Weak economies are notoriously difficult to revive by official intervention. They are just as difficult to restrain when running too hot as the authorities use both the brake and the accelerator* only gradually. Interest rates usually rise or fall by a series of quarter or half point moves instead of more sudden jumps. This leads (in the US at least) to the business cycle, as described in our website video. Economic activity that is too brisk keeps accelerating after the first few pushes on the brake and rates have to rise a lot, bit by bit, until the desired cooling happens. Then as rates fall, again bit by bit, it takes a long time for this to provide enough encouragement for optimism and growth to resume.
This is how the entire post-WWII US economy worked – booms alternated with recessions, mostly caused by (and certainly exaggerated by) tentative official action. When this kind of negative feedback is in force it is mostly quite benign as things rarely get out of hand, despite some shrill headlines and the occasional bit of excitement, as in 1979 when rates had to rise a lot. The equilibrium beloved of economists is never actually attained but there is a kind of stability. External events like oil price rises or the advent of cheap manufactures from China were dealt with in the same way, using the same tools – looser money and lower interest rates were seen as the way to stimulate flagging performance when the (mostly oil) shocks were negative but the opposite restraining levers were not applied when the shock was positive (China re-entering the world). This was a big mistake.
Two types of thinker were unhappy with this post-war business cycle – both politically inspired. Left wingers hated the downswings, especially the aspect of ‘creative destruction’ that the Austrian economist Schumpeter saw as vital for avoiding stagnation. The pain was too sharp and governments of the left were tempted to tinker with the cycle by demand stimulation when the downswing came and it was the time for the destructive part of that process. When some Marxist ideas that had developed in Frankfurt (known now as ‘political correctness’) came to prominence in the West and with it the impulse to shield us from every kind of harm (even hurt feelings) ‘counter-cyclical intervention’ became fashionable. This reached full strength under one British Chancellor of the Exchequer* who claimed in 2007 to have abolished harmful ‘boom and bust’ completely.
There was a direct equivalent from the right wing. A disciple of Ayn Rand, that strange apostle of laissez-faire politics, became the Chairman of the US central bank (the ‘Fed’) for the 20 years until 2006. During this period the US economy experienced two major stock market bubbles, both of which ended (as always) in ‘busts’. In both cases the Fed kept interest rates lower than many considered prudent because it claimed there was no threat from inflation. In the first boom, productivity gains from widespread adoption of cheap and effective IT were seen as a restraint on costs and similar restraint was provided in the second by cheap mass production of goods in China. In both cases the Fed chairman considered that sharp asset price rises in equities and real estate were not his concern, as if this were somehow not another sort of inflation. The results were bad in the first case and catastrophic in the second, as even a brief review of the last decade reveals.
So this strange alliance of deluded left and right wing thinkers produced two bubbles in a row, the second of which resulted (when it burst) in the greatest destruction of wealth in peacetime, ever. The fact that much of that wealth was a product of that same bubble while it inflated (so was not real in the first place) does not reduce the awful consequences of broken financial systems and completely ruined national economies that we face today. People should pay attention to feedback.
So it seems that a few wiggles in economic performance are a necessary self-correcting process after all, as originally proposed by Schumpeter, and that the destruction part is no less important than the creation. But what happens next? Those relatively harmless cycles stemming from the clumsy interaction between monetary authorities and economic growth seems to have been replaced since 2007 by something much more violent. Cycles only ever appear stable when there is a rough balance between encouragement and restraint and when the economic ups and downs are relatively minor compared to the size of the economy involved – swings of a few percent, say. Now however, from the US housing bust alone there has been an estimated $7.5 trillion of wealth destruction and from this and related causes the US federal debt is over $15 trillion. The US economy produces only $15 trillion per year and so these numbers are large, both relatively and in absolute size. Figures from some European countries are worse and in Japan are twice as bad.
One thing remains the same however – the authorities’ lag in responding. Just as in the second half of last century when quite small-scale cycles were the norm, various central banks have again been slow to respond to the course of events since 1998/1999 as they try vainly to cope. The Fed was too loose on the way up in 1999 and again in 2006/7. Three recent books argue that it was too tight on the way down in 2008/9. Others, in Europe especially, were also a bit slow to move rates in each circumstance and the European Central Bank even tried to tighten during the present slump.
The effect of this lag is far more serious now than it was in the 20th Century. If, as we maintain, the existence of economic cycles is entirely the result of the interaction between an economy and the central bank that oversees it, then those cycles are not set in stone – they do not come from some natural law. Any change can tip this feedback loop into a new state and this seems now to have happened. As the ‘normal’ cycle of post WWII economic rhythms was disrupted by well-intentioned stupidity in the last dozen years, the scene was being set for the next set of cycles to develop. The generating mechanism remains in place – central banks do, and will, continue to respond to developments with a lag. Now however those developments are bigger, meaning that the responses will be bigger, as we see already in the enormous money creation that is Quantitative Easing (QE) and its local variants. Lags mean that these larger responses will in turn have larger consequences and so on.
Many commentators have remarked on the apparent lack of effect that QE has had in effecting a ‘true’ economic recovery. There has been some observation (guesswork, really) that the printing of money to buy financial assets is naturally self limiting and that each round of activity has had less effect than its predecessor. That last part is true, but only up to a point. The longer-term effects of this enormous stimulus are still gathering and have yet to be felt – like being in a car when the wheels are spinning in mud. The driver presses more and more on the accelerator* which just makes the wheels spin uselessly, faster. Then, there is sudden traction and the car leaps forward. The current extreme pace of money creation is caused by starting late and from seeing too little apparent long-term benefit from doing it so the driver is now pressing the pedal harder. The process will go on too long and the effects will be far greater than desired, including an inflationary surge of unknown intensity. The next response after that will be a much greater tightening than we are used to seeing, causing a large fall, so we are in a new era of economic cycles with larger amplitude.
Asset prices will follow but with the usual erratic correlation between values and fundamentals. Longer-term price volatility (i.e. those up and down swings that are measured monthly, quarterly or annually) is likely to increase and will probably stay that way for many years to come. The wide range that equities have already been in for the last 13 years will continue and may even widen further – especially if inflation takes a strong hold. There will be upswings large enough to count as bull markets, interspersed with great down swings that will no doubt be named ‘bear markets’. All that will be happening in fact will be a giant range with little overall progress.
But is this inevitable? Almost certainly, yes. Lags are not essential for feedback loops to take hold but they magnify the effects. To use another motoring analogy – think of a driver who skids on a patch of ice. The correct response is to steer into the skid, but there is little grip so more steering is needed. Eventually the car comes back into line but by now the driver has over-steered so the car swings a bit beyond the straight line into another skid. The driver steers the other way into this new skid with the same results so the car ‘fish-tails’ down a perfectly straight road in a series of slides, due to a lag between the driver’s turn of the wheel and the car’s response. In economic cycles matters are even worse. The effect on the economy of any policy move, such as a change in interest rates, is always lagged because of the sheer time that change takes to penetrate the real world. Worse too is the way in which decisions are made in any society that is governed by consent. Instead of a solitary driver, able to respond quickly, the need to move any of the controls of an economy is always controversial and a case must be made and re-made for any action, say an increase in rates. Some agree, others maybe vehemently opposed and so argument leads (usually) to a compromise. This weakens the action (and is why interest rates move in such small increments) and the economy has already moved further in the direction that led to the need for action in the first place so needs more it immediately. So the whole process continues. The levers are always pulled too little and too late so they are eventually pulled too much. This is made even worse by the poor understanding of feedback among policy makers, many of whom are economists in thrall to outmoded ideas. Serial overshoot is the result of this double-lagging. This makes cycles unavoidable.
Feedback loops are possible to read however, given the right tools. We have already seen the wide swings in stock markets since the first bubble of 1998/1999, in the Nasdaq, all of which highs and lows were marked by long-term extension signals. Extensions mark the end of moves – monthly extensions mark the end of long-term moves and compressions mark the beginning. We have been seeing some monthly-scale compressions in a few equity indices, as reported and in some other assets too. Monthly signals are rare and these compressions indicate that a new trend will begin that will last a median of around 15 months. Occasionally they lead instead to a large-scale widening of the current range. Although we have not seen very many of these signals yet (and we may not – they are hard to generate) the pre-conditions exist in many more equity indices in many countries showing that pressure is building up. Current or recent equities signals are:
and in grains:
These are just a foretaste of greater volatility to come – much greater and at a large scale, not just in the form of bigger daily ranges. If your toolbox lacks feedback-calibrated equipment you will find the next decade very challenging.
* With apologies to Dante
* Gas pedal, for American readers
* Britain’s name for the minister of finance
