The Real Effect of Economic Bailouts and Stimulus Packages

In virtually every nation on earth the ruling government plays a massive role in the lives of all citizens. The actions, laws, and policies implemented by those in power often have drastic and far reaching consequences for each and every person. Recently, confronted with an economic crisis like no other, the US government has taken bold and aggressive action, initiating a number of massive "bailout" and "stimulus/spending" packages, which many see as necessary to pave the road back to economic prosperity. While these plans will undoubtedly have a significant impact not just on Americans, but on people all over the world, exactly what that effect will be is unknown. The people in power, as well as many of those in the mainstream media, portray this unprecedented government action as crucial for economic recovery, and even go as far as to say that the government, and only the government can get the economy growing again. However, by examining in a logical manner the path that the government is taking, one will find that unfortunately the proposed actions are not the answer to what ills the economy, and instead will do much more harm then good.

In most cases the advocates of the government's economic policies use Keynesian economics and a concept proposed by John Maynard Keynes known as the paradox of thrift, to try and persuade people that what they are doing is not only correct, but the best and only solution. Basically, the paradox of thrift states that "if everyone saves more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth". From this it is presumed that in order to dampen the effects caused by the decline in consumption, governments should step in and fill the void with spending projects of their own. Doing this it is believed will lead a country out of a recession and back towards growth. While the US and many other economies are indeed experiencing declines in consumer spending, as well as increases in personal savings rates, the proposed solutions by the government will certainly not help. Furthermore, the Keynesian line of thinking is incorrect and illogical, and the consequences of taking action based on these beliefs will only lead to a worse economic crisis down the road.

Firstly, to see why following Keynesian economic principles will not speed up economic recovery, but instead make the problem worse, one needs to understand what savings is and how it contributes to growth in an economy. While many politicians as well as the majority of talking heads in the media, will have you believe that spending is the engine of economic growth, this is not the case as in fact it is savings that is the real engine of growth. Spending is just a means of acquiring goods, or a form of barter, basically one party takes the money they have earned through the production of goods and services and exchanges (spends) it for goods and services that others have produced. This means that without an existing pool of goods and services (which in present day economies provides one with money), one cannot partake in spending. Savings on the other hand, occurs when someone produces a surplus of goods and services and thus earns a quantity of money above the amount that they need to acquire the goods and services they wish to obtain. This excess of goods and services allows a person to lend or invest some of their money with a borrower, the borrower can then use the money (which is backed up by goods and services produced by the lender) to support themselves while they produce goods and services of their own. So it is actually real savings which leads to economic growth, as real savings when transferred to a borrower, provides that person (such as an entrepreneur) with the means of producing more goods and services (growing the economy), and eventually repaying the lender.

It is important to realize that when an individual decides to save, the money that they save does not just go under a mattress, therefore being removed from economic activity. Instead the money is usually put into a bank where it is lent out and invested in other areas. Banks do not only lend to consumers, but more importantly to entrepreneurs and businesses. Acquiring money from banks allows entrepreneurs and businesses to start new projects, expand operations, purchase new equipment, etc..., all with the hope of increasing productivity, profits, and therefore the aggregate supply of goods and services in the economy. Some critics will say that during times when there is a banking crisis (such as 2008 and 2009) that savings deposited at banks are not lent out. However, this is misleading because while banks may not lend as much to consumers or businesses whom they believe to have a high risk of default, they do continue to invest in areas that they believe will create a suitable rate of return based on the amount of risk they are undertaking. Another reason that it is important to let savings increase during recessions, and especially during recessions that are accompanied by banking crisis, is because a rise in savings rates allows for a bank's capital to be replenished. Higher savings means that more money is deposited into banks and as banks recapitalize they can then partake in more lending, further helping with economic recovery.

When one understands the crucial role that savings plays in an economy they realize that is utterly foolish for politicians to talk about the need for a stimulus package that discourages savings. The fact that the government is attempting to prevent people from replenishing the pool of real savings is one major problem relating to the economic plans in 2008 and 2009, but it is certainly not the only problem. A further downfall is the government spending associated with these plans as it will only lead to greater problems, and examining the effect that government spending has on the long term health of an economy reveals just how damaging it can be.

As was mentioned earlier in order for one to spend they need to have something which others will accept in exchange for the goods and services they wish to acquire, and in modern economies money is used for this purpose. While the majority of economic participants earn money through the production of goods and services, the government does not. Governments do not produce anything, instead they obtain their funds through two primary methods; taxation and the printing money. Taxation which can be defined as "a charge against a citizen's person or property or activity for the support of the government", provides governments with funds to support their spending, while at the same time decreasing the available funds that individuals have for their own purposes. Taxation is obviously quite unpopular as it produces a noticeable effect on an individual's wealth. For this reason politicians usually avoid increasing tax levels substantially as they understand that doing so could seriously harm their re-election chances. The other method governments use to obtain money, which is preferred by most politicians, is printing money, or in other words increasing the money supply. Like taxation, increasing the money supply also decreases the purchasing power of private citizens and leads to a decline in their level of real wealth. While it is easy to see how taxation decreases ones wealth, increases in the money supply effect wealth in an indirect and discreet manner.

Printing money leads to inflation, and this causes a decline in an individual's wealth level, whether it is noticed or not. Inflation can be defined as an increase in the total money supply in an economy, which subsequently leads to a decrease in the relative purchasing power of each dollar. This definition is different from the common perception of inflation, that being an increase in the price of goods, or an increase in the Consumer Price Index (CPI ). However, it is crucial to understand that an increase in the price of goods is a consequence of inflation, but not the cause of it. It is actually possible to have inflation but not necessarily see an accompanied rise in the price level, or to have an increase in the price level but not have any inflation (this can be further understood by reviewing this article on the topic). Furthermore, it should be noted that when a government prints money, in order for it to lead to inflation the new money must enter the economy, and this usually occurs either through direct government spending or by banks making loans and taking advantage of the fractional reserve system. However, if the government prints $1 billion for example, but the banks that have access to these funds decide not to expand lending and instead leave the money sitting in reserves, this will not lead to inflation as these new dollars do not enter into economic activity. So to be more accurate inflation should be thought of as a net increase in total money in the economy, with total money including both dollars printed by the government and total credit supply.

When a government increases the money supply by printing new dollars to fund economic plans, what happens is each dollar that was in existence before the printing took place, declines in value or purchasing power when these newly printed dollars enter the economy. This is because there becomes a greater supply of dollars competing for an unchanged number of goods and services. Thus, like taxation, printing money shifts wealth from the private sector to the government. Taxation is an obvious transfer of wealth as the government takes money directly from each individual, thus lowering the absolute number of dollars each person has. Printing money, on the other hand, is discreet as the absolute number of dollars each individual has does not change. Instead after the government has printed money each dollar is worth less, meaning an individual can purchase fewer goods and services with the same amount of money then they could have prior to the money supply increase. Realizing this makes it quite obvious why politicians favor using the printing press to fund their spending habit rather then increasing tax rates. Using the printing press can be thought of as a silent tax, or one that the majority of citizens do not even realize they are paying, and therefore it is certainly not as threatening to a governments survival as an outright increase in tax rates.

After one realizes that to fund spending and bailout packages the government takes money from each citizen, transferring wealth away from private hands, the question then becomes will the government spend the money in a more beneficial manner then the private sector. And beneficial is meant in the sense that the money is being spent in areas with the highest productivity levels, the greatest rates of return, and the best growth potential. Money being spent in this fashion is essential because for a true economic recovery to take place money and resources need to be transferred from failing sectors, industries, and companies, to productive, innovative, and fast growing ones. When this is allowed to happen job creation increases, productivity rates increase, the level of goods and services increases, wealth levels rise and the overall economy grows in a strong and sustainable manner.

Unfortunately, one will quickly find that governments do not spend or invest in areas that will strengthen the economy and kick start a recovery. Instead they primarily put money back into uncompetitive, wasteful, and low productivity industries and individual companies, as these are often the sectors of the economy which lobby politicians the most. In 2008 and 2009 banks, insurers, and car manufacturers, or more specifically companies like GM, Citigroup, AIG, and Bear Stearns to name a few, were the beneficiaries of the transfer of wealth. The private sector of the economy on the other hand, will invest its excess savings in a much more efficient and optimal manner then governments. For example they certainly won't invest huge sums of money into companies such as the ones just mentioned, as they realize that these are failing companies which are unlikely to grow or create strong rates of return, and thus will be a hindrance to profit potential and economic growth if allowed to survive. Instead private hands look to find areas to invest in that are most likely grow, prosper, and create a return on the money invested, and allowing the private sector to divert money in this fashion is essential for an economic recovery to take place. It should be noted that while not all money invested and spent by private hands goes into the most productive areas of the economy, as bad decisions are made, overall much more will be diverted to the right areas with private investment then under government control. One needs to remember that while the private sector is motivated primarily by profits, governments and politicians are more motivated by lobbyist, constituents, special interest groups, and above all by the need for survival. And this fact alone makes it easy to see why private hands will divert money throughout the economy in a far more beneficial manner then governments ever will.

When a government decide to undertake a massive spending or bailout plan, such as those implemented in 2008 and 2009, essentially they fund these plans by transferring wealth from private hands into government control. Governments justify their actions using Keynesian economic principles which they portray as being the only ideas that if followed will guarantee economic recovery. However, by following these views governments are instead impeding recovery and actually making the situation worse. The spending and bailout plans attempt to prevent increases in savings rates and instead transfer money away from the private sector and put it back into unproductive, stagnant, and in some cases completely failing industries. This type of action hinders economic recovery and growth, and also leads to greater economic problems in the future. Until it is realized that the solution to a recession is not to transfer money away from the private sector and private decision making, but instead to allow individuals and private entities to move money and resources away from the failing industries to more productive and higher growth areas, a true, prosperous, and enduring recovery sadly will not occur. To conclude the following quote by Ludwig von Mises possibly best reveals why we are in this mess and how important it is for the dominant economic beliefs of Washington to end their influence on the American economy:

“The unprecedented success of Keynesianism is due to the fact that it provides an apparent justification for the “deficit spending” policies of contemporary governments. It is the psuedophilosophy of those who can think of nothing else than to dissipate the capital accumulated by previous generations. Yet no effusions of authors however brilliant and sophisticated can alter the perennial economic laws. They are and work and take care of themselves. Notwithstanding all the passionate fulminations of the spokesmen of governments, the inevitable consequence of inflationism and expansionism as depicted by the “orthodox” economists are coming to pass. And then, very late indeed, even simple people will discover that Keynes did not teach us how to perform the “miracle … of turning a stone into bread”, but the not at all miraculous procedure of eating the seed corn.”

The Price Is Always Right

The price of a financial instrument (stock, future, option etc..) is the most critical factor of consideration for all investors, regardless of their investment style, when deciding what and when to buy or sell. The current price determines whether a trader will enter a long position, believing that price will increase in the future, or enter a short position, believing that prices will fall. Although given the critical importance of price, there is an all too common misconception many traders have about it, and that is the belief that at times the current price is wrong. In certain situations, some traders believe that after the price of a financial instrument has moved far and fast in one direction, that it has reached an incorrect level, and thus invariably must return to its previous range. Often they come to this conclusion not through logical, proven, and well thought-out analysis techniques, but based on purely emotional reactions. These traders will then enter positions with the belief that price has to return to levels which they are more used to and comfortable with. However, this way of looking at the price level is fundamentally flawed because when one truly comes to understand what drives price movements as well as what price reflects, they will realize that price can never be wrong.

Investors most commonly come to the the belief that price is wrong when it has moved either far to the upside, or far to the downside, in a short period of time. Even more frequently, this belief of wrong prices occurs when price reaches unseen levels in relation to what history has seen. A recent occurrence which saw the aforementioned trading behavior take place was during the dramatic move of oil prices in 2008 (for a price chart click here). Early in 2008 oil prices increased to new highs, breaking the coveted $100 dollar level for the first time and leading many investors, media talking heads, and self-anointed experts, to announce that these prices couldn't be sustained and now was the time to sell any existing long positions or even worse short oil futures. However, as we all know this was certainly not the end of oil's bullish move as prices increased almost another 50%, peaking at $147.30 in July of 2008. If one had traded based on the assumption that price at $100 was wrong then they would have missed out on a lot more profit potential (if they were already long), or if they had shorted oil futures as many investors did, they would have likely sustained substantial losses (assuming that they did not have huge amounts of spare capital to fulfill margin calls, and extremely strong conviction to watch the dramatic increase in oil price unfold). While the price of oil did quickly fall off its summer high, the same irrational beliefs and trading practices occurred on the way down. In the fall of 2008, oil moved back to around $80 a barrel, and at this level many of the same people who thought it was a sell at $100, now believed that this dramatic decrease presented an excellent buying opportunity. Again without analyzing the price changes in logical and proven methods, they believed that price was again wrong and it would soon move back towards the $100 level, possibly even eclipsing its high. But by late 2008 oil had moved sharply from the $80 level, decreasing to below $40 a barrel, which resulted in huge losses for those who bought at around $80 a barrel.

If ones steps back and analyzes this trading phenomenon it is easy to see why it happens, irrespective of the fact that it is not a logical or sustainable trading strategy. The primary cause of this behavior among market participants results from the fact that many investors make trading decisions based on emotions. When prices move quickly and significantly either up or down it greatly plays on the joys and fears of traders. Seeing prices at new, and in some cases never before considered possible levels, moves many investors out of their emotional comfort zones, causing them to make irrational decisions. Often these new prices (such as oil prices in 2008) are so far from what most have become comfortable with, that many traders automatically or possibly even unconsciously, convince themselves that the prices are wrong and will soon return to the levels with which they have become accustomed to and believe to be "right", and thus think that they must take advantage of these prices while they can. To make matters worse the speed at which prices often arrive at the new levels cause many to quickly enter trades with hope and emotion overriding clear analysis and good judgment. However, at times like these it is crucial for investors to step back and use the proven trading methods they have developed to see if they can discern with a high probability where price will go next, without letting emotions cloud their judgment. If traders continue to trade based on these harmful emotions which cause them to believe that prices are at "incorrect" levels, they will quickly run out of trading capital, as ultimately the price of any freely traded financial instrument can never be wrong.

To further grasp why price cannot be wrong, and why trades should never be made based on this premise, it is crucial to understand exactly what price means and what it reflects. The price of a stock, future, exchange-traded fund, or any other freely traded good for that matter, is determined by the interaction between supply and demand. Supply of an equity will rise when the number of people who wish to sell their contracts increases, while demand rises when the number of people who want to buy contracts increases. When demand increases faster then supply, price will rise, while when supply outpaces demand, price will fall. Investors normally make the decision to purchase an equity (increasing demand), when they have a piece of information which they believe will result in a rise in the future price level. Conversely, one decides to sell an equity (increasing supply), because they obtain information which they believe will lead to a fall in price. So all these bits of information, whether they are correct, well thought-out, or even logical, determine supply and demand, and reflect the collective psychology that all market participants have towards a financial instrument. When price is understood to be resulting from the collective impact of the overall psychology of all market participants on supply and demand, one can see that logically price is never wrong, as for each and every moment that trading takes place, price is at the only level which matches the demand of the buyers with the supply of sellers.

The only way that the price a financial instrument can change is through a shift in supply and demand levels, brought about by a change in trader psychology. Therefore, a successful trader should only enter a trade when they have reason to believe that future market psychology will change, resulting in a change in the future price which allows them to earn a profit. They should not enter a new trade or close an existing position because they believe price is wrong. It is important to understand this point as it is often what distinguishes between the rich and soon to be poor investors. All too often traders enter a position solely because price reaches a level which many never thought possible and this produces an emotional reaction in them which causes them not to analyze market psychology in a logical manner. Furthermore, even if one believes that the market psychology relating to a specific financial instrument is flawed or incorrect, one must have reasons as to why market psychology will ultimately come around to a view in line with their own, which will lead price in the direction they anticipate.

To conclude, most investors actually see some of their greatest returns when prices reach new levels, as these are often the times which see huge price moves and also when the general market consensus is confused and reacting emotionally. Traders who use logical and well tested methods of analyzing trading psychology which are not influenced by their emotions, but instead on criteria which they have proven increases the probability of entering a successful trade, can often take advantage of these large moves. So in order to be a successful and profitable investor one cannot look at current price in a manner of being right or wrong, too high or too low, but instead must pay attention to trader psychology and look to find reasons why the psychology could change and what effect these changes will have on the supply and demand of the financial instrument under study.

Technical Analysis - Won't Predict the Future, Will Increase the Odds Of a Winning Trade

When one makes the decision to become a trader one of the first things they need to do is choose what type of analysis they will perform in order to make the decisions of what and when to buy and sell. The two main schools of thought relating to trading are fundamental analysis and technical analysis. Fundamental analysis can be defined as making trading decisions based on analyzing companies financial reports, competitive advantages, market conditions etc... Technical analysis on the other hand uses the past price data of an equity, future, or any other financial instrument, to make decisions on when to enter and exit positions. While many traders use a combination of both methods, technical analysis is certainly the less prominent and less widely accepted method of investing. Critics of technical analysis go as far as to lament it as a pseudoscience such as astrology, and believe that past price movements have little if any predictive value for making trading decisions. While I myself am a proponent of technical analysis I agree to some extent with the critics, not that it is a pseudoscience, but that there is little predictive value in past prices. However, that being said it does not mean that technical analysis has no value because in fact it can be extremely useful for traders, not to predict the future, but to increase the probability of entering profitable trades.

To be a successful investor you need to increase your odds of making profitable trades, while using appropriate risk management to ensure that the sum of your winning trades is larger then the sum of your losses, and hopefully by a wide margin. Technical analysis if used correctly can greatly increase those odds, and for it to be used correctly one needs to first abandon the notion that there is any predictive power in it. One should not be looking for the ultimate indicator or set of indicators hoping to find something that will tell them where the price of a equity (or any other financial instrument) will go next, because this search is likely to be frustrating, futile, and could lead to an unsuccessful trading strategy. Another dangerous habit which should be avoided is trying to pick market tops and bottoms. Traders look at certain technical indicators and see that the levels that they have reached are in line or have exceeded the levels of previous market tops and bottoms and based on this they will enter a trade. However, trends, be them up or down are never the same size, in either percentage gained or lost, or in time taken to complete. Often trends continue for far longer than many expect and leave certain technical analysis indicators in overbought or oversold levels for extended periods of time, so it is very dangerous and often a near impossible task to successfully and consistently pick tops and bottoms.

To make the most out of technical analysis it is essential to understand what a price chart reflects and what useful information traders can extract from it. Firstly, technical analysis makes use of two primary variables, price and volume, and virtually all technical indicators are derived from the data of these two variables. Price is understandably the most important of the two, but volume can also reveal a lot about the underlying price movements. A good analogy regarding price and volume, which was presented in this interesting article, is that volume is the fuel driving the move. As the tank gets emptier (less volume) the likeliness for the trend to continue decreases as the lower volume reflects the fact that there are less buyers and sellers willing to make trades at the current levels. Price on the other hand being the most important variable in technical analysis reflects all the information that is known about the financial instrument, by all market participants, at any one point in time. The movement of price over time, be it on a monthly chart, a daily chart, or even a minute chart, reflects the changing psychology of traders regarding the instrument under study.

Analyzing these components of a chart; price, volume, and price change over time, can dramatically increase the probability of entering a winning trade. To do this one must first and foremost identify the underlying trend. If you are a short term day trader, then you need to identify the short term trend such as hourly, 15 minute, or even 1 minute, if you are a longer term trader who holds positions for weeks or more, then you need to identify the longer term trends such as daily, weekly, and monthly. The reason that it is so important to identify the underlying trend is because like an object in motion, trends are more likely to continue then to reverse, and trading against the prevailing trend is one of the surest ways to lose money and quickly. The trend can be identified in a number of ways the easiest and best of which is to look for a series of well-defined higher highs and higher lows in an uptrend, or lower lows and lower highs in a downtrend.

Moving averages are also useful in trend analysis. The slope of a moving average, or the level of price with respect to a certain average (price should be above in an uptrend and below in a downtrend), can also help determine the trend. Another use of moving averages to identify the trend is for an uptrend you want to see the shorter period averages above the longer period ones, and vice versa for a downtrend. The more one analyzes and examines charts the better they will become at identifying whether the trend is up, down, or in a consolidation. Consolidations are periods of sideways price movement which don't show consistent higher highs or lower lows. Markets consolidate often and sometimes for prolonged periods of time, and it is usually wise for traders to stay on the sidelines while the market is consolidating. Entering during a consolidation is risky as often these times see high levels of volatility which can quickly stop you out of a position, while other times see very little price movement, thus limiting any profit potential. So it is best to first see evidence that the consolidation period is over, and a new trend is forming before entering.

After one has identified whether price is moving in an uptrend, downtrend, or consolidation, further analysis of charts must be done to increase the probability of entering a winning trade even more. One should look for more supporting evidence in the form of indicators, trend lines, support and resistance levels, price patterns, candlestick patterns, or volume levels that further suggest that price will continue to move in the direction of the trend. Trend lines or support and resistance levels can be especially helpful, if price has just recently broken and closed above or below a resistance or support level, this improves the chance that the trend will continue. However, if one is considering going short for example, but notices that there are significant levels of support that price must break below to continue downward, then the probability of a successful short trade has likely decreased (or at least the size of the move). Next lets assume that a trader considers going long (as an uptrend has been identified), and a bearish price pattern presents itself such as a head and shoulders pattern , or double top , while a reversal to a downtrend is certainly not guaranteed, the probability of a successful long trade is now lower. It should be remembered that often price patterns present themselves and really have no effect on the subsequent price moves, but it is important to analyze and pay attention to them as the more one analyzes charts the better they become at picking out the important patterns.

Ultimately, how technical analysis should be used for entering positions is first traders should identify the primary and relevant trend, and then apply further filters to limit their entries even more. One trap that some technical traders fall into is looking for the perfect setup where all indicators and patterns line up, these setups, however, do not often reveal themselves and looking exclusively for them may lead to frustration and the missing of many good opportunities. Probably the most difficult thing about trading is finding the right balance between looking for the correct setups and taking enough appropriate risks to allow for profit potential, but hard work and dedication does lead one to finding the correct balance. To conclude, technical analysis will not provide you with predictive power, but if used correctly, it will help increase your ratio of winners versus losers. And if one increases their probability of entering winning trades, along with using stringent and well thought out risk management and exit strategies, then they will greatly increase their chances of becoming very successful and profitable investors.

Just a final note, while this article primarily discusses using technical analysis for entering positions, one must realize that this is really only one half of the puzzle. A successful trading strategy must also involve a well thought exit strategy for both profitable trades and losses.