“If something cannot go on forever, it will stop.”
This aphorism, which is quoted with increasing frequency, was coined by Herb Stein, a great economist – and friend of Israel who, together with Stanley Fischer, was closely involved on behalf of the US government in the Economic Stabilisation Program of July 1985, that saved the Israeli economy in the mid-1980s. Stein was a very clever man, and the quote proves it. On the face of it, the idea being expressed is pretty obvious and so seemingly devoid of wisdom. However, in the economic sphere, the basic truths that are supposedly obvious need to be highlighted and repeated, sometimes endlessly, because they are so regularly ignored and/or ridiculed.
Any process that cannot go on forever will eventually stop. That was true of the house price boom in Florida and Nevada in 2005, as it was of the dot.com boom in 2000, and of countless other economic and financial phenomena throughout history. You didn’t need any special insights or knowledge to know that the housing mania that developed in the US, Ireland, Spain and elsewhere a decade ago would end in a massive bust. You did, however, need the guts to stand up to the thundering herd who were convinced that it would go on forever, and who invented ideas, concepts and a warped version of reality to ‘explain’ why that would be the case. As in most similar situations, these arguments were variations on the basic theme that “this time it’s different”.
But it never is. The most immediate and critical current application of what is sometimes referred to as “Stein’s law”, is with regard to the US government – and, by extension, to other governments around the world which are locked into a deficit cycle in which they borrow more and more to fund larger and larger parts of their spending. Thus it is obvious to any sensible person that the US government cannot forever run a deficit of some $100 billion per month. Therefore, this situation will stop. Once that is recognised, the discussion can turn to how it might stop, with the two main options being either a process initiated by the US government, in which it acts to reduce its borrowing requirement, either by spending less or by increasing its revenues (read taxation), or alternatively, by a process imposed on the US government from the outside – in practice, by the financial markets – to force it to stop.
However, obvious though this is, the policy of the Obama administration has been and continues to be to avoid admitting the obvious and to pretend that what cannot go on forever will nevertheless not stop – at least not in the timeframe relevant to this administration. There is nothing especially bad or stupid about the current administration in this respect, despite the demonization of the Obama people by the Republicans. Bush Jnr was as bad or worse and the basic attitude is very deeply entrenched in Washington (and Tokyo, and many other places), on both sides of the aisle.
The Federal Reserve, under Greenspan and now under Bernanke, has been a willing and eager accomplice in generating, supporting and facilitating the entrenchment of the mindset that fundamentally unsustainable processes can indeed carry on forever. The methods used by the Fed, and by other central banks around the world, over the last several decades but especially since 2008, have been to supply liquidity to the financial system and thereby cover up the fact that the banking system is bust and the banking function (of lending money to businesses and households to finance investment and affordable consumption) is fundamentally broken. This has been further developed so that the central banks provide sufficient funds for the purchase of much – sometimes most, and in some cases even all – of their government’s issuance of new bonds. The pretence that the central banks are not ‘monetizing the government’s debt’ is scrupulously maintained, but the reality is that without the various mechanisms employed, that debt would either not be sold at all or, more likely, would need to offer much higher interest rates to attract investors.
As this column has noted many times over the past few years, the entire edifice of the financial markets has become warped by the vast pools of liquidity being created by the central banks. However, like all addictions, the free-money drug requires ever-greater doses to have the same effect, while the side-effects become more harmful as the dosage increases – and as the negative side-effects accumulate over time. The markets are now so hooked on central bank-provided liquidity that the merest mention of the possibility of reducing – let alone ending – the dosage causes tremors and traumas.
That is what has happened in the markets over the last couple of days, in response to publication of the minutes of the Fed’s most recent discussion of the future path of what it terms, euphemistically, as ‘accomodative’ monetary policy. Nothing has been decided and no action has been taken, nor is any likely in the near term. But no matter. The mere mention of the idea that the free-money policy is ultimately unsustainable is totally unpalatable to the markets.