Get ready for the “Great Immoderation”

By J Saft
May 8, 2009

James Saft Great Debate – James Saft is a Reuters columnist. The opinions expressed are his own –

The recession will soon be dead, laid to rest alongside the idea of the “Great Moderation”, a set of hopeful assumptions that underpins expectations about economic growth and asset valuations.

This, when investors, bankers and executives ultimately realise it will cause them to pull in their horns, take less risks and be less willing to pay high prices for assets.

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 with central banks and governments playing a role similar to what Chicago tavern keepers used to do — opening up early so last night’s patrons can have a quick nip to take the edge off on the way into work.

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?

What if these people now decide that the universe is a less friendly place and that they ought to, heaven help us all, save a considerable amount against the day?

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. That is more or less the argument of Larry Summers and the U.S. administration, who are betting that this is the kind of thing that happens only very rarely.

This is a version of the 100-year storm argument beloved of company managers trying to explain why their results are so poor; the implication is you could not have been expected to plan for a freak storm and once it is past it is back to the good times.

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. As in Japan, 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.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–


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Much of the wealth created over the last few decades, actually much longer, has just been due to speculation. We have been under the impression that we could regulate the speculation to a suffciient degree that we could gain it’s benefits, additional economic activity, while only having to deal with the cost of minor downturns. Except the leveraging went deeper and deeper with each cycle.

Imagine that someone gives you $1000.00 and tells you to make money off of it. Now if you were to invest it and make $100.00 in a year you would, by most standards, have made a decent return. But by entrepreneurial standards you would have done terribly, someone buying junk at garage sales and selling it online could probably beat that return over a year. The problem is, though, that if everyone takes that view then the market becomes saturated with vendors and no one can make money. Really the same is true of the stock market, there aren’t enough viable growth oriented investments to warrant the amount of capital which is thrown at the stock market. The point becomes not rewarding good business ventures as much as it does simply gambling. So all you are doing is working a game of asset inflation. There is simply too much capital available. We have become addicted to a shadow economy based on gambling.

The Fed is supposedly worried about controlling inflation, if so it needs to not just worry about the CPI but inflation of asset values as well.

Circa 2009 widget sell price = $100
Circa 2009 widget SG&A = $60
Circa 2009 widget net income = $40

Quatitative easing and massive stimulus packages drive
inflation and interest rate ramp up by 2010-11.

Circa 2011 widget sell price = $140
Circa 2009 widget SG&A = $80
Circa 2009 widget net income = $60

Debt-ridden companies could get killed, and those with manageable debt levels could thrive in an inflationary climate!

Posted by Mitch | Report as abusive

Funny to see that the economy is now so called observing some green apples falling from the sky, make sure they do not hit you on the way down on the head. The economy as you state is now shortly ending its’ recession, funny to say, that the recent back to back quarters for US GDP tolled a negative number bearing greater than 12%, yes, the green apples are falling, just like consumers are spending mad for luxury items, not necessities like WalMart sells, cars and homes sales are improving, if you define the decline rate of sales are decreasing as no longer a problem, hey so be it, same goes for the unemployment numbers. The most funniest thing is now banks, which led in the revival of this Spring Rally since early March 2009 are now issuing new capital stock to raise their liquidity levels as the US Government’s TARP line of credit nears its’ max, no wonder the rally was important that the US Government had marketed and pushed with daily speeches and Prime Time interviews, wow I do feel free money is falling from the sky, and the smart money is still injecting cash on the sidelines now at this overbought market levels. Hoping to see that the S&P 500 by year end goes to 2000 and the rally continues for another 39 more weeks for the sake of the current government and financial institutions, as the recession is at the end as everyone is hinting on, or maybe this is just my false hope and wishful thinking, as it took approx. 8 years for the housing bubble to burst with anyone including a pets which possibly would be able to get a mortgage or line of credit approved by banks. Any how let us see what the government markets to emotionally adjust the general public’s state of false confidence and banks to colude in resolving their greed from the past, luckily changing accounting rules legally was a great help in making these banks seem they are just perfect now within a period of a few months.

Posted by r. korban | Report as abusive

There are many ways to tell a story. The one story that keeps getting glossed over is not about recessions and business cycles or even governmental intervention. It’s about corporate power. The financial lobbyists are overwhelming the government. They love when we blame the fed or republicans or spending so long as they control the power. They are the powers that be, the wizards behind the curtain (of OZ). We are only chasing shadows until corporate power get reined in. Until then it all just for show while the people clean up after the greed.

Posted by Ron Berry | Report as abusive

It sounds like the bears are grumbling when instead they need to fatten up (get out of the market) before winter so they will have enough to survive. The bulls had to do the same. It is over and time to face it, instead of so much news about the bolonga. Two months ago the constituents returned to the stores if you were watching the parking lots. The sense has changed. Bears, mark my words, fatten up and hibernate!

Posted by DN | Report as abusive

This economy is broken. Humans have become nothing but cattle. We are raised on a steady diet of obedience and faith in government. We are fed consumerist ideas and told that there in lies the key to happiness. How happy do YOU feel?

If you believe the economy is getting better that’s great. What does that mean for you? Does it mean that if you’re lucky, you’ll be able to go back to working for less than what it costs to pay your bills? Does it mean you can breath easy until the next disaster.

Ever notice how junkies go crazy when they don’t have their drug of choice? But once they get their fix they feel better for a while. Ever notice how when you don’t have enough money, you get edgy, tense, or sometimes even suicidal? And yet when that money comes in you feel so much better.

We are sick. And we have allowed ourselves to be enslaved by the dollar. We are economic junkies. If you work for a living, is this what you want? If not, you would do well to speak up before your opportunity vanishes.

When the world economy gets bad enough, tensions will brew and war will ensue. Then the “back bone of the American economy” will be come the American bullet catcher.

Game Over ?

They have until October.

Politics always trumps Free Markets and it’s all calculated!

If this fiasco hasn’t turned-around by then, the O-Team will send in “The Cleaner” and the Election Cycle will rein.

- End of ’09, bargaing and hope will be lost and heads will roll (i.e., L.S. and T.G. are out and the nation is a step closer to socialism)
- 2010 will bring depression and will end with acceptance
- 2011 re-election campaign kicks in with promises of “Road to Recovery”
- 2012 Capital gets the backseat with Labor is in the drivers seat. O-Team is re-elected with majorites in both Houses.

The fate of capitalism as we know it, will forever have changed!


Posted by Peter | Report as abusive

The average American citizen has one major concern,getting back to normal.The working class have suffered enormous lost due to corporate greed and as many have lost everything some are willing to gamble more.Thomas Jefferson warned that if government got in bed with banking institutions it would be the American people as a whole that would suffer.Does this Country and its Constitution have any hope of surviving such a blind lust for money?I recall a story of a crucified man watching as soldiers gambled for his clothes.How far is Wall Street willing to go ?

it’s interseting to learn that the banks of US was only 78 billion dollars short of business as usual. why didn’t the US government give them the money earlier so we wouldn’t have to go through a GFC?

Posted by Ding | Report as abusive

RB, A vastly different element to the economic calamity of today, vs those of even the recent past and that of the ’30s is information and sophistication of the worker bees, economic participants required to keep the global wheels turning. The occlusion of markets, shadow banking and delusional culture of the giant international corporations is stripped bare and why confidence will not be returned. Tier 1 Capital is cooked you say-why is no one really surprised is the better question.

Broadly leaders of government(s) culpable and complicit in enabling it. These wealthy and powerful hold no national interests but are steadfast in a dogmatic extremism which supply excessive rewards at the cost of others which rose exponentially over the last 15 years.

Rather than systemic risk management, it is/was a systemic free-for-all and broke essential lynch-pins in keeping the mechanisms of base economics working. Modeling, philosophies and banal incentives disconnected from reality for so long, the hazards remained unseen. Trade deficits alone at stunning levels a gigantic red-flag which was ignored by those who believed their obtuse and manipulative means could replace it. Narcissism and giant egos were supported rather than given margins of law or consequences in self-perpetuating dysfunctional systems.

Globalization of corporate giants, finance giants over-reached until a category 5 economic hurricane of “counter-party” risk was created coupled with a global tsunami of leverage and debt.

The tragedies are however real and in particular include the less enabled individuals coping with and shacked by this ruse of an economic system of opportunity. The lack of choices of the hoards of involuntary, undereducated, passive ‘investors’ in the market-solutions for funding educations, retirement, health care,housing, lives etc. also led down a primrose path of faddish schemes of money making. It has nothing to do with value, growth, production, innovation or even trade as it has revealed itself to be nothing more than a facade with false promises and false returns of snake oil salesmen.

There is an opportunity for a return to more fundamental, less volatile and more secure economic paradigm, I am dubious that construct will arise without the foundation of this barn built with toothpicks falling down first. Inflation is required for the current system to survive.

Deflation risk gone as new homes are being demolished? There’s one way to decrease the inventory. I want to know why this still isn’t a risk. I suspect I know why-supplies of everything will be reduced until demand outstrips it and therefore-inflation will produce that necessary capital that needs to be raised. Problem is, it will be among those basics everyone needs to survive as larger and larger populations of individuals necessarily must return to basic needs versus idealized/manufactored wants.

Posted by NS | Report as abusive

I think a lot of the recent press releases lately about the economy bottoming out are premature, and to some extent even conspiratorial on the part of government officials, the real estate industry, and the press. Maybe I’m being too negative, but it’s just my sense of things right now. A lot of people in this country have a hard time being truthful anymore. I live in an American town with a population of about 60,000 people. In the past two months I have seen more and more homes come up for sale with fewer and fewer sales. Our next door neighbors on a quiet street just moved out of a nice neighborhood leaving their house empty. They were not able to sell it. They bought it four years ago, and they will probably take a loss on it.

Posted by Juan Way | Report as abusive

The worst of the Swine Flu seems to be past, polar bears are doing just fine, marijuana will be soon be legalized (hooray!), prayer is an act performed by people in need of a divine daddy figure, and the Great Recession is on the ropes and will soon be history. How grateful am I? Words fail me. Maybe it’s time to put in that sun room (gotta borrow for that, I’m afraid) , take a Caribbean cruise (credit card at the ready) and buy that Swiss watch I’ve always wanted (don’t I deserve it after all this travail?)

It’s back to our old ways! I’m so happy. Really. All this saving, paying off debt, eating in, worrying about retirement is such a drag. Hey, I’ll never make it to the top of the capitalist Ponzi pyramid, so I may as well live it up. I’ve got no kids, so the banks will have no one to come after when I’m gone.

Life is good. Morning in America.

Posted by Robert Foster | Report as abusive

Juan, your story of the neighbor who lost their home after some years is the story of millions of people. In 1933, the worst year of the Great Depression, 275,000 properties were foreclosed. In the past year approximately the same number of homes have been foreclosed upon every month. Our population today is not even three times as great.

The next real estate collapse will be commercial properties. Warehouses and factories recently completed or under construction are either empty or construction suspended. Consumer spending habits have inexorably been altered rendering many of these massive facillities unnecessary in the forseeable future.

These facts have not escaped the Administration or Congress in Washington. As so many other commentators have stated in these blogs, the American taxpayer is left in the dark as to the realities of our predicament. Informed consent is essential for government to work effectively. It would appear the outrage of Congress over deception and fraud in the business world is nothing more than calculated deflection.

Posted by Anubis | Report as abusive