EXPERTS
JAMES SAFT
30 July / August 2009
Get ready for the
'great immoderation'
The recession will soon be dead, laid to rest alongside the idea of the 'great moderation', a set of
hopeful assumptions that underpins expectations about economic growth and asset valuations
Economists, observing
that since the 1980s
recessions have been mild
and short and expansions long
and robust, developed the
theory that better economic
management, namely cutting
rates in the aftermath of
bubbles, globalisation and, get
this, improvements in financial
markets, had led to a sort of
best-of-all-possible-worlds
'great moderation', in which
economic volatility fell and with
it the risk premia required for
holding financial assets.
This little theory has,
needless to say, come
somewhat unstuck during
the current downturn which
has been great but far from
moderate. This raises the
uncomfortable possibility that
the last 25 years of good times
were just a bit of luck, or even
worse, an artificially engineered
consumption binge.
It's a debate which is
far from academic and
its outcome will influence
much more than the actions
of central bankers and
regulators. While financial
market volatility has been
a feature during the past
decades, the idea, or at
least the feeling, of the
great moderation has
seeped into the culture,
influencing the behaviour of
actors across the economy.
A corporate manager is
going to be more likely to
leverage up and go for the
big hit if he feels as if most
recessions are mild and
short, in the same way that
a consumer will buy a boat
on credit or an investment
property for the same
reasons. If the weather never
gets that cold why waste
money on insulation?
This is really about volatility,
which, because it can tend
to ruin you, is expensive.
Most investment or economic
management strategies
have at their heart attempts
to limit or cushion volatility.
And so, if we really can
expect more volatility in the
economy we can expect it
to find expression in a lower
ceiling for economic growth,
leverage and asset prices.
Of course, the current
debacle may be just one data
point rather than a trend, a
view financial markets seem
to have adopted. This is a
version of the 100 year storm
argument beloved of company
managers trying to explain
why their results are so poor.
This thinking lies behind
the strategy of making
financial conditions so easy
that people are tempted
to borrow and invest. It
just might work, and we
just might have a sharp
and long recovery which
generates enough revenue
to pay off the public debts
we are now racking up.
But two other possibilities,
both speculative, spring
to mind. One is that
deleveraging proves to be
not just an event but a state
of mind. People may simply
decide that they've had
enough risk, thank you very
much, leading to a weak
recovery, a relapse and then
a quandary about how best
to pay off the bills we've
recently run up.
The other is that the
current mix of policy, deep
cuts in interest rates, deficit
spending and quantitative
easing, the effects of which
are little understood, ends up
breeding volatility of its own,
probably in inflation.
The cost of that volatility
will be an unpleasant
surprise to the investors
now bidding up the prices
of shares and managers
now preparing to invest for
expansion, and one that
might lead them to at last
act more conservatively.
Add to arguments for a
new 'great immoderation'
that emerging markets will
almost certainly be more of
a driver of global economic
growth under most of the
reasonable scenarios in the
coming decade. Emerging
markets historically are
more volatile and if as they
grow to be a bigger piece
of the pie are likely to make
overall growth more volatile.
None of this takes away
from the essentially good
news that the recession looks
to be ending soon, but higher
economic volatility will hang
heavy over the recovery and
the cycle to come.
James Saft
More articles by James Saft can be found at
blogs.reuters/jim-saft © Copyright Thomson Reuters 2009.
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