Rational Exuberance?

 |  Includes: LEH, LEH.F, LEHMQ
by: Ryan Avent

Kenneth Rogoff closed his latest column, on the question of whether Lehman's collapse mattered or not, by writing:

Asia may be willing to sponsor the west for now, but not in perpetuity. Eventually Asia will find alternatives in part by deepening its own debt markets. Within a few years, western governments will have to sharply raise taxes, inflate, partially default, or some combination of all three.

That's the conventional wisdom—that piles of debt accumulated over the past decade must eventually be handled somehow, perhaps through the making of difficult choices on taxes and spending, but more likely through inflation and selective default.

The odd thing is that markets don't seem to be playing along. In a June Wall Street Journal column, Arthur Laffer included a chart plotting the recent, massive growth in the monetary base—it essentially doubled over the past two years—and said that current policy is potentially far more inflationary than anything that happened during the 1970s. And yet, we learn that headline inflation in July was unchanged, and core inflation rose by 0.1%. Year-over-year headline prices are off 2.1%, and core prices rose just 1.5%.

Of course, this reflects slack in labor markets and industrial capacity, and declining commodity prices due to weak aggregate demand. But markets are supposed to be forward looking. By all accounts, recovery has arrived or is imminent. Banks should soon begin loaning out their reserves. The velocity of money should be increasing even as we speak. Where is the inflation?

Meanwhile, Brad DeLong notes the curious behaviour of interest rates:

I]t is astonishing. Between last summer and the end of this year the U.S. Treasury will expand its marketable debt liabilities by $2.5 trillion--an amount equal to more than 20% of all equities in America, an amount equal to 8% of all traded dollar-denominated securities. And yet the market has swallowed it all without a burp...

And he's absolutely right. The latest 30-year rates show no sign, no sign at all, that either serious inflation or default is a real possibility.

What does this suggest? Well, it could mean that there's more recession to come. Or it could mean that markets are confused. Or it could mean that the Arthur Laffers of the world have got it wrong. We'll have to see. What does seem clear is that those who warned that deficit-funded stimulus couldn't be effective because debt and inflation concerns would push up interest rates, stifling economic activity, were dead wrong.

This article originally appeared on The Economist.com