Wall Street may own the GOP, but Wall Street investors REALLY pay attention to politics when it comes to what effect politics will have on economic activity.

Investors know that if the government stops spending right now economic activity will slow down.  That’s bad for equity prices in particular, and commodity prices too if the slowdown looks severe enough.   So failure to reach some ‘grand bargain’ where spending is severely curtailed is not a bad thing from an investor standpoint. 

Europe, on the other hand, bothers investors a great deal.  Why?  Because Europe is the world’s largest economy taken as a whole.  And the biggest customer for US products.  If Europe sinks back into recession it will hurt US companies, irrespective of whatever negative effects weakened European banks might produce.  

Domestically, the Feds need to keep spending and if that spending directly hires unemployed people the domestic economy is guaranteed to strengthen more quickly.  Obama is touring the country beating the drum for his latest stimulus, one that directly hires and is guaranteed to put people back to work.  If he is successful, the country will benefit.

And so too will equities benefit.  Austerity, on the other hand, will sink the economy and equity prices too.

For one thing, balance sheet recessions occur rarely.  In the last 83 years the US has had two:  The Depression of the 1930s and the Great Recession of 2008-09 (we’re supposedly out of the recession now but it doesn’t feel like it).

In a normal, healthy economy this is what happens.  You get paid $1,000.  You spend $900 and save $100 and put it into the bank.  The $900 spent is someone else’s income, and the $100 in the bank is lent out to further economic activity.  In a fractional banking world, that $100 may be used as a  bank reserve that can allow $500 in lending, for one example.  So the total economic activity is $1,400 and the economy grows.  The person whose income was the $900 orginally spent, spends $810 and saves $90 in the bank and the sequence repeats itself including the bank lending out $450 on the $90 saved.  Total economic activity now increases by another $1,350.  And so on.

But in a balance sheet recession everyone decides to pay down debt at the same time.  And no one borrows because they want to pay down debt, not increase it.  So the $100 saved by the first person in the example above gets stuck at the bank.  As a result instead of economic growth, the only income for anyone else is the $900 spent.  And the same thing happens for the second person, whose $90 is saved gets stuck in the bank too.  The result is that the economy shrinks.  You get a very nasty recession or even worse, a depression.  These types of recessions/depression actually make deleveraging harder, not easier, because debt levels remain constant while income, the ability to pay debt, shrinks.   This situation is also known as the ‘paradox of thrift.’  During the Depression many banks simply returned everyone’s deposit and closed the doors because there was no loan demand.

So the intuitive saving when things go to Hell economically has to be countered by someone.  There needs to be that borrowing and the resulting economic activity in order to actually get the deleveraging done.  And that ‘someone’ is the federal government:  The only institution which can lean against the wind, the paradox of thrift, sufficiently enough to break the back of a balance sheet recession.

In 2008 China spent 17% of its GDP in stimulus in order to avoid a serious recession.  In one year.  In addition China spent those stimulus funds building things.  Provincial projects that would otherwise have been shelved were put into action.  As a result China’s economy recovered relatively quickly.  Japan, beginning in 1988 when property values dropped 85% across the country, began a strong stimulus program that continued until 1995 when it was wound down and Japan plunged again into recession until stimulus was ramped up again.   The deleveraging didn’t stop until 2005 so Japan’s recovery lasted seventeen years.  All that time, except for five quarters following the 1995 mistake, Japan’s GDP didn’t shrink.

We need to spend on infrastructure in a big way, creating jobs in a big way, and pushing back in a big way against the private deleveraging.  And we need to keep doing this until the deleveraging is finished.  This deleveraging will run its course more quickly, and more successfully, if we do.  Once that is done, we can pull back government spending and let a now healthy private sector expand and pay down public debt.

If you want a better explanation it’s here, in a link at economist’s view.   It is an interview of Richard Koo, chief economist of Nomura Securities.

A paper at the New America Foundation estimates that inefficiency costs  created by old infrastructure comes to an estimated $195 billion annually.  Even a House Republican can figure that comes to $1.95 trillion a decade in wasted money for the economy–but if they want to save time and not make any errors in math they can ask the nearest Democrat for the right answer.

Here’s some more math.  The American Society of Civil Engineers estimates we could easily use more than $3 trillion to maintain and upgrade our various legacy infrastructures.   The Political Economy Research Institute at the University of Massachusetts estimates every $1 billion so spent creates 18,000 jobs.   So $1 trillion invested where the engineers say we should invest creates 18 million jobs, twice the 9 million jobs lost to the Great Recession.

From the article:

Quantifying Efficiency Loss
Bottlenecks and traffic delays in our ground and air transportation systems are paralleled by inefficiencies across many modes of infrastructure.  According to various estimates from government institutions and non-profits organizations, the efficiency lost because of poor infrastructure is probably in excess of $195 billion per year and would be higher if it included private infrastructure networks, such as freight rail or telecommunications, and infrastructure networks that are regulated largely by states and municipalities, such as ports and inland waterways.  

Beezer here.  We spent more than $700 billion on TARP, and another $800 billion on the first stimulus plan, most of which came in the form of useless tax cuts.  The recent ‘compromise’ between Obama and the Republicans during the lame duck period of the last Congress tacked another $850 billion over two years on the deficit.  All on more tax cuts.  Failing to eliminate the Bush tax cuts for those making more than $250,000 per year adds $45 billion per year to our deficits.

Meanwhile unemployment still hovers around 9%.   Yet we could spend $1 trillion over the next few years and create 18 million jobs, most of them in the private sector.  Even if the UMass academics are wildly wrong and the money only creates 9 million jobs, it would still eliminate our unemployment problem, thus our unemployment insurance bills, and it would also eliminate the revenue loss from the Great Recession.  Our short term deficits would evaporate.  And as the New America paper indicates, we would at the same time eliminate $1.95 trillion in waste the next ten years.

Conclusion.  We’re imbeciles.

There’s a growing body of thought that chronic trade imbalances and manipulated currencies used to support export industries in the developing world are the root cause of the Great Recession in the US and Europe.

This isn’t the 800lb Gorilla, this is what the Gorilla is about to break.  The Gorilla is the United States, more specifically the Federal Reserve of the United States.

It is suspected that the Federal Reserve is about to embark on a huge quantitative easing effort, dubbed QEII.  Essentially the Fed has decided it will start buying assets, mostly Treasuries, in the trillions of dollars.  This will result in dollar depreciation, even lower interest rates in the US, and it is hoped enough inflation to finally get money moving into capital investment instead of being stuffed in the virtual mattress.  

The primary goal is to break a currency regime that has been in place for more than two decades.  That regime depended upon a strong dollar beneath which export markets could peg their own currency.   QEII will put pressure on that strong dollar and the more the dollar devalues the greater the strain on economies who depend upon exports to grow.

Why is the 800lb Gorilla doing this?  Because it is now believed the old arrangement crippled the US economy by inducing Americans to buy much of what they use from foreign manufacturing.  In effect, American productive capacity was idled because American demand was being satisfied by other country exports.  The result is chronically high unemployment in the US and chronically high demand for the dollar and Treasuries coming from exporters who are flush with dollars.

In short, America has been induced into an artificial output gap where demand is satisfied by exports instead of domestic manufacturing.   The Great Recession and its stubbornly high unemployment showed the real underlying consequence of global trade flows that were manipulated by mercantilist export led nations such as China.

Tim Duy writes a well respected blog called Tim Duy’s Fed Watch.  In a recent post he writes:

“How has it come to this?  To understand the challenge ahead, we need to begin with two points of general agreement.  The first is that the US has a significant and persistent current account deficit, which implies that domestic absorption of goods and services, by all sectors, exceeds potential output.  In other words, we rely on a steady inflow of goods and services to satisfy our excess demand, a situation we typically find acceptable during a high growth phase when domestic investment exceeds domestic saving.  The second point of agreement is that high unemployment implies that actual output is far below potential output.  We clearly have unused capacity.

Points one and two appear that they should be mutually exclusive, but they are not.  The fact that they are not begs an explanation. Paul Krugman sends us to Paul Samuelson to provide that explanation:

 Here’s what he [Samuelson] wrote in his 1964 paper “Theoretical notes on trade problems”: “With employment less than full and Net National Product suboptimal, all the debunked mercantilist arguments turn out to be valid.” And he went on to mention the appendix to the latest edition of his Economics, “pointing out the genuine problems for free-trade apologetics raised by overvaluation”.

I think Samuelson is correct; an excessively high dollar is the explanation for the simultaneous existence of a sizable current account deficit and excessive unemployment.  Indeed, there appears to be a externally determined downward limit to real value of the Dollar, and we are close to pushing against it:”

Duy quotes another blogsite,  Angry Bear, to explain why becoming so reliant on foreign production eventually results in persistently high unemployment.

“Since the early 1980′s when the US started borrowing abroad to finance its two structural deficits — federal and foreign–trades share of consumption has risen from about 6% to some 16%. Normally this has a small negative impact on the US economy, but sometimes you get quarters like the last quarter. Last quarter real domestic consumption rose at a 4.9% annual rate. That was an increase of $162.6 billion( 2005 $). But real imports also increased $142.2 billion (2005 $). That means that the increase in imports was 87.5% of the increase in domestic demand.

To apply a little old fashion Keynesian analysis or terminology, the leakage abroad of the demand growth was 87.5%. It does not take some great new “freshwater” theory to explain why the stimulus is not working as expected, simple old fashioned Keynesian models explain it adequately.

Years of current account deficits – deficits induced not by the decisions of private savers looking to maximize returns but by foreign public sector entities seeking to maintain export growth – has literally resulted in a US economy that, on net, is unable to produce the goods its citizens want to consume.   Hence a blast of stimulus flows overseas , the rising trade deficit heralded as a sign of strong US demand despite the inconvenient truth of little net job creation.” 

Beezer here.  In other words most of the increase in demand stimulus might create becomes stimulus for foreign, export led, economies.  The money is just passed on out of the country.  Which is why we’ve recommended domestic infrastructure projects.  That money doesn’t just flow out to another country.  It’s real stimulus.  

Meanwhile, Paul Krugman points out we didn’t really have much in the way of stimulus anyway.

“Here’s the narrative you hear everywhere: President Obama has presided over a huge expansion of government, but unemployment has remained high. And this proves that government spending can’t create jobs.

Here’s what you need to know: The whole story is a myth. There never was a big expansion of government spending. In fact, that has been the key problem with economic policy in the Obama years: we never had the kind of fiscal expansion that might have created the millions of jobs we need.

Ask yourself: What major new federal programs have started up since Mr. Obama took office? Health care reform, for the most part, hasn’t kicked in yet, so that can’t be it. So are there giant infrastructure projects under way? No. Are there huge new benefits for low-income workers or the poor? No. Where’s all that spending we keep hearing about? It never happened…….

Consider, in particular, one fact that might surprise you: The total number of government workers in America has been falling, not rising, under Mr. Obama. A small increase in federal employment was swamped by sharp declines at the state and local level — most notably, by layoffs of schoolteachers. Total government payrolls have fallen by more than 350,000 since January 2009.

Now, direct employment isn’t a perfect measure of the government’s size, since the government also employs workers indirectly when it buys goods and services from the private sector. And government purchases of goods and services have gone up. But adjusted for inflation, they rose only 3 percent over the last two years — a pace slower than that of the previous two years, and slower than the economy’s normal rate of growth.

So as I said, the big government expansion everyone talks about never happened. This fact, however, raises two questions. First, we know that Congress enacted a stimulus bill in early 2009; why didn’t that translate into a big rise in government spending? Second, if the expansion never happened, why does everyone think it did?”

Beezer again.  Krugman is obviously correct, but so what?  His opinion, although powerful, is being swamped by a huge flood of advertising/marketing money coming from supra-national corporate treasuries and the wealthy who depend upon them for their wealth.  And much of that money was unleashed by the recent decision of the US Stupid Court overturning a century of regulations aimed at controlling the power corporate treasuries could wield on government if not restrained.

These are corporations that benefit from our current account imbalance.  Think China Mart.  Or oilmen like the Koch family, a primary contributor to several of the secret ‘fronts’ being used now to defeat Democrats and install compliant Republicans.

Meanwhile, the Federal Reserve is ready to begin a new phase of currency battle.  This development may be far more important than whether or not Republicans can gain control of Congress.

J. Bradford DeLong, an economist at UCal Berkeley and former Treasury official with Clinton, raises some economists on their own petard with an article entitled ‘Economics for Parrots’ published at Project Syndicate.

Economists know the rules of supply and demand but seem to have forgotten them recently, DeLong says.  The parrot analogy came from a quote by British economist J.R. McCulloch who said that the only training a parrot needs to be a passable political economist is one phrase: “supply and demand, supply and demand.”

“….economics would be useful if economists were, indeed, likeMcCulloch’s parrots – i.e., if they actually looked at supply and demand. But I think that much of economics has been discredited by the manifest failure of many economists to be as smart as McCulloch’s parrots were.

Consider the claims – rampant nowadays in the US – that further government attempts to alleviate unemployment will fail, because America’s current high unemployment is “structural”: a failure of economic calculation has left the country with the wrong productive resources to satisfy household and business demand. The problem, advocates of this view claim, is a shortage of productive supply rather than a shortage of aggregate demand.

But it should be easy – at least for an average parrot – to tell whether a fall in sales is due to a shortage of supply or a shortage of demand. If a fall in sales is due to a shortage of demand while there is ample supply, then, as quantities fall relative to trend, prices will fall as well. If, on the other hand, the fall in sales is due to a shortage of supply while there is ample demand, then prices will rise as quantities fall.

Which do we see now? There are no places in the US economy where wages or product prices are rising more rapidly than expected. There are no places where a shortage of qualified labor or of available capacity is sufficiently great to induce managers to pay more than they have been used to paying for good hands or useful machines.”

And DeLong says these economists are getting another policy response wrong because they, despite their claims to pay attention to supply and demand, apparently aren’t. 

“Or consider the claims – also rampant these days – that further government attempts to increase demand, whether through monetary policy to alleviate a liquidity squeeze, banking policy to increase risk tolerance, or fiscal policy to provide a much-needed savings vehicle, will similarly fail. These measures, too, are supposedly doomed because they all involve increasing governments’ liabilities, and financial markets are at a tipping point with respect to sovereign debt. If governments that have already tapped-out their debt-bearing capacity now issued more debt or money or guarantees, they would deal a mortal blow to confidence.

Once again, an adequately trained parrot, unlike many economists nowadays, would ask whether the economic problems that current levels of government debt are causing reflect too much public debt supplied by governments or too much public debt demanded by the private sector. If the problem were that supply is too great, then new emissions of government debt would be accompanied by low prices – that is, by high interest rates. If the problem were that demand is too great, then new emissions of government debt would be accompanied by high prices – that is, by low interest rates.

Guess which one the US and many other countries have? For a parrot, that’s a no-brainer: the public-debt problem is not that governments have issued so much debt that investors have lost confidence, but that governments have issued too little debt given the enormous private-sector demand for safe places to park wealth. The problem, the parrot would say, is that households and businesses are still trying to build up their stocks of safe, high-quality assets, and are switching expenditures from buying currently-produced goods and services to increasing their shares of an inadequate supply of government liabilities.”

DeLong wonders what future historians will ask when they look back on today’s debates over whether or not the federal government gave the American economy too much, or too little.

“When economic historians examine the Great Recession, their overwhelming consensus is likely to be that its depth and duration reflected governments’ refusal to try to do more, not that they tried to do too much. They will agree with the parrots that falling inflation showed that the macroeconomic problem was insufficient demand for currently produced goods and services, and that the low level of interest rates on safe, high-quality government liabilities showed that the supply of safe assets – whether money provided by the central bank, guarantees provided by banking policy, or government debt provided through deficit spending – was too low.

The question that will be a mystery to them is why so many economists of our day did not know how to say: “supply and demand, supply and demand.”

No one can foresee the future.  Even those who work very hard to make predictions are often wrong.   That said, Beezer can’t help himself.  So here goes.

The question is what will happen if the Republicans win enough seats in Congress to become the majority party?  That by itself is a big assumption.  An unknown that won’t be answered until November’s mid-term elections.  But the question is really about the nation enacting a deficit reducing viewpoint carried by Republicans, as opposed to the stimulative viewpoint of Democrats.

If the Republican viewpoint holds (think John Boehner of Ohio as House Majority leader) then there will be cutbacks in federal deficit spending aimed at stimulating demand.   Unless that demand rises for some other reason, then the current ‘output gap’ will widen.  A wider output gap means more cutbacks in production, which means more unemployment.

Which means less demand, which forces more cutbacks, which further increases unemployment.  At some point the output levels reach low enough levels to close the gap between output and demand.  No one knows what that level is beforehand.  You just have to experience it to find out for certain. The last time we experienced this dynamic was when the country entered the Great Depression.

A second feature of this dynamic is that it is deflationary.  That means just holding onto cash is a good investment because prices are declining and each dollar buys more.  It also means that debt is harder to pay off because the debt owed has to be paid off with more valuable dollars.  In reality that sounds like a pretty good deal for creditors.  They receive dollars back which buy more than the dollars they initially lent.

Unfortunately, this assumes they get paid back at all.  In a poor economy like today’s, never mind a Depression, a great amount of debt is not being paid back.  That the debtor defaults and is ruined provides little comfort to the creditor who doesn’t get paid.  In fact creditors can be ruined as well if the default rates reach high enough proportion.

Given this understanding, enacting Republican policies focused primarily on debt/deficit reduction will result in higher unemployment than otherwise would be the case and will also make paying down debt much more difficult.  All of which will increase the deficit and retard debt reduction, both on private balance sheets and public balance sheets.

As for the various bond, commodity and equity markets, it is very hard to predict the immediate reaction to a large Republican landslide.  Beezer is convinced that no matter what the immediate reaction the day after, gimlet eyed investors will do what investors do, they will protect their capital at minimum, and some will leverage existing cash to take advantage of widespread declines in equities and probably commodities, if they begin to show weakness.  Corporate bond markets might suffer as well, mainly because of fears of widespread defaults.  In contrast US Treasuries might rally somewhat in a rush to safety.

What might avoid this sequence of events?  Whatever it is has to be able to break the output gap by raising demand.  This is because raising demand generates jobs, which further increases demand.  And that is a positive for the economy.

Republicans argue that jobs aren’t being created because of poor demand, but because of general business uncertainty over regulations, increases in medical costs, and a fear of higher taxes.  Until those fears are assuaged the economy won’t grow, Republicans maintain.   And Republicans intend to cut taxes across the board, undo financial regulations recently passed, and also undo recent health care reform legislation.  By doing so, business will regain it’s confidence in the future and will start investing in capital, including jobs, is how this thinking goes.

Beezer is certain there is a demand problem, not one of output.  Machinery is idle all over the land for lack of customer orders, and 8 million people have lost their jobs as a result.  During the great Depression of the 1930s some banks simply closed their doors and gave depositors back all their money.  They did this because few people or businesses wanted loans, and those that did couldn’t in all likelihood pay them back.    We have a similar situation today, although not as severe as it was during the Great Depression, when unemployment was 24%. 

Investors know this too.  Stimulus programs in the 1930s were much larger as a percentage of GDP compared to today’s programs.  Unemployment dropped more than 10% as a result of these programs.  But there was still unemployment as high as today’s 9.5%.  Nonetheless, in 1936 and 1937 conservatives in Congress forced the government to scale back much of this support.  The immediate result was another deep recession where unemployment soared back to 19%.

The supports were re-installed, of course.  But the economy never got back to the levels of 1935 and 1936 until the advent of WWII, which amounted to the most massive stimulus program in our history–one that was 300% of GDP.  In today’s dollars that war pumped the equivalent of $30 trillion dollars of stimulus!  And politically the entire effort was a classic example of a European type of socialism.   That observation aside, this massive stimulus created productive capacity at a very steep rate, and this productive capacity became the engine for peacetime growth after the war.

Considering all this, investors are quite likely to ‘sell’ certain assets if Republican policies begin to be implemented at this time.  They may favor Republicans politically, but that preference is definitely subservient to their desire to preserve wealth.