Eye of Newt and Toe of Frog - How we find ourselves in the Broth of a Great Experiment in Economics

Adrian Clayton of Alphen Asset Management writes that he is not sure that many of us appreciate that we are presently intimately involved in carving-out a unique chapter in history.

Way back in the 1930's John Maynard Keynes committed economic heresy when he argued against neoclassical economics. Economic theory at the time advocated that free markets could self regulate in that as long as wages were completely flexible, economies would always be at 'full employment' as individuals would always employ rational thoughts and the rationality of the individual would ultimately lead to the optimum functioning of the entire system. 

Keynes argued against the efficiency of the private sector as a 'bottom-up' driver for allowing an economy to function on its own. He believed that private sector decisions where individuals acted in their own interests were very often not friendly to the economy as a whole and when these inefficient decisions were aggregated, poor macroeconomic results could occur. He pointed to business cycles where an economy could experience severe troughs or peaks and in a downturn, a glut of goods could arise leading to severe unemployment. 

His solution to the problem was that government intervention was imperative for creating balance within a financial system. This could be achieved by monetary and fiscal policies. Put simply, Keynes felt that when the private sector was failing, governments could stoke economic growth by undertaking fiscal projects (e.g. building roads, dams and other forms of infrastructure) thereby stimulating employment and in time aggregate demand for goods and services augmenting this with monetary policy in the form of lower interest rates.

In the early 1970's, after the collapse of the Bretton Woods System and with the onset of the oil shocks and the subsequent surge in inflation, Keynes' theories radically lost popularity as they were considered inflationary. Instead, the monetarist came to the fore and they argued for a system of price stability where the supply of money would be strictly controlled. So now we know the theory, what does this have to do with an experiment in which we are all partaking?

Well, I am sure you would have guessed by now that the actions taken by the G20 over the last 24 months to stave off what could have been a complete economic meltdown originated directly from the darkest coves of Mr Keynes' study. Obama, Brown, Wen Jiabao you name them, they all attacked the problem in precisely the same way that is rapidly engaging government development projects and slashing interest rates to stimulate aggregate demand.

Until now this seems to have been an economic concoction that has delivered the goods but in truth we are only at the start of this journey. Sceptics have been quick to point out that of the possible economic scenarios unfolding in the years ahead, two are most likely. 

The first is along the lines of monetarist thinking. The financial system has been flooded with money; this will ultimately lead to strong inflationary pulses, possible stagflation and even potential monetary debasement. The second is that governments will in time begin removing liquidity from their economies, but most of these economies will not have reached a point of robustness to deal with this change. The effect is asset price deflation, aggregate demand reduction and a perpetuation of the events of 2008.

Of course the scenario we all hope for is that positive economic news flow continues to stream forth as is currently the case, that inflationary forces remain subdued, that slowly monetary extraction occurs and simultaneously, the private sector enjoys traction that is sustainable so as to induce a normal economic cycle.

The Alphen Angle is an electronic newsletter of PSG Alphen Asset Management. To read more about PSG Alphen please go to AlphenAM.co.za