Living in a World of “Rational Expectations”
The Well-Timed Strategy for Week Ending May 28, 2009
by Peter Navarro, Ph.D.
May 26, 2009

Market Pulse

The theory of “rational expectations” was developed by conservative, neoclassical economists (primarily the “Chicago School”) to explain why it is fruitless to engage in any kind of Keynesian fiscal or monetary policy to artificially stimulate an economy. The best way to explain this theory -- which is HUGELY relevant for today’s financial markets -- is with an example.

Suppose, then, that the US government engages in a massive fiscal stimulus to jumpstart an economy in recession. But also suppose that this massive stimulus will require equally huge budget deficit financing that over time will surely increase both interest rates and inflation. Since people are rational, they will therefore “expect” the advent of higher interest rates and inflation and behave in ways that will defeat the intent of the stimulus.

In particular, consumers will save more because they know the stimulus will only eventually provoke an even deeper recession. This behavior will suppress consumption spending, thwarting recovery. Businesses will also try to raise prices in anticipation of inflation while workers will demand higher wages -- thereby causing an inflationary shock earlier rather than later. Bond market investors will refuse to buy the bonds needed to finance the deficits because they know as interest rates rise, bond prices will fall. Stock market investors won’t buy stocks because they know another bear market is coming. And foreigners won’t help the US government finance its deficits because they know the dollar will become worthless -- along with their US bond holdings.

The liberal critique of rational expectations theory -- think Krugman or Reich -- is that people aren’t really that smart about macroeconomics or that rational to fully anticipate all of the effects so there is a period of time during which a fiscal stimulus can actually work its magic.

So who’s right?

Well, right now, the financial markets are a living, breathing experiment to prove -- or disprove -- the rational expectations argument. When BOTH the stock and bond markets turned bearish last week, that seemed to be a signal that the rational expectations argument may hold sway.

Of course, readers of this column will know that I’ve been speculating on at least a brief bullish cycle of a few months or even a year or more. However, readers should also know that I am a secular bear precisely because the Obama-Bernanke-Geithner-Summers Program contains the seeds of its own destruction -- see paragraphs above.

So, with last week’s action, we are back in dangerous waters again ever so quickly. I’m holding my GE 2011 leaps and 2011 leaps for Dupont because I think that company manages the business cycle well. However, I bailed on my Delta leaps with a small profit -- I see oil and jet fuel prices on the rise again as the dollar falls.

I may also cash out my Intel and B of A leaps with small losses -- depending on what unfolds over the next week or so. So stay tuned….

International Notes:

This article of mine appeared on October 12, 2006 in the Chicago Tribune. It is as relevant today as it was then.

Only China, not U.S., can rein in N. Korea

North Korea is a significant threat to global economic and political security–even without nuclear weapons. Neither the U.S. nor UN sanctions can bring North Korea to heel–only China can.

The North Korean economy, and therefore its political system, is immune to UN sanctions because its primary economic activity is to traffic in illegal arms, drugs, and counterfeit and smuggled goods. It sells weapons to rogue nations and terrorist organizations. North Korea is the primary supplier of methamphetamines to Japan and much of Asia and a significant link in the world heroin chain. Fresh, crisp and decidedly counterfeit U.S. dollars are printed in North Korean government mints and distributed around the world, and North Korea is a major conduit for Chinese counterfeit goods and a leading supplier of smuggled cigarettes.

In this illegal trade, North Korea plays the “wholesaler” to crime” retailers” that include the Russian mafia, the Japanese yakuza, the China-Hong Kong triads and a thriving Thai underworld. This economic activity takes place far below the reaches of any UN sanctions; and each of these activities contributes in its own unique way to global economic, political or social instability.

Add to this volatile black market mix a nuclear weapons capability and it is easy to understand why world leaders are so uneasy. But who might these North Korean nuclear weapons be aimed at?

The answer certainly isn’t South Korea. Even a madman like North Korea’s dictator Kim Jong Il is rational enough to realize that to drop a bomb on Seoul would be merely to invite nuclear fallout back on himself. That leaves other targets like Beijing, Tokyo or Anchorage. It also leaves the worst nightmare of the U.S.: the sale of a North Korean suitcase nuke to a terrorist organization that eventually winds up obliterating New York or Los Angeles or Chicago.

Clearly, this nuclear rat that is now roaring must be dealt with, but the U.S. is totally unequipped to do so. U.S. military capabilities are stretched to the breaking point in the Middle East, and U.S. troops would likely be no match for North Korea’s 1 million-plus army in a conventional land war. A naval blockade is nonsensical, particularly since it would likely trigger a North Korean move to overrun Seoul. That leaves only some type of surgical missile strike aimed at destroying North Korea’s nuclear capabilities, but that would probably provoke either the same type of North Korean attack on South Korea or a sharp confrontation with the Chinese.

Given these grim realities, what’s a world to do? In truth, the only solution is a Chinese one. Just as the Soviet Union once propped up Fidel Castro’s Cuba economically, so now does the Chinese government prop up North Korea. China now provides North Korea on a heavily subsidized basis with much of the food and energy it needs. To withdraw this aid would be to both starve and freeze a wide swath of the North Korean population and trigger a political implosion.

Perhaps even more important, China continues to provide North Korea with the same kind of military backup and shield that it once did with such effectiveness during the Korean War of the 1950s. Behind this Chinese shield, North Korea is free to tweak the noses of everyone from the U.S. president to the UN secretary general. Without this shield, it would be truly isolated and at least much easier prey for a joint U.S.-South Korean strike.

China now has a very important choice to make. On the one hand, North Korea provides an important strategic buffer from a U.S.-aligned South Korea and a useful economic conduit for China’s counterfeit activities, which contribute a significant share to China’s booming gross domestic product. On the other hand, China must now face a madman with an arsenal of nuclear weapons that could just as easily be aimed at China as the U.S.–or bring down the world economy with a terrorist nuclear strike. With North Korea’s recent nuclear testing, this hardly seems like a difficult choice.

THE CHINA EFFECT

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© 2009 Peter Navarro

“Any trader or investor who ignores the power of macroeconomics over the world’s financial markets will, sooner or later, lose more than they should and if they are trading on margin, perhaps more than they have.”-- If It’s Raining in Brazil, Buy Starbucks

Peter Navarro is a business professor at the University of California and the author of the best-selling investment book If It's Raining in Brazil, Buy Starbucks and The Well-Timed Strategy. His latest book is The Coming China Wars: Where They Will Be Fought, How They Can Be Won.

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