LONDON, Oct 13 (Reuters Breakingviews) – Consensus opinions suggest the U.S. economy is on track for a soft landing. This explains why the S&P 500 Index (.SPX) is up more than 20% in the last 12 months. The problem is that the consensus often turns out to be wrong. At the beginning of 2007, most economists also expected a slight impact from the US real estate downturn. Looking back even further, investors remained relatively optimistic after the stock market crash of October 1929, even as the United States teetered on the brink of a depression. The maverick British economist Bernard Connolly argues that current expectations of a gentle decline are equally misguided.
Connolly is best known for his 1995 book The Rotten Heart of Europe, a scathing criticism of the European Monetary Union that cost him his job at the European Commission. His latest book, “You Always Hurt the One You Love: Central Banks and the Murder of Capitalism,” will make him no friends in monetary policy circles. In Connolly’s view, central banks – particularly the Federal Reserve – are responsible for a number of financial disasters over the last quarter century. Now, he says, they have brought us to the brink once again.
Connolly’s problem lies not with individual central bankers, but with their economic models. The canonical framework, he says, ignores the fact that economic and financial activities need to be coordinated over time. Central bank models assume that the economy never deviates far from equilibrium and that economic shocks, when they occur, are random, unpredictable, and self-correcting. The central banker’s bible is American economist Michael Woodford’s “Interest Rates and Prices,” published in 2003. But “in the index to the 800 pages of Woodford’s book,” says Connolly, “there is not a single entry for ‘risk.'” Uncertainty”, “banking” or “finance”.
In the real world things are a little different. Connolly is concerned with how economic activity takes shape over time: how current spending and saving are related to future consumption, and how current investment meets future demand. The economy is not always in balance. Intertemporal coordination breaks down, Connolly claims, when real interest rates do not match society’s time preference, that is, the ratio by which people, on average, value current consumption over future consumption. Problems also arise when interest rates are not aligned with company profitability.
On this basis, Western economies have been trapped in a state of disequilibrium for more than a quarter of a century. The rot began in the mid-1990s, when the United States experienced an unexpected surge in productivity growth. According to Connolly, rising corporate profits should have been accompanied by higher interest rates. Instead, Fed Chairman Alan Greenspan chose to keep U.S. interest rates low, contributing to the creation of a stock market bubble. Aided by their paper wealth, American households saved less and pushed consumption further into the future.
When the inevitable market crash occurred in 2000, there was a threat of a hard economic landing as demand waned. The Fed responded by cutting its key interest rate to 1% in 2003, inflating another bubble, this time in housing. Once again, households used up some of their bubble wealth by taking out home equity loans worth hundreds of billions of dollars per year.
When the real estate crisis occurred in 2007 and the bankruptcy of Lehman Brothers followed a year later, central bankers were caught off guard again. The global economy threatened to fall into an even deeper hole. The Fed responded by cutting interest rates to zero and using various tools to drive down bond yields. Central bankers prevented another global economic crisis and asset prices eventually recovered.
In his market reports since the early 2000s, Connolly has consistently argued that Western economies are trapped in a state of intertemporal disequilibrium – with real savings increasingly being replaced by bubble assets and consumption fueled by debt. These economic imbalances prevented central banks from returning interest rates to normal levels. Whenever they tried, the economy threatened to collapse.
This insight allowed Connolly to foresee both the Great Recession that began in 2008 and the European sovereign debt crisis that soon followed. Fundamentally, nothing has changed in his analysis. To sustain spending, ever-increasing amounts of bubble assets were required. Central banks found it impossible to normalize interest rates. The Fed abandoned its previous attempt to raise interest rates in early 2019 after the U.S. economy faltered and the stock market plunged. When Covid-19 hit, short-term interest rates dropped to zero.
Connolly describes that real interest rates are on the assembly line and are trending deeper and deeper into negative territory. He predicts that long-term bond yields will ultimately be lower than short-term interest rates. Such an outcome would be catastrophic for capitalism, as the problems of economic coordination would become even more intractable. The financial system could not function with a permanently inverted yield curve. Governments would have to take on the role of lending. According to Connolly, the direction is towards full-fledged socialism. Unless liberalizing economic reforms are implemented that increase productivity and allow interest rates to rise.
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In this analysis, monetary conditions are not significantly different from those before the Lehman bankruptcy. As before 2007, central banks are primarily focused on containing inflation. They remain blind to the underlying economic and financial imbalances. The Fed’s key interest rate is back to 2007 levels. Connolly says the financial system can’t tolerate even this relatively “normal” rate. There is simply too much debt and bubble assets. Although 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 interest rates. This happened in mid-2007 and again in recent weeks.
According to Connolly, another financial crisis is not far away. When markets collapse, central bankers will revert to their old ways, cutting interest rates and driving up asset prices. Under these circumstances, long-term government bonds should offer investors the best protection. For example, inflation-protected U.S. Treasury bonds, whose face value increases in line with consumer prices, currently yield around 2.4% for a 30-year security. That’s a fair return in normal times and could prove to be an excellent investment if Connolly’s analysis proves even halfway correct.
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CONTEXT NEWS
The Price of Time: The Real Story of Interest by Edward Chancellor was published in paperback in September.
Bernard Conolly’s book You Always Hurt the One You Love: Central Banks and the Murder of Capitalism was published in hardback in September.
Edited by Peter Thal Larsen, Streisand Neto and Thomas Shum
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