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Against the tide: Credit bubble – Investors in an autumn fog

Renewed quantitative easing is not a sound answer to the threat of double-dip recession or deflation. A credit bubble cannot be cured by pumping in more credit.

The horizon for investors is shrouded in autumn fog. There could be a double-dip recession and debt deflation. Alternatively, the big economies might restore blissful growth. Or, more likely, the world economy will stay stuck in a sustained post-credit-bubble deleveraging that will deliver below-trend growth for years ahead.

Offering so many possible outcomes might sound like a fudge. But it just tells you that the fat tails of economic outcomes are almost as thick as the most probable one. Indeed, Knightian uncertainty ("the type of uncertainty in which there is no underlying probability distribution", according to European Central Bank president Jean-Claude Trichet speaking at the recent Federal Reserve Jackson Hole seminar) clouds over the economic skies. In this post-credit-crisis world, macroeconomic volatility, the antithesis to the Great Moderation of the disinflationary decades (which reduced risk and boosted asset values), is here to stay.


What is clear is that any firm signs of double-dip recession or deflation (the former will be seen as increasing the risk of the latter) will be met by central banks in the US, UK and Japan (let’s call them the interventionists) adopting a new round of quantitative easing (QE2). QE2 differs from QE1 in that central banks will buy more sovereign debt, so monetizing the excessive debt and deficits that have constituted the big policy plank to combat the credit crisis so far.

Central banks in the eurozone, Sweden, Norway, Australia and New Zealand will not follow this example (let’s call them the austeroids). The austeroids would continue to tighten fiscally and return monetary policy to normal settings. If global growth returns to normal rapidly, then everyone will join the austeroids in tightening policies.

The conviction of the interventionists is that the impact of monetary and fiscal stimulus on the real economy is that of a cog and wheel – a mechanical relationship that means stimulus equals growth in GDP. My view is that a fuzzy cloud of behavioural economics messes up these mechanics, meaning that financial markets can offset part or all of the impact of any stimulus on economic growth.

The debt picture

OECD gross gov’t debt to GDP and net gov’t debt to revenues, 2010 forecasts

Source: OECD

Take monetization of sovereign debts and deficits – the next stage of QE proposed by the interventionists. This will worsen sovereign credit quality by facilitating excessive sovereign debt issuance and yet reduce the cost of many forms of borrowing, including that of sovereign debt. That’s a price divergence that is as unsustainable as that other result of post-credit crisis stimulus: liquidity creation. QE2 will boost the prices of risk assets, for a while, because the banks will prefer to punt on asset prices rather than lend to the real economy. But the quality, and thus productivity, of state spending is very poor. Around three-quarters of the increase in government spending has been applied to maintaining excessive household leverage and consumption.

The excesses of the credit bubble have consequently not been worked off, because the endeavour of the state is to maintain them rather than address them. The price is future growth. There has been a misallocation of resources away from productive to unproductive uses that will act as a tax on growth.


The most relevant measure for the sustainability of state leverage is sovereign debt to tax income. For most OECD countries, this measure is much more worrying than the usual sovereign debt to GDP ratios. It tells us that taxes will have to rise, and rise dramatically. Rising taxes are anti-growth. And the return to the big state with big debts and deficits is anti-productivity and pro-inflation down the road (even if temporary slack in the economy is holding inflation down now).

A credit bubble cannot be cured by more credit. Public policy has piled on debt while the reduction in private sector leverage is inchoate. Total leverage (public plus private) has risen since the credit crisis began. So deleveraging must continue for years and growth will be held down because of it, irrespective of monetary policy. The interventionists will eventually be punished for the debasement of their currencies and the unsustainable level of their sovereign debts.

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