Blogger’s note: Edward Chancellor’s monetary history tour de force, The Price of Time (August 2022), was sent to clients in the Christmas of 2022. It elicited more positive responses than any book gifted theretofore. Its theme continues in Chancellor’s latest Breakingviews column, provided below.
Chancellor quotes fellow British economist, Bernard Connolly. In his latest book, Connolly posits that central banks have often done more harm than good in their attempts to protect their economies. Their actions have stifled innovation, perpetuated asset bubbles, and exacerbated wealth disparity.
Connolly idealistically envisions a world where markets self-correct without the rampant intervention made standard by Alan Greenspan. Connolly’s critics argue that the fine balance between stabilizing economies and letting them run their natural course is more nuanced. Thus, the battle lines are drawn again in this interminable ideological war.
Breakingviews: Why An Economic Soft-Landing May Prove Elusive
Consensus opinion suggests the U.S. economy is on course for a soft landing. This explains why the S&P 500 Index has climbed more than 20% in the past 12 months. The trouble is that the consensus often turns out to be wrong. In early 2007, most economists also expected a mild fallout from the U.S. housing downturn. Going further back, investors remained relatively upbeat after the stock market crash of October 1929, even as the United States teetered on the brink of depression. The maverick British economist Bernard Connolly argues that current expectations of a gentle descent are equally deluded.
Connolly is best known for his 1995 book “The Rotten Heart of Europe”, a withering critique of the European Monetary Union that cost him his job with the European Commission. His latest book, “You Always Hurt the One You Love: Central Banks and the Murder of Capitalism”, won’t make him any friends in monetary policymaking circles. In Connolly’s view, central banks – chiefly the U.S. Federal Reserve – are responsible for a succession of financial disasters over the past quarter of a century. Now, he says, they’ve taken us to the brink once again.
Connolly’s beef is not with individual central bankers but with their economic models. The canonical framework, he says, ignores the fact that economic and financial activity must be coordinated across time. Central bank models assume that the economy never strays far from equilibrium, and that economic shocks, when they occur, are random, unpredictable and self-correcting. The central banker’s bible is “Interest and Prices” by the American economist Michael Woodford, published in 2003. Yet “in the index to the 800 pages of Woodford’s book,” says Connolly, “there is not a single entry for ‘risk’, ‘uncertainty’, ‘banks,’ or ‘finance’.”
In the real world, things are rather different. Connolly is concerned with how economic activities take shape over time: how current spending and saving connect to future consumption, and how current investment meets future demand. The economy isn’t always in balance. Intertemporal coordination breaks down, Connolly claims, when real interest rates are out of line with society’s time preference, which is the rate at which people, on average, value present over future consumption. Problems also occur when interest rates are not aligned with corporate profitability.
On this basis, Western economies have been trapped in a state of disequilibrium for more than a quarter of a century. The rot set in during the mid-1990s, when the United States experienced an unexpected upturn in productivity growth. Rising corporate profitability, according to Connolly, should have been accompanied by higher interest rates. Instead, Fed Chair Alan Greenspan chose to keep U.S. interest rates low, thereby helping to stoke a stock market bubble. Bolstered by their paper wealth, American households saved less and brought forward consumption from the future.
When the inevitable market crash came in 2000 a hard economic landing beckoned as demand dried up. The Fed responded by slashing its benchmark interest rate to 1% in 2003, thereby inflating another bubble, this time in residential housing. Once again, households consumed part of their bubble wealth by taking out home equity loans worth hundreds of billions of dollars a year.
When the housing bust arrived in 2007, followed by the bankruptcy of Lehman Brothers a year later, central bankers were again blindsided. The global economy was poised to fall into an even deeper hole. The Fed responded by reducing interest rates to zero and employing various tools to lower bond yields. Central bankers staved off another Great Depression and asset prices eventually rebounded.
In his market reports from the early 2000s onwards, Connolly constantly maintained that Western economies were trapped in a state of intertemporal disequilibrium – with genuine savings increasingly replaced by bubble wealth and consumption bolstered by debt. These economic imbalances prevented central banks from returning interest rates to normal levels. Whenever they attempted to do so, the economy would threaten to collapse.
This insight enabled Connolly to anticipate both the Great Recession that started in 2008 and Europe’s sovereign debt crisis which followed soon after. Nothing fundamentally has changed in his analysis. Greater and greater amounts of bubble wealth have been required to sustain spending. Central banks have found it impossible to normalise interest rates. The Fed aborted its previous attempt to raise rates in early 2019 after the U.S. economy hit the rocks and the stock market plunged. When Covid-19 arrived, short-term rates returned to zero.
Connolly describes real interest rates as being on a conveyor belt, heading deeper into negative territory. He predicts that yields on long-dated bonds will eventually end up below short-term rates. Such an outcome would be disastrous for capitalism, since problems of economic coordination would become even more intractable. The financial system could not operate with a permanently inverted yield curve. Governments would have to take up the role of allocating credit. The direction of travel is towards full-blown socialism, according to Connolly. Unless, that is, liberalising economic reforms are enacted that boost productivity and allow interest rates to rise.
In this analysis, monetary conditions are not so different to those that pertained before Lehman failed. Central banks are primarily focused on containing inflation, as they were before 2007. They remain blind to underlying economic and financial imbalances. The Fed’s policy rate is back where it was in 2007. Connolly says the financial system can’t tolerate even this relatively “normal” rate. There’s simply too much debt and bubble wealth out there. Though the yield curve has been inverted for some time, Connolly argues that the danger point occurs when long-term borrowing costs converge with short-term rates. This happened in mid-2007 and again in recent weeks.
Another financial crisis is not far away, in Connolly’s view. When markets collapse, the central bankers will return to their old ways, cutting interest rates and boosting asset prices. Under those circumstances, long-dated government bonds should provide the best protection for investors. For example, U.S. Treasury Inflation-Protected Securities, whose face value rises in line with consumer prices, currently yield around 2.4% for a security maturing in 30 years. That’s a fair return in normal times and could prove an outstanding investment if Connolly’s analysis turns out to be even half correct.