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That ‘Great Moderation’ moment again

Image: Scorpions and Centaurs

In 2004, when then Fed Chairman Ben Bernanke popularised the term “The Great Moderation,” it seemed to almost all concerned that humankind had finally conquered the vagaries of the free market.  Both inflation and unemployment were low and the stock markets were booming.  Monetary policy, independent of government interference and centred around bond-buying and interest rates, had ushered in a decade of economic prosperity of a kind last seen in the 1960s.  The economic woes of the 1970s and 80s appeared to have been confined to the history books.

Only a handful of contrarian economists sounded the alarm.  Excluded from the mainstream econometrics clerisy, however, these modern day Cassandras were dismissed as cranks or ignored entirely.  Nevertheless, just a year after the Bernanke speech, global production of conventional oil peaked.  Demand overtook supply and oil prices spiked upward; causing a wave of price increases through western economies.  Responding as the textbooks instructed, central bankers sold off government bonds in order to raise interest rates; believing that this would lower demand for goods and services, causing prices to fall.  In reality, the sudden collapse in corporate and household borrowing – which is the means by which more than 97 percent of our currency is spirited into existence – created a cascading collapse in the global banking and finance sector.

Bernanke’s ‘Great Moderation’ moment was hardly unique.  Francis Fukuyama’s 1989 declaration of ‘The End of History’ in the wake of the collapse of the Soviet Union can hardly be said to have anticipated the 2001 attack on the Twin Towers of the World Trade Centre and the ensuing US-led Middle Eastern wars of intervention and regime change that followed; still less Brexit, Trump and the rise of the populist right.  Suffice to say that these moments of relative tranquillity in human affairs are anomalies that should never be regarded as anything more than a brief respite from the storm.  Statesmen and economists alike would do well to eschew the temptation to regard them as anything more momentous.

It is in this light that we should read the latest murmurings from the high priests of banking and finance that ‘inflation has been conquered.’  This, in effect, is what current Fed Chairman Jerome Powell told the US Congress following its decision to ditch further interest rate raises:

“The economy can sustain much lower levels of unemployment than we thought without troubling inflation.”

The theme is taken up by Jim Edwards at Business Insider, who explains – in true techno-utopian fashion – that:

“We should be living in the Weimar Republic. But we’re not.

“Inflation is gone.

“Even 10 years of interest rates set near zero no longer generates consumer price increases…  Inflation has been solved. We solved it, through our new inventions.

“Spotify makes music cheaper. Uber makes taxis cheaper. Google makes information cheaper. Facebook makes advertising cheaper. Amazon makes shopping cheaper. The gig economy makes wages cheaper.

“The macro effect of all this ‘solving’ is a permanent downward pressure on prices — which is good for workers who don’t want their wages eaten away by inflation (but bad for workers who want nominal pay rises).”

Edward’s article ends with a rallying call for what may well prove to be our civilisation’s final act – turning on the government printing presses and spending our way into oblivion:

“Governments now have more fiscal ‘space’ to invest and build…  Now is the time to spend. Not just to create inflation (and avoid deflation, which can be even worse). But to build the energy, transport, defence, health, and education infrastructure we will need for the future. Low cost debt makes this spending cheap.”

Government spending on this scale is unlikely before the next financial shock.  However, Edward’s article resonates with the stance emerging from the central banks as they seek to prevent a serious slump in an already sluggish economy.  Outgoing ECB Chairman Mario Draghi has already indicated that European interest rates will be going down – even if this means going negative – in order to shore up the EU economy.  In the US, Powell looks likely to cut interest rates in the near future; while the Brexit-embroiled Bank of England may have little choice but to cut rates to zero or beyond in the event of a no-deal Brexit in October.  Meanwhile, David Lipton, acting head of the IMF has called on world central bankers to cut interest rates to prevent the current slowdown morphing into a full blown crisis.  As James Politi at the Financial Times reports:

“In an interview with the Financial Times as G7 finance ministers and central bankers prepare to meet this week in France, Mr Lipton said that ‘in light of sluggish growth and downside risks, it makes sense for monetary policy in the major central banks to remain accommodative’. 

“Mr Lipton said he did not want to comment on specific decisions in individual countries, but added that central banks should not shy away from loosening policy — if it was justified — because of fears of losing ammunition to combat a future downturn. 

“’Our view is that if the economy needs support, you provide support — but not inappropriate policies that contribute to the slowdown, just in order to be in a position to fight the very slowdown that has been created,’ he said.”

What if, though, inflation has not gone away?  What if inflation actually has been hiding in plain sight? 

The answer to these questions can be found once we consider where new currency enters the economy.  Very little of it has entered what we might call the ‘real economy’ of ordinary households and businesses – most of which still struggle to obtain loans at interest rates anywhere near as low as those offered to the financial sector by the central banks.  This is why we have witnessed a “retail apocalypse” throughout the western economies as ordinary people’s discretionary spending has been cut to the bone.  It is also why the gig economy is thriving – not because of the technological wizardry espoused by Edwards, but because of the creation of a new precariat class desperate for employment of any kind in the face of increasingly inadequate social safety nets far more punitive than those enjoyed by the baby boomers.  It is an 80:20 economy in which a small minority living in or connected to a handful of global cities like London and New York continue to enjoy growing prosperity while the majority either stagnate or witness their standard of living being crushed into the dirt.  It is also why, of course, we have Mr Trump in the White House, Brexit strangling the UK, and why there are yellow vest protestors on the streets of French cities.

The traditional ‘Keynesian’ solution to this state of affairs is based on the belief that it is better to pay someone to dig a hole and then fill it in again than to leave that person destitute.  The reasoning being that whereas a rich person is most likely to save any additional income they receive, a poor person will most likely spend it.  And so, if governments borrow to invest in large-scale infrastructure projects that employ and pay unemployed and under-paid people, the ensuing increase in spending will generate profits for businesses and cause a rise in business investment.  In this way – as happened in Western Europe and Japan after World War Two – a virtuous growth cycle can be started; ushering in a period of rising prosperity for ordinary western households.

The fact that this hasn’t happened, however, goes a long way to explaining why inflation appears to have been defeated.  Faced with an economy populated by zombie firms and households after the 2008 crash, the recipients of quantitative easing and zero (when adjusted for inflation) percent interest rates had little incentive to invest in business development.  For all of the rhetoric about the coming hi-tech ‘fourth industrial revolutions’ and ‘the internet of things,’ beyond the global cities and archipelago of top-tier university campuses, the economy has regressed into a low-skilled/low-paid/labour-intensive state reminiscent of the 1890s.  Starved of investment and battling a slump in consumer demand, real economy businesses have sought to cut costs by slashing workers’ pay and conditions and by removing physical costs of doing business, such as owning or renting property – one reason why online businesses are surviving for the time being.

Inflation still exists – and thrives – it just isn’t in the real economy.  Instead, the beneficiaries of post-2008 monetary policy have desperately sought investment opportunities that offer an above-inflation return.  Most obviously, stock markets have risen on a scale normally only coinciding with a major expansion of the real economy.  In part this is due to corporations buying back their own shares; and thus limiting supply.  The fact that they have been able to do this, however, is due to the high demand for (relatively) high-earning investment opportunities for the already wealthy.  Less obviously, asset classes such as property, fine art and collectables, which are only accessible to the already wealthy, have seen their prices explode over the last decade.

The obvious problem with this asset inflation is that, rather like the pre-2008 financial sector, it is a Ponzi scheme that depends upon continuous growth in investment.  A large part of the value of the “assets” into which so much of the paper wealth of the already wealthy has been pumped will disappear the moment the bubble bursts… which might explain why we are seeing ‘inflation is gone’ stories just now.  Whereas the rest of us have – at best – seen our living standards stagnate for more than a decade; the already wealthy are only now beginning to experience a downturn in their incomes.  As Felix Richter at Statistica reports:

“After seven consecutive years of growth, the world’s high-net-worth population, i.e. everyone with investable assets in excess of $1 million, suffered a $2.1 trillion loss in collective wealth in 2018…

“Before you break your piggybank to make a charitable donation for millionaires in need, be informed that the decline can largely be attributed to the ultra-rich, i.e. the top 1 percent of the world’s high-net-worth population, who accounted for 75 percent of the total decline in global millionaire wealth. Meanwhile the millionaire-next-door segment ($1 to $5 million of wealth – Capgemini’s terminology, not mine) only suffered a 0.5 percent dip in collective wealth.”

While governments happily cut public spending and central banks refused to budge on higher interest rates when ordinary households saw their prosperity plummet, causing retail businesses around the world to collapse; it is a different story now that the ultra-rich are affected.  Now, we are told, is the time to cut interest rates, increase stimulus measures and even begin to reverse a decade of government spending cuts… if that is what it takes to allow the ultra-rich to continue getting richer.

The problem, however, is that reversing the current decline in the real economy – which has now infected the rarefied heights of the financial world – necessarily involves pumping more debt-based fiat currency into the real economy; where it will inevitably lead to an increase in demand for goods, services and labour that the post-2008 economy simply cannot provide.  Most obviously, increased demand for oil – which underpins everything that the global economy does – will inevitably lead to shortages that will drive prices up from the already economy-crushing $60-80 band that they have been in since 2017.  Add in (not so) ‘black swan’ events like the impact of the International Maritime Organisation’s mandatory switch to low-sulphur (i.e. diesel) fuel for the global shipping industry, or the outbreak of a hot war in an oil producing state like Venezuela or Iran; and we have a recipe for an economic collapse that will make 2008 look like a walk in the park.

Even without those events, however, the unintended consequences of post-2008 monetary policy are likely to come home to roost in the next couple of years anyway.  It is those sections of the financial sector that have not benefitted from post-2008 monetary policy that are most likely to ultimately burst the bubble.  Most notably, pension and insurance funds that depend upon returns of at least five percent have been depleted as a result of continuing to pay more in benefits than they can sustain.  In some sectors, this has resulted in renegotiations that have left beneficiaries considerably less well off than promised.  Thus far, however, each renegotiation has been reported in isolation by the mainstream media, rather than as an example of a broader trend.  Nevertheless, when the high(er) interest “junk bonds” that these funds have been obliged to invest in – such as the US fracking bubble – dry up as more firms go bust than ever repay their debts, then the pensions and insurance industries are toast; most likely triggering the same kind of cascading collapse that almost brought global finance to a halt in 2008.

Slashing interest rates, more quantitative easing and even increased state spending may keep the bubble inflated for a few more years yet (something that will not have been lost on a US president who is up for re-election in 15 months’ time) but only at the cost of an even greater collapse later on… at which point we will very likely experience a degree of stagflation (rising prices and a collapsing economy) that will make the Weimar Republic of 1923 look like an oasis of economic prosperity… and leave economists and journalists ruing the day they declared that ‘inflation has been defeated’.

As you made it to the end…

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