Economic Ideology

By economic ideology, we mean schools of economic thought such as Keynesianism, monetarism, socialism, and so on. All these schools are based on defined goals and a set of means to achieve those goals, but are limited by the constraints of reality, much the way an architect is limited by gravity; just as the Egyptians had to learn the rules of gravity often by trial and error, so does society have to learn economic reality through trial and error.

To understand how economic ideology affects investing, we have to first understand the goals of that ideology. For centuries, the goal of the prevalent forms of economic ideology was simply the personal goals and preferences of either the individual or group of individuals at the top of the power structure. Economics was all about what the person wearing the crown wanted.

Over time, this power structure has evolved, and the way people interact and view each other's innate rights has evolved.

This is the evolution from a kingdom-type structure, in which the purpose of society was to serve the whims of royalty, to socialism, which attempted to allocate resources so as to maximize the “good” for society as a whole, which of course was defined by those in charge. In order to achieve these goals, the expected and acceptable means have evolved from the use of force with the threat of injury or incarceration, to more subtle forms of coercion using societal pressures and the threat of ostracism. This is an evolution from the threat of a gun to the doctrine of political correctness.

Regardless of how angelic or demonic the goals and means may be, all economic ideology is faced with the simple constraints of human nature. A totalitarian regime, in which the minority dictates the use and allocation of resources, is constrained by the risk of a populace uprising. Whenever the ruling group goes too far, the subservient majority can use the sheer strength of their numbers to physically take over the mantel of power. Unfortunately, this process often results in a new group of despots taking over and the cycle continues. This threat of violent revolution has been the dominant constraint throughout most of history and becomes more likely the further day-to-day reality gets from societal expectations. We have seen such constraints take over in the recent Middle East uprisings.

As societies progress, the constraints evolve in something more subtle. These are based in the simple laws of human nature. For example, if income tax rates are increased from 30 percent to 90 percent, people will generate less income. No amount of political will can change this. It is a simple fact: Human nature innately evaluates effort expended to reward and if one can only keep 10 percent of one's efforts, a Netflix marathon becomes a lot more attractive.

In the United States in recent decades, the primary goals have been dominated by the identification of the best allocation of societal resources to maximize the “public good.” From the 1990s, one of those goals has been increasing the level of home ownership.

We have been and are still living through the inevitable consequences of how those goals were implemented, which is all about economic ideology. We lived through a housing crisis, with home prices falling across the nation to a degree never before seen. In early 2012, a Wells Fargo report indicated that there were about 3.2 million homes vacant, about 85 percent higher than the normal levels, with another 1.6 million likely becoming vacant because of foreclosures.

Families were forced to go through a painful deleveraging process (paying off debts) after the low interest rate/free credit for everyone festival pushed household debt to income levels from their historic norms around 65 percent to a peak of almost 140 percent in 2007, per data from the Federal Reserve. That credit contraction slowed economic growth, so we saw household income levels falling while families struggled to pay down their debt.

The easy, but dangerous, way to assess the problems is to claim that those people, that political party, or that part of the government is dumb, evil, lazy, or whatever insult suits the situation.

The reality is that the economy is incredibly complex, in some ways more art than science. In science you seek to run experiments to determine the impact of something by holding all other variables constant. That is impossible when it comes to the economy. We will never know what would have happened without the TARP bailouts or without the Federal Reserve's quantitative easing programs; everyone has theories, including your authors here, but no one can positively know.

That being said, there really is no such thing as a free lunch, so when you see government efforts to push the market in a specific direction, know that there will be consequences, much the way there are consequences to diverting the path of a river. Our goal is to help you see ways to protect yourself from them and ideally to even profit from them. So let's walk through the different theories and where you can see their effects today.

Schools of Economic Thought

Earlier we told you that the growth of an economy is dependent primarily on three things: labor, capital, and resources. Since the dawn of mankind, there have been a lot of opinions about them, which can be organized into schools of economic thought. To understand what you read or hear about the economy, you need to understand these schools of economic thought. These theories impact the way we all think about the economy, especially those in the government, and maybe even more importantly, they affect the thinking of those who report to the rest of us what is going on and whether it is a good thing or a bad thing.

Most recently, the prevailing narrative has been that the Fed's quantitative easing (QE) programs would help get the economy back on its feet. We can never really know what would have happened without the program, whether economic growth would have been slower, faster, or the same because we'd have to be able to repeat that time in history, not have QE, while keeping everything else the same. The important thing was that the prevailing narrative believed QE was necessary, so the markets reacted as if it were true and beneficial to the economy as successive rounds were discussed and implemented.

Like religion, there are almost endless permutations of views on how an economy works or ought to work. Lucky for you we like to keep it simple and will just break them all down into seven major schools of thought:

1. Neoclassical economics
2. Fascism
3. Socialism
4. Keynesianism
5. Monetarism
6. Austrianism
7. Supply-side economics

There is no consensus about which is correct, and they overlap to varying degrees, but the one most widely followed by those who work in or closely with governments is Keynesianism. This makes intuitive sense, as Keynesianism ardently supports active government intervention in the economy, which validates what many politicians are already doing and are inclined to do, fair enough! Schools primarily teach neoclassical with a Keynesian slant, which is sometimes referred to as the neoclassical synthesis.

The following is a high-level overview of the different schools of thought. Keep in mind as you read these that since the study of economics is a “soft science,” these theories don't have perfectly clear definitions with uniform consensus and tend to evolve over time. They are a bit like religion, where, for example, Lutheran, Episcopalian, Protestant, and Catholic all are variations of Christianity. Since we aren't talking about something objective like or , these definitions are of course subject to interpretation.

Neoclassical economics was developed in the eighteenth and nineteenth centuries and is a very broad term, lacking universal agreement on just what it encompasses. It includes the works of Adam Smith (author of The Wealth of Nations), David Ricardo, Thomas Robert Malthus, and John Stuart Mill. It holds that the value of a product depends on the costs involved in producing the product and, according to E. Roy Weintraub, rests on three assumptions:

1. People have rational preferences among outcomes that can be identified and associated with a value.
2. Individuals maximize utility and firms maximize profits.
3. People act independently on the basis of full and relevant information.

This approach focuses on the determination of prices, outputs, and distributions through supply and demand. This is where we get the concept of a supply curve and a demand curve, shown in Figure 3.1.

What the graph illustrates is that as the price of something goes up, those providing it will be willing to supply more of it. As the price of something goes down, more people will buy it. The quantity suppliers are willing to supply at various prices can be charted as can the quantity that will be purchased at various prices. The point where they meet is the equilibrium price and output quantity.

You can think of this as similar to your basic physics class in which you were taught how things would work in a vacuum; if you dropped a feather and a bowling ball from the same height at the same time in a vacuum, they'd hit the ground at the same time. This provides the foundation for most of modern economic theory, but much like that bowling ball and feather, reality is a bit different from that perfect vacuum. Let's look at those three assumptions again:

• People have rational preferences among outcomes that can be identified and associated with a value. (So it makes perfect sense that Gläce Luxury ice has been able to sell 50 cubes for $325. Enough said.)
• Individuals maximize utility and firms maximize profits. (Michael Jordan had a stint in the MLB and Time Warner merged with AOL, a profit destroyer of epic proportions.)
• People act independently on the basis of full and relevant information. (Housing was booming because, well, everyone was buying a house and of course they will continue to do so in the future. Full and relevant information? If the markets had full information, we wouldn't have insider trading laws.)

In contrast to the focus on the individual in neoclassical economics, fascism, which originated in Italy after World War I, places the “State” above all else; thus, governments are free to do whatever they deem necessary. There are no limits. It typically involves a mixed economy, with government interference deemed necessary to ensure national self-sufficiency and independence. In this ideology, an individual is primarily viewed simply as a tool to further the “best interests” of the State.

The original symbol of this ideology is a bundle of sticks tied together, which in Italian is called a fascio (plural is fasci), sometimes including an axe with its blade emerging. The symbolism here is that one rod alone may be broken easily, but together they are much stronger—in other words, “strength through unity.” You can see this symbol of a tied bundle of sticks at the Lincoln Memorial, symbolizing the president that kept the union together.

The most extreme example of fascism is Nazi Germany. The core of fascism is so simple, and can be so deceptively seductive, that it is usually found weaving its way through other schools of thought, particularly in challenging times. At the end of World War II, the ultimate consequence of this model was made heartbreakingly clear, but remnants of it can still be seen today as political leaders proudly claim they will “do whatever it takes,” to which we like to sarcastically add, “and be damned the consequences as I'll most likely be out of office when they arrive!” Try throwing that one out at your next dinner party after everyone has had a drink or two.

Socialism essentially believes that the free markets are inherently unfair and prone to disaster. Implicit in these assumptions is the belief that a select group of people in government can and should decide what is more “fair” than would exist without intervention and that manipulation to bring about a more “fair” state is a moral imperative. This also assumes that more “fair” is an objective truth, rather than a subjective opinion developed by those in power. This paradigm requires that masterminds control the money supply, interest rates, production, employment—basically, most aspects of the economy. Implicit in this is the belief that these masterminds are capable of running thing better than would otherwise be the case, and that such omniscient and benevolent masterminds will be in continual supply. Basically, this theory believes that society is best served when government takes things away from some individuals and gives them to others in order to rectify the innate unfairness of life.

In today's world, the Declaration of Principles of the Party of European Socialists gives a good idea of how this ideology is currently implemented:

• The welfare state and state-provided universal access to education and healthcare are society's greatest achievements.
• A strong and just society must ensure that the wealth generated by all is shared fairly, as determined by the state.
• Collective responsibility makes society stronger when people work together, and all people are enabled to live a dignified life, free of poverty and protected from social risks in life.

Anytime you hear discussions around “fair share,” you are hearing the influence of socialism.

Keynesianism is named after the British economist John Maynard Keynes (June 5, 1883–April 21, 1946), who was an advisor to Franklin Roosevelt. His economic theories were developed primarily in the 1930s, during the Great Depression. Keynesianism overturned the older ideas of neoclassical economics that were widely adopted by leading Western economies after World War II. Keynes was even included in Time magazine's list of the 100 most influential people of the twentieth century. His theories propose that governments are obligated to use monetary policy (meaning money supply) and fiscal policy (meaning government spending) to alter the economy from how it would otherwise behave. He strongly supported government deficit spending as a way to solve unemployment (remember his theories were developed during horrific levels of unemployment in the Great Depression) and provided the theoretical basis under which sovereign debt has grown to its current levels across most of the world. Keynes versus Bono—now that would be an interesting battle of global influence!

We like to sum up the Keynesian viewpoint this way: “Free markets are volatile and don't produce the greatest ‘general good’ possible. Governments are obligated to and are able to successfully manipulate economic factors to provide a less volatile economy and make everyone better off than they would have been without the intervention.” There is an underlying assumption here that an objective state of highest “general good” exists as a singular truth and that individuals in government are able to consistently identify that state and alter conditions to move toward this truth. Keynesianism is a somewhat lighter version of socialism in that it focuses more on altering economic factors where socialism looks at both economic and social issues. While Keynesianism often gets the lion's share of the blame for the recent global financial meltdown, governments worldwide have relied heavily on it to justify their responses that crisis. When you hear anyone talk about how government must do what it can to help the economy through stimulus, think Keynes.

Monetarism is sometimes also referred to as the Chicago School (of economic thought). Monetarism is most widely associated with Milton Freidman and supports primarily a free market economy with little government intervention save for, as the name would imply, monetary policy (money supply). The concern of the monetarists is that as productivity increases, without an increase in the money supply prices will fall. Think of a simple economy that produces 10 items this year and has $100 as the total money supply. Over the year, those 10 items are produced and exchanged, but the supply of money remains $100. Next year, due to productivity gains (in general people are able to produce more as they get better at what they do—better known as moving down the learning curve), 12 items are produced in this society. The price of all 12 items still can only add up to $100. Thus, a fall in some if not all prices must occur. This theory assumes that chronically falling prices is a bad thing, as it will deter buying, with the buyer asking the question, “Why buy today when the price will be lower tomorrow?” If all buyers were to behave in this way, the economy would come to a standstill.

The goal of a monetarist is to keep the money supply growing at roughly the same pace or slightly faster than the economy so that in general prices remain relatively stable or increase just a little bit year after year. Think monetarist when you hear talk of a “target inflation rate.” This assumes that if you think the price of something will increase in the future, you are more likely to buy it today and that, for the economy, buying today is better than buying tomorrow.

Implicit in this theory is the assumption that individuals in government are able to predict with reasonable accuracy the growth in productivity over time and can also accurately expand the money supply to match increases in productivity. It also assumes that individuals in this position of considerable power will be able to resist pressures to waver from this goal. Recall the recent massive expansion in the money supply in response to the financial meltdown of 2008.

An interesting challenge for the monetarists is malinvestment, which refers to poorly allocated business investments due to either artificially low cost of credit or an unsustainable increase in money supply. Classic examples include the dot-com bubble and the U.S. housing bubble. The additions to the money supply are not evenly injected into the economy. Think of the economy as a big bowl of whip cream. The additions to the money supply are like dollops of cream tossed into the bowl. Those dollops don't immediately spread out evenly, but instead form little “cones of malinvestment,” meaning money flows unevenly into very specific areas at first. Only over time do the dollops melt down, and eventually, the level of the entire bowl rises.

Austrian economics, or Austrianism, gets its name from its founders and early supporters, who were citizens of the old Austrian Habsburg Empire. Best-known Austrians are the 1974 Nobel Laureate Friedrich Hayek and his mentor, Ludwig von Mises. In economics, the Austrian paradigm is the philosophical descendant of Adam Smith and the other so-called classical liberals, today referred to as libertarians. In politics, the Austrian School is often considered the descendant of Patrick Henry, James Madison, Thomas Jefferson, and the other American founders. The Austrian school has received greater attention in recent years, as many proponents of this school predicted the financial crisis years in advance. Contrast this to an interview with Ben Bernanke (a monetarist with, we believe, Keynesian leanings) in July 2005, in which he stated that the global economic fundamentals were extremely strong and expected continued strong growth. Arthur Laffer (a supply-sider) in a 2007 video claimed the U.S. economy had never been in better shape.

Austrians view the economy as a living ecosystem rather than a machine. They believe the mastermind concept implicit in every other doctrine is deeply flawed and contend that it is not possible for political leaders to know what is best for each individual and that any manipulations in an attempt to produce a “greater good” will only cause harm. Thoreau summed up the Austrian perspective when he said, “If I knew for a certainty that a man was coming to my house with the conscious design of doing me good, I should run for my life.”

The emphasis of this school is on individual rights, with government's only legitimate function being their protection thereof. It differs from many other schools in that while fascism, socialism, and the like paint a utopian end-state that can be achieved if the group in power is just given the ability to do what needs to be done, the Austrian school holds that no such utopian end-state exists and that the best society can achieve is to basically let each individual live as he or she chooses and that the natural level of “unfairness” that exists cannot be improved by government intervention.

Supply-side economics developed during the 1970s during a period of stagflation (a period of inflation and stagnant economic growth) and as a response to the perceived failure of Keynesian economic policy. It is a mixture of Austrian and neoclassical economics and proposes that production or supply is the key to economic prosperity and that consumption or demand is only secondary. This idea is summarized by Say's law of economics, which states: “A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.” The theory focuses on low taxes and less regulation in order to stimulate the supply side of the economy. It also strongly supports the theories of Arthur Laffer, who is given credit for the Laffer curve, which states that tax rates and tax revenues are separate and that increasing tax rates above a certain level leads to decreasing tax receipts. This theory was supported by the drop in capital gains tax rates from the late 1970s and into the 1980s, during which time each drop was met by an increase in tax receipts. This theory gained notoriety under President Ronald Reagan, who lowered income tax rates with the theory that a drop in tax rates would result in increased economic growth, which would then lead to increased tax receipts.

Comparing Economic Theories

We like to compare the Austrian perspective to the other schools of thought, with the exception of neoclassical and supply-side, using an ecosystem analogy. Austrians look at a forest and say it is complicated, messy, unpredictable, and doesn't consciously follow any concept of fairness. That being said, any manipulations will only do harm. The forest system is too complicated for any human intervention to be able to consistently improve what exists naturally without eventually causing great harm, often through unintended consequences. Fascists, socialists, Keynesians, and monetarists look at the forest and say, “I can do better.” They just differ on what needs to be improved and what tools they are willing to use.

A primary difference between Austrian and neoclassical concerns the relationship between cost and price. Recall that neoclassical economics holds that the price of a good is based on the costs incurred to produce it. An Austrian would say that's all well and good when deciding whether or not it is worth your while to produce something, but once the good is produced, costs have no relevance and the only thing that determines price is what someone is willing to pay for it. Imagine you build a house with the intent of selling it once it's built. The neoclassical economist would say that your price will be based on your costs plus some target profit. The Austrian says once it is built, you'll end up selling it for the best price you can get, regardless of cost. That price may be above your costs, generating a profit that exceeds your expectations, or below your costs, generating an unanticipated loss. Thus, cost and price are in the end, independent.

While Austrian economist and supply-side economists often end up in the same place, Austrians criticize the supply-siders for not being more critical of government spending. The two schools are quite similar, however, with slight differences in the areas they emphasize.

The way an Austrian economist thinks can be best summarized using a quote from author P.J. O'Rourke: “Giving money and power to government is like giving whiskey and car keys to teenage boys.”

Supply-side focuses on the—big surprise here—supply/production side of the economy, while Keynesian focus on the demand side in terms of fiscal policy to generate higher employment rates, thus more consumption/demand.

Whenever you hear economic information presented in a newspaper, on television, or in a magazine, keep in mind that how the information is being presented and the assessment of the policies around it will be affected by the biases of the person presenting the information coupled with the prevailing narrative (what the majority believe to be the truth of the day) and just how much the individual wants to agree with or disagree with that narrative. These narratives aren't necessarily true, so investors need to keep a focus on the fundamentals of an economy or a stock, but understand that even a completely incorrect prevailing narrative can dominate the fundamentals for some period of time.

The Economy versus the Market

The market is like the weather while the economy is like the climate. We can enjoy an unseasonably warm day in the middle of winter or shiver through an exceptionally cold day in the middle of summer, but that doesn't change the season or latitude. The prevailing narrative in the markets may push investments into an area beyond that which the fundamentals will support, sending returns higher and higher as everyone jumps for their seat on the rocket, igniting ambitions in much the same way as the gold rush of the 1840s and 1850s. Unfortunately for those who hop off too late, eventually reality, the inescapable gravity of economic fundamentals, exerts its pull and the prevailing narrative suddenly switches with the new version exclaiming how all along we knew the prior one was only for fools! The bubble bursts, followed by much handwringing, finger pointing, and adamant pledging, “This must be addressed!” by politicians ensues. That is, until the next Dutch Tulip Tornado (1637), South Sea Shindig (1720), Mississippi Mania (1720), Roaring 1920s, Computer/Tech Craze (1980s), Dot-com Dementia (1990s), and Real Estate Rage (2000s) ignites, and off we go again. Prudent investing requires separating the weather from the climate, taking advantage of unseasonable trends, while always being wary of the inescapable gravity of economic reality.

Cocktail Investing Bottom Line

• Economic growth is driven by three factors: labor, capital, and resources.
• Economic theory provides the prevailing narrative through which information is interpreted, what the information means, and if it is viewed as a good thing or a bad thing.
• Be aware of the prevailing narrative, how different parties (governments, companies, and so on) will speak to you in a particular economic theory voice, and how it differs from the actual data.
• Economics and investing is about probabilities, not absolutes, so it is important to look for data that confirms (or refutes) your hypothesis to increase the chances that you are on the right (or wrong) track.
• We would also recommend searching for data that may contradict your hypothesis to identify any potential flaws. In our experience, this helps us think through the hypothesis from several angles. If the confirming data outweighs the contradictory data, you are more likely to be on your way to a well-thought-out and solid hypothesis.