Saturday, 1 April 2017

The rise and rise of debt, correlation and commotion

The rise and rise of debt, correlation and commotion

Trilemma/dilemma + The Second Machine Age  + Financial Sector Drag vs Secular Stagnation  =

If economics is perceived as a dismal science then the onus on economists is to make it less so.
If I could only persuade my teenage children to read one book, one magazine article and one slide-show of a speech in order to pique their interest in the subject, I'd have them read the Economist on Helen Rey's Trilemma, look through the slides of Claudio Borio's speech to the NABE a few weeks ago, and then settle down to read Brynjolfsson and Mcafee's "The Second machine Age" over the Easter holidays.

The chart captures the whole of my career, which started after I left university in 1984. Lower and lower real interest rates, higher and higher debt levels.

Professor Rey argues, convincingly, that in today's connected global economy, if you have relatively free capital flows you can't have monetary independence whether you let you exchange rate float freely or not.  She observes, in the process, that asset price movements are correlate and are to a significant degree a function of the policies of the US Federal Reserve. Put it another way - Fed policy drives all markets, and increases asset correlation as well as leading us to a world where risk is either 'on' or 'off'.

Claudio Borio makes the simple observation that monetary policy which is consistent with equilibrium in the real economy but not in the financial sector, isn't an equilibrium interest rate at all. This is so obviously true it took a genius to point it out. If interest rate-setting central banks are only judged by a mandate of an inflation target and an economy at full employment,  they may have a tendency to set rates at levels which allow the kind of ever-upward march in debt levels seen in the chart. If they took the idea of financial stability seriously, they would set policy differently, but it's not directly part of their mandate and as we can all see at the moment, fear of too-low consumer price inflation is still delivering interest rats that risk increasing global debt.

The Second Machine Age is just a great book in its own right. But it does help explain why low unemployment might not be associated with wage-induced inflation and indeed why inflation might stay low regardless of where interest rates are set by the Fed, the ECB and any other central bank.

If technology is the main driver of subdued wage growth and inflation; if US interest rates are set at levels to keep inflation down when it's down anyway; and if the rest of us import Fed policy through the global finance system, then we can just get used to asset price volatility being depressed, asset prices being hyper-correlated, debt levels going up and the profit share of GDP in most countries. marching slowly higher. All with sporadic episodes when markets that can't adequately price risk are exposed to sudden re-pricing on (often politically-inspired) surprises.

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