A Doomsday Cycle

Economists Peter Boone and Simon Johnson think the economic system could be stuck in a “doomsday cycle“:

Over the last three decades, the US financial system has tripled in size, as measured by total credit relative to GDP. Each time the system runs into problems, the Federal Reserve quickly lowers interest rates to revive it. These crises appear to be getting worse and worse — and their impact is increasingly global. Not only are interest rates near zero around the world, but many countries are on fiscal trajectories that require major changes to avoid eventual financial collapse.”

By trying to cushion off every downturn and stop market corrections from running their full course, the Fed seems only to lay the groundwork for a new vicious round of boom and bust, making each crisis worse than the last one.

This development can hardly continue, and at some time the whole policy regime must come crashing down, not unlike what happened to the post-war Keynesian policy regime during the 1970s.

Boone and Johnson fear we are nearing “a calamitous global collapse”, something which does not seem implausible given recent developments in both developed and emerging markets. The developed world is looking at a full-scale fiscal crisis, caused by fiscal stimulus programs and sluggish growth trajectories pushing up entitlement spending at the same time as tax revenues have declined.

Emerging markets are looking at a new round of asset bubbles, in part fuelled by carry-trade from low-yielding developed economies, such as the U.S., into higher-yield countries. Another major culprit is the immense monetary stimulus initiated by the Chinese government in 2009 to counter the economic downturn following in the trail of the financial crisis. This monetary expansion has led to a surge in bank lending and a large-scale Chinese investment boom. In some cities, land prices have risen more than 200 percent in year. This boom could very well come crashing down in the not so distant future.

Both the sovereign debt crisis of the developed world and the potential financial crash in emerging markets have the potential to trigger a new global recession, or worse, a global economic collapse.

In other words, governments’ attempts at cushioning off economic downturns and stimulate the economy “back on track”, lays the groundwork for the next crisis. This vicious cycle only seems to get more and more volatile, as the fluctuations seem to get wider and more frequent. And each time, the amount of stimulus and bailouts needed only seem to grow. This development is hardly sustainable. As Boone and Johnson points out: “If each cycle requires greater and greater public intervention, we will surely eventually collapse.”

When will be able to break out of this cycle? We have lulled ourselves into believing that the government will always be able to pick up the pieces after every period of excess. But our unwillingness to ride out the recession — even when they are milder than the most recent global recession — leads to the next round of excesses and financial instabilities, as central banks cuts interest rates and inject new liquidity into the market, refilling the punchbowl to get the next party started. Boone and Johnson write:

Given the inability of our political and social systems to handle the hardship that would follow economic collapse, we rely on our central banks to cut interest rates and direct credits to bail out the loss-makers. While the faces tend to change, each central bank and government operates similarly.

It seems that only a full-scale crisis and concomitant breakdown in the policy regime, then, would break the cycle. What is needed is for policy-makers and voters alike to wake up to the reality of how the current modus operandi of macro-economic policy only gives us short term superficial fixes at the cost of even more economic distress around the bend.

This was originally posted on the Atlas Sound Money web site.