Secular stability

The defining characteristic of US economic data since the financial crisis is not stagnation, but stability. We all look back on the Great Moderation with incredulity at the hubris of economists. But has reality morphed into the Greatest Moderation?

There was always a kernel of truth in the Great Moderation. Cyclical economic risk associated with inflation had indeed been eliminated. The striking property of inflation of the last 20 years has been its complete invariance to shocks and policy changes. Very few economists held as a prior that core inflation would barely move in response to oil prices fluctuating from $10 to $150, or the monetary base rising at the fastest rate in history, to unprecedented shares of GDP (even though the latter had already happened in Japan). The profession’s continued obsession will Philips curves and the delightfully naive idea that central banks can hit inflation targets of their choice, reveals a persistent denial of this essential fact. Inflation is truly dead, and policy makers don’t need to worry about it.

But this was true pre-crisis. We now all know that inflation problems are not the only sources of cyclical risk – leverage and a shortage of liquidity in the banking system can be even more pernicious. But what do human beings do after experiencing a frightening trauma? They try to prevent its reoccurrence.

For all the post-crisis hand-wringing, and the regulatory complexity of Dodd-Frank and Basel III, preventing banking panics is relatively straightforward. High liquidity ratios limit runs, and high capital ratios limit default.

Hong Kong is a case study. It is a ‘Taleb economy’ – it is anti-fragile because volatility is created by design. By pegging the Hong Kong dollar to the US dollar, Hong Kong has made wild swings in asset prices – particularly housing – a structural feature of its economy. You could not design an economy more prone to boom and bust. Interest rates might as well be set randomly. GDP growth is determined by China and money market rates by the US. Consequently the Hong Kong Monetary Authority has always maintained the highest capital and liquidity ratios in the developed world. Their mental scarring occurred in the early 1980s, and they survived the Asian crisis without a material bank failure.

So what happens to an economy that has a well regulated banking system and no inflation? We don’t have to surmise. Australia is the obvious case in point – and it hasn’t experienced recession for 25 years. (And before you say ‘China’, bear in mind Australia withstood the Asian crisis, the GFC, and the commodities boom-bust cycle, and all the way through had one of the most highly levered household sectors!)

The United States has had its wake up call. The Great Recession laid the foundation for secular stability. Inflation is as dead as it ever was and the risk of a banking crisis has collapsed – liquidity ratios are the highest in history and capital ratios are high, and the Fed and all other regulators who experienced those terrifying months in 2008, remain petrified of reoccurrence.

As the longest phase of uninterrupted private sector jobs growth in the United States persists, and the probability of recession declines, is the price of secular stability inevitably low growth?

Not at all. Australia suggests not. So does logic and empirical evidence. Marty Feldstein has restated the very old arguments about inflation being overstated (wasn’t the Boskin report in 1996?) and therefore real GDP growth being higher than measured. Boskin suggested this added 1% to real growth.

It was ever thus. Beware economists bearing productivity statistics, and read this empirical masterpiece by Bryjnolfsson and Hitt if you’re in any doubt. The more striking observation is that we are supposed to simultaneously worry about technology taking all our jobs and secular stagnation. The facts suggest the opposite is true on both counts. We are simultaneously witnessing rapid innovation and near full employment.

As for the output data, give the statisticians another 20 years at least before believing any of it. There have of course always been measurement issues, but that doesn’t change the fact that 0% real growth is ‘stagnant’ and 3% real growth rapidly compounds! And there are good reasons to believe that measurement problems are greater than in the past – the service sector share of GDP has risen and the nature of investment has fundamentally changed. Most investment occurring today is not even accounted for as capital expenditure.

So, to paraphrase Paul Samuelson, and Charlie Munger: Instability creates stability.