The Great Immoderation

It’s only a year or two ago that the world’s monetary authorities, G8 politicians and their cheerleaders in the press were celebrating the arrival of a new era in economic policy making.

They named the perceived combination of steady growth, low inflation, and low unemployment “the Great Moderation.” Here are Ben Bernanke on the subject, and Gerard Baker of the Times in London.

Markets seemed to concur. In 2007 the VIX, which measures the volatility expectations built into equity option prices, fell to all-time lows of below 10%, implying that investors saw only steady going ahead.

But as we confront the economic realities of 2009, it’s becoming more and more evident that the “great moderation” was in fact a debt-fuelled asset price boom, and one without precedent in recent human history – a great immoderation, in fact.

For a sobering look at the scale of the problem, take a look at the debt-to-gdp charts in Australian economist Steve Keen’s blog (especially the last one, showing aggregate debt levels in the US). Note also the interesting charts from Japan, which show that, although private debt levels have fallen since the early 1990s, government borrowing has more than taken up the slack. The result (for Japan) has been nearly two decades of stagnation. As one of the commentators to Keen’s article put it, the crowding out effect of the huge public debt levels means that Japanese economy slows to a stop, as soon as rates are moved much above zero.

What does this mean for the US, and the other Anglo-Saxon economies? Unfortunately it looks as though our governments will follow exactly the same path as Japan, with an explosion of state debt to try and counteract the private sector recession. Interest rates will be held at very low levels, whatever the cost, and if it looks as though there is insufficient demand for government debt from investors, forced savings schemes such as this one or this one will be introduced (giving a couple of UK examples – incidentally, forcing banks to buy government bonds at 1%-3% yields, while they have to pay 12% back to the state on their preference share issues, doesn’t seem likely to restore these institutions to financial health any time soon).

There doesn’t seem any ultimate escape from the debt trap that we are all in than widespread default, or massive inflation to devalue the burden of the contracts.  This resolution, however, may be many years away – Japan, after all, has muddled through for years, exchanging private debts for public ones, without ever being able to restore the economy to a state of vibrancy.

So the hangover from the great immoderation is likely to be a very long one – indeed, in time we can expect it to be proportionate to the length of the debt binge.  On Steve Keen’s charts, measuring that takes us back to the early 1980s for the Anglo-Saxon economies – a quarter of a century. That’s a sobering thought for the start of 2009!

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