Get ready for the ‘great immoderation’

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.