Central banks let the good times continue for too long and we are all paying a higher price as a result
Economic growth is like a party – the longer it continues, the more trouble is likely to ensue. Investors, like partygoers, are likely to push the limits to make the most of the good times. The longer this is allowed to continue, the greater the carnage that is likely to be left in the wake of the revelling. Thus, it is not a coincidence that a period known as the “Great Moderation” has been followed by the “Great Recession”. This is not the first cycle of boom and bust, but if it could have been predicted, why did central banks let things get so out of hand?
Theory behind boom and bust
The business cycle is a normal part of any economy. The key driver of the cyclical nature of the economy is perceptions of how the economy will perform in the future. Views about the economy change over time meaning that it is unlikely economic growth will continue at a steady rate. This is because, when the economy is operating smoothly, confidence perks up. Consumers will spend more and save less as worries about the future ease. Greater spending by consumers will prompt companies to invest more due to expectations that their businesses will expand.
Optimism will also spill over into asset prices. As prices for assets such as houses or stocks rise, the higher values attract more buying. The hope of easy money lures in more and more buyers spurred on by the belief that prices will continue to rise. Debt levels expand as consumers and businesses take out loans to take advantage of the economic growth. Instead of this extra credit being put to productive use, it is easier to make money with speculative investments on property or stocks. Thus, debt increases along with asset prices, each fuelling a rise in the other.
This cycle inevitably gets out of hand as rising asset prices outpace the growth of the economy as a whole. Prices reach unsustainable levels with the potential to trigger a financial crisis. The cycle then goes into reverse with businesses slashing investment and consumers cutting back on spending. The economy retrenches for a period as debt is repaid and asset prices fall back to more reasonable levels. The harsher economic climate weeds out the weaker companies and business eventually picks up as the economy stabilizes again. At this point, the party spirit returns and the business cycle begins afresh.
Economists make for bad students of history
The business cycle has been repeated throughout history but this is quickly forgotten when times are good. Economists at central banks were patting themselves on the back for a decade or two of low inflation and steady economic growth which the previous head of the Federal Reserve Ben Bernanke labelled the Great Moderation. Central banks thought they were keeping a lid on the economic boom time. Interest rates were raised in an attempt to keep some semblance of order but hindsight has shown that this was insufficient.
Everyone was getting too carried away with no one to rein in the revelry. The indulgent ethos of the time was best captured by the head of Citibank who foolishly said in late 2007 that “as long as the music is playing, you've got to get up and dance”. Central banks should have acted like police, stepping in to turn the music down, but were more like cheerleaders urging on the good times. Any Cassandras who prophesized the coming of the global financial crisis were marginalised as party poopers.
There was a line of thought that the financial markets knew best and central banks should just step in to clean up the mess when anything went wrong. But letting the party go on for much longer than it should have done has only made the clean-up job that much bigger. Even new tools are not proving much good in mopping up the aftermath. If the partying had been cut short sooner, we would probably not be still suffering from the hangover.