Booms, busts, and famous last words
Can runaway booms descend into busts absent monetary tightening by the world’s central banks? I pose this question in the wake of an extraordinary exchange on January 22 in Davos, Switzerland, between Bloomberg editorat-large Tom Keene and Bob Prince, co-CIO of Bridgewater Associates, in which the latter posited the notion that “we’ve probably seen the end of the boom-bust cycle.”
It is striking that one of today’s titans of finance has given us what appears to be another version of “this time it’s different,” which the famous investor Sir John Templeton once described as “the four most expensive words in investing.” My own basic take has been that the US economy over the past three years has been weaker than the underlying quantitative data suggest and that there is ample historical precedent to suggest that credit cycles can end, even in the context of a low-interest-rate environment, notably via a deterioration in the quality of credit itself, as the great economist Hyman Minsky once explained in his financial instability hypothesis.
The truth is that for decades, the US – indeed the entire global economy has been characterized by an economically unsustainable model in which larger and larger portions of GDP gains have been going to a smaller number of people at the top (who also have a higher propensity to save than people with lower incomes, which means the “trickle-down” effect is minimal to non-existent). Wage gains also appear to be leveling off, which could have ominous implications for sustainable future growth.
Yet many investors like Prince seem to accept today’s buoyant asset bubbles as a given in the absence of a concerted effort by the central banks to “take away the punch bowl just when the party gets going” (in the famous words of former US Federal Reserve chairman William McChesney Martin), via higher interest rates. In the words of Bob Prince (quoted in Doug Noland’s Credit Bubble Bulletin): Bob Prince: “2018 I think was a lesson learned. The tightening of central banks all around the world wasn’t intended to cause a downturn wasn’t intended to cause what it did. But I think lessons were learned from that. And I think it was really a marker that we’ve probably seen the end of the boom-bust cycle.”
Bloomberg’s Tom Keene: “Is it the end of the hedge fund business in modeling portfolios off the guesstimates of what central banks will do?” Prince: “That won’t play much of a role nearly as it has. You remember the ’80s when we sat and waited for the money supply numbers. We’ve come a long way since then.… Now we talk 25 plus [basis point Fed rate increase], 25 minus. We’re not even going to get 25 plus or minus and we got negative yields. That idea of the boom-bust cycle – and that history that we’ve been in for decades – is really driven by shifts in credit and monetary policy. But you’re in a situation now where the Fed is in a box. They can’t tighten, and they can’t ease – nor can other central banks, particularly the reserve currencies. And so where do you go from here? It’s not going to look like it has.”
Prince goes on to acknowledge that “cycles in growth are caused by the boom and bust in credit: Credit expansion, credit contraction,” but makes the assumption that “those expansions and contractions of credit are largely driven by changes in monetary policy.” That may have been the case for much of the postWorld War II period, but if we look back further, there is evidence to suggest that Prince’s hypothesis is another variant of the dangerous “this time it’s different” truism.
Why have so many people gotten this wrong? The misconception probably stems from a famous statement made in 1997 by Massachusetts Institute of Technology (MIT) economist Rudi Dornbusch: “None of the US expansions of the past 40 years died in bed of old age; every one was murdered by the Federal Reserve,” and this was more or less true of the US economy from 1946 until the 2000s. But then economic dynamics changed. Yes, the Federal Reserve raised the Fed funds rate by 400 basis points in the mid-2000s, but it reversed almost all of that move and began opening the floodgates of bailout financing by early May 2008. Nevertheless, the US and global economies fell off a cliff in the second half of that year as global financial fragility erupted into a full-blown global systemic crisis to a degree unseen since the 1930s.
Why was it different that time? The reason is that there had emerged myriad asset bubbles and a related unprecedented rise in private indebtedness in the US and other economies.