxation divert savings towards consumer spending and future growth potential is lost.
We will cover the effects of government deficits and debt in a future blog post.
Monetary Policy and The Business Cycle
Money and credit are not primary elements, but outgrowths tht become necessary only after a group of people have been able to save more than they spend for any length of time, and have wealth to exchange in a marketplace of goods & services. This is key: money & credit are not basic building blocks of the economy. Evaluation of needs, production of necessities, saving the excess, investing the excess, innovation and exchange are the basic building blocks.
Yet, in today’s complex market economy, money and credit are vital links in the economic machine. As an economy grows more and more complex, money and credit become prerequisites for economic progress and growth, but only if understood and implemented according to their basis in human action. Instead, they are improperly understood and this leads to periodic booms and busts-the business cycle.
A credit expansion begins with an increase in free reserves held by member banks. These reserves, due to the fractional reserve system, create even more loans. The reserves on the other hand, come from one source: individuals and businesses that deposit money in the bank.
The FOMC has two principal tools of monetary policy:
- the control of short-term interest rates;
- and the ability to alter reserve holdings through open market operations.
When the economy makes a turn for the worse, the usual policy reaction is to make reserves plentiful and to lower short-term rates. This should stimulate banks to lend more, which in turn will stimulate business expansion. However, the inevitable result of this form of credit expansion is a boom that will lead to a bust. How much time will it take? Paul Volker said around 8 years; Ray Dalio said 6-9 years. It will depend on the nature and extent of the credit expansion, as well as the fiscal policy that government imposes on its citizens during the process.
Investments (which are necessary to fuel further growth) are usually put on hold in recessions, waiting for new savings and a wave of confidence. However, credit expansion makes it appear that capital savings exist already. Businesses utilize this newly available credit because they can access it first. However, we need to realize that this is not the “natural” behaviour of a business or an individual during a recession when there is a lack of confidence in the future prospects for the economy. So policymakers create an “illusion” which influences businesses and consumers. Sure, production can rise, employment can rise, prices will rise.
People feel better but it’s all based on the inflationary process of credit creation which, in my own simple mind, is like pressing the accelerator and paying attention to the revving engine of your car when it’s out of gear, whilst ignoring that fact that you’re not moving.
When people start to notice their purchasing power dropping, and that their future income will be insufficient to sustain their current lifestyle, things change. The search for value starts: whether it be precious metals, real estate or gold, people change their habits and the banks notice. The cycle is interrupted abruptly and businesses and/or individuals that made investments based on the past credit expansion will now be stuck.
At this point the population usually calls on the government to do something. However, the only thing that would really help would be cutting both taxes and public spending. Practically, however, this almost never happens. So what happens instead is a new credit expansion. And the cycle starts once more.
If we take 2009 as the last “bubble burst”, when stock markets bottomed, then 2017 is the 8th year of expansion and 2018 will be the 9th – pushing the letter. This lengthy period has been possible due to creative measures by Central Banks worldwide, which have gone way beyond traditional policy measures and have by definition created a bubble of previously unknown magnitude and consequences. At the same time, fiscal policy has been quite restrictive across the globe as taxes have been rising steadily and governments have been spending as usual. So any recovery we’ve seen is entirely due to central bank activity and governments have neutralized most of the effects.
Over to You
If you understand the limitations of government intervention and monetary policy, you should have a clear picture of why the “Trump Trade” is such a big deal. Central Banks are exiting their creative QQE plans and raising rates. This will put pressure on the real economy.
Trump, on the other hand, is attempting to reduce the size of the US government (hence potentially reducing the amount of resources it absorbs each year) and is also attempting to lower corporate tax rates (hence allowing businesses more breathing room). These measures can realistically dampen the negative effects of the credit contraction. This is why the markets have recently been paying so much attention to the tax reform.
By understanding the essential effects of policymaker intervention – as well as the habits of policymakers alike – you will definitely be able to understand and forecast the market’s reaction and position yourself correctly.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.