The Big Lie
Peter Warburton - December 17, 2020
For 25 years, fondly described as the Great Moderation, we were spun a line that better macroeconomic management (or monetary policy) had secured a permanent reduction in output and inflation volatility, for which the reward was lower interest risk premiums. In turn, this permitted balance sheets to become more highly leveraged, safely, and real asset prices to be higher in perpetuity. These bold assertions were savaged by the global financial crisis, but the force of this reality check has waned materially since 2014. The same proud assertions are in common currency again, prompted not by a belief in sound economic management but emboldened by the rear guard actions of increasingly fearful public authorities and central banks. The Big Lie is that yesterday’s and today’s credit-financed promises will be honoured tomorrow in today’s money.
At the heart of this issue is a contest between two contrasting underlying volatility narratives. The official version is that economic volatility (see figures 1 and 2) has been genuinely and permanently lowered, due to better economic intelligence, better policymaking and better policy communication. If good luck has played a part, it is a minor part. The subversive alternative is that inherent economic volatility has been suppressed by fair winds of structural change and quiescent policymakers who have forfeited their independence and sold their souls to the financial market devil. The devil is resolutely opposed to tighter monetary policy in all circumstances. Is the appearance of lower output and inflation volatility also the reality? Or is this low volatility dependent on a restrictive policy regime? Could the pretence of economic stability mask an underlying dysfunctionality that will erupt, ushering in regime change? Or is this low volatility a by-product of globalisation and global capitalism, tides which have turned and are now racing back to sea?
The stakes could hardly be higher. In the US and UK, leverage ratios have ascended to stratospheric income multiples. The policy imperative is to dampen economic shocks by whatever means, to repress interest rates and to prevent credit defaults. Paradoxically, an interval of elevated output growth and inflation, with accompanying rises in volatility, is an essential component of the exit strategy from Covid-19. Yet a return of borrowing rates to levels approaching the pace of annual nominal GDP growth would have disastrous consequences further on. We may have already reached the point at which the rebalancing of the public finances is impossible without a resurgence in inflation, implying falling leverage ratios and lower real asset prices. As stockmarkets stretch to new records in nominal terms, beware a real terms reckoning as the Big Lie is exposed.
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