Wolfgang Munchau of the Financial Times wrote a very important comment piece in Monday’s Financial Times. In it he said that central banks are targeting asset prices to avoid the brunt of cyclical downturns. This policy is inducing asset bubbles and creating a more volatile real economy with unpredictable negative consequences.
I want to expand upon his comments here because his analysis fits well with a number of macro points I have made in the past. First a quote from the Munchau piece:
We did not need to wait until the Dow Jones Industrial Average hit 10,000. It has been clear for some time that global equity markets are bubbling again. On the surface, this looks like 2003 and 2004 when the previous housing, credit, commodity and equity bubbles started to inflate, helped by low nominal interest rates and a lack of inflation. There is one big difference, though. This bubble will burst sooner…
The single reason for this renewed bubble is the extremely low level of nominal interest rates, which has induced people to move into all kinds of risky assets. Even house prices are rising again. They never fell to the levels consistent with long-term price-to-rent and price-to-income ratios, which are reliable metrics of the property markets’ relative under- or over-valuation…
…there is danger no matter how the central banks react. Successful monetary policy could be like walking along a perilous ridge, on either side of which lies a precipice of instability.
For all we know, there may not be a safe way down.
The argument Munchau is making should be familiar to you as ‘the asset-based economy’ (which I will now retroactively add as a tag to prior posts). To date, the best outline I have provided for you was in a post earlier this month called,”A brief look at the Asset-Based Economy at economic turns.”
The Asset Based Economy View of America
My pre-conceived thesis is as follows:
The U.S. has been living beyond its means for a generation as reflected in the increase of debt to GDP across a wide-spectrum of sectors of the economy.
This increase has not been worrying to policymakers because they have only been watching debt service burdens, to the degree they have been tracking debt.
Because of “the Great Moderation,” interest rates have fallen, permitting a secular increase in debt to GDP levels without increasing debt service burdens.
The Federal Reserve has a dual mandate to support economic growth (through full employment) while maintaining low consumer price inflation (through price stability). Cognizant that debt services burdens were not acute and consumer price inflation was low, the Federal Reserve was able to target asset prices through lowering the Fed Funds Rate as a mechanism for reviving the economy when cyclical downturns occurred.
As a result, the Federal Reserve under Sir Alan Greenspan followed an asymmetric monetary policy of only increasing interest rates slowly in the face of large levels of asset price inflation but reducing those rates very quickly to stem asset price declines.
The result has been a belief that the Fed would save the economy when it ran into trouble, the so-called Greenspan Put. This has increased the appetite for risk in the financial sector and, most crucially, has meant that debt levels always increased after a brief downturn. The heroic actions of the Bernanke Fed have only increased this belief in the Fed as economic savior, sowing the seeds of the next asset bubble.
This Asset-Based Economic Model can last through several business cycles – but will eventually collapse when debt service burdens become too large.
But, given Munchau’s comments, I want to add a few of my own to flesh out what is happening here. First, this is not just an American phenomenon. The post I wrote on London house prices earlier Monday shows that asset prices are being targeted as a vehicle for economic reflation in Britain as well. The US and the UK are far from alone as nearly every major central bank has been using an extremely accommodative monetary policy to prevent a deflationary bust.
Munchau invokes Hyman Minsky’s model of financial instability to help explain how this sets us up for a volatile future because traditional macroeconomic theory is inadequate for understanding what got us to this point. In essence, the idyllic state of economic and price stability we know as “the Great Moderation” is really just a financialization of the economy. However, a large financial sector leads to excessive dependence on asset prices to fuel growth, which in turn leads to an accumulation of debt.
The financialization leads to both a widening gulf of income in society as the monied class profits (look no further than record financial sector bonuses during a weak recovery for proof). I believe it also leads to regulatory capture and crony capitalism. The debt buildup precipitates asset price deflation during busts — and the potential for a deflationary spiral in the real economy. As a result, central banks flood the economy with money to prevent this outcome. This flooding of the economy with liquidity in bad times, therefore, has the unintended consequence of making monetary policy asymmetrical.
The asymmetry results in extreme volatility in asset price. All the while, debt keeps accumulating. Clearly, this increases the likelihood of a major bust and depression. Hence Stability (the great Moderation) creates Instability (a pronounced Boom-Bust cycle).
The question is: where does this all lead? Munchau asks this question at the end of his post and suggests that “there may not be a safe way down.” His discussion about likely policy responses evokes memories of my “Scylla and Charybdis” post. Here is the key part from it:
So, you have a huge amount of excess reserves, hard to sell assets on the Fed’s balance sheet. Add in the fact that the Federal Reserve is going to be loathe to choke off an incipient recovery and you have the makings of inflation when recovery takes hold.
Moreover, there is a rise in commodity prices which is adding inflation to the pipeline. Much of the recent decrease in headline inflation numbers is due to the collapse in commodity prices. But, Copper is near a seven-month high. Oil is near a seven-month high. And all of the agricultural and industrial commodities are taking off again. As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary.
In sum, any pickup in the economy is going to be met by a host of inflationary forces. This is one reason that bond yields have been increasing and the spread between the two-year and 10-year U.S. government bond is near a record.
Scylla and Charybdis
So, how do I see this push and pull of deflationary and inflationary forces playing out? There are two outcomes I am looking for.
Outcome Number One
No policy traction. This is a sluggish muddle-through Japanese scenario where the Richard Koo thesis of the balance sheet recession comes into play. You would see an output gap and below-trend growth for an extended period. Most pundits would say it is the lack of lending that is creating the problem. However, what if it is the lack of borrowing which is at fault? Then, we are going to see no traction from monetary policy.
Outcome Number Two
Start-Stop economy. I believe Bernanke would prefer this outcome. This is one in which the Federal Reserve allows the economy to recover by keeping interest rates low. The result is a rise in inflation. We could see inflation rising to 3 percent inflation and then to 5 to 7 and 10 percent. An example would be animal spirits coming back in 2010. And leading to 3 percent inflation followed by 7 percent including $100 oil and then interest rate hikes and another recession at which point the deleveraging begins again in earnest. Followed by more easing and on it goes. But, of course, the problem with outcome two is it is unstable and that it invites an aggressive policy response which risks situation one as an ultimate outcome.
Neither of these scenarios is one in which asset markets are likely to benefit, one reason I see the latest uptick in share prices as nothing more than a bear market rally.
What you should draw from this is the following:
- The Great Moderation is revealed as an illusion once we reach the zero bound, where interest rates are near zero. At this point the asset-price reflation can no longer rely on interest rates alone, but must also use increasingly heavy-handed tactics to get the economy going. This is where we now are.
- Terminal Debt is fast approaching. Steve Keen believes we are at a Terminal Debt stage, where no more debt can possibly be accumulated to revive growth. However, I have presented you with evidence that this is not necessarily the case (see posts here and here). Nevertheless, it is fast approaching.
- The central bank is damned if it does and damned if it doesn’t. This was the takeaway of the Scylla and Charybdis post: All roads lead to a W-style Japanese depression or a deflationary bust because deflation is secular (Terminal Debt) while inflation is cyclical (asset prices). An inflationary scenario will invite a policy response which kills the recovery.
- This is good for government bonds but not for risky assets. Longer-term, this is a good environment for government bonds. They are the risk-free asset in an environment of secular deflation. Shares are not a good investment in this situation despite huge rallies. Remember, we saw huge bear market rallies after 1929 and again in Japan after 1990.
I believe we are in the reflationary period of a longer-term depression right now. As a result, there is substantial downside risk for the economy going forward. Like Munchau, I don’t have any magic bullet solution to this dilemma – although I do have a number of ideas. Feel free to chime in with your thoughts on the way forward.