Monthly Commentaries

Don't forget the feedback – January, 2012

In January, all equity markets appreciate as continued good news about the U.S. economy trumped negative headlines out of Europe. The TSX was up 4% in January with the MSCI and US markets both up 3.5%. News that the Federal Reserve would not increase short term rates until at least 2014 kept the bond market stable for the month. Overall, an impressive start to 2012. In late January I was asked to participate in one of the federal government's pre-budget consultations. The meeting room was populated with business owners, accounts, lawyers and of course members of the finance industry. Two things struck me about the meeting: First, I was surprised at how pessimistic people were about the future even though their businesses were growing - albeit at a slower pace than five years ago. Second, people's comments were overwhelmingly framed from a microeconomic perspective. This month I wanted to focus on the perils of thinking about a nation/government as a business particularly when it comes to setting policy.

Consider two homes, the frugal Fischers and the spendthrift Spencers. Now, let's suppose that the Spencers have been borrowing heavily to support their lifestyle and now find themselves in difficulty. So, the Spencers make significant cuts and significantly curtail their spending. This spending reduction results in some of the local businesses finding that the demand for their products has fallen. Unfortunately, the Fischers work for one of these local businesses and find themselves unemployed as their employers are forced to make cuts to offset the loss in demand for their products. As you can see, in aggregate the economy is now significantly worse off. At first glance, it would seem sensible for the government to design policies that would encourage everyone to behave like the Spencers. However, what those policies ignore are the feedback loops that occur within an economy. It is precisely the lack of appreciation of these feedback loops where the framing of macroeconomic policy in microeconomic terms goes off the rails. An economy is not a business.

Many of you will have recognized that my story about the Spencers and the Fischers is a description of the paradox of thrift - if everyone tries to save money during time of recession demand falls and economic growth and consumption decreases. In order to offset this effect central banks typically cut rates and governments increase spending. The combination of those two measures would reduce the impact of the Spencer's decision to cut spending. Once the Spencers are in a position to spend again, the government would reverse course. Governments and people have to be careful not to frame policy in very narrow microeconomic terms. A phrase like getting our house in order may have popular appeal but does not account for the very real feedback mechanisms that exist in the economy. In economics, as in investing, the simple story or sound bite may be fraught with danger. Arthur Heinmaa, CFA Managing Partner