We’ve had the Great Recession and the Great Liquidity. Next comes the Great Unknown.
Central banks have averted the Great Depression 2.0 courtesy of liquidity injections on an unprecedented scale over the past 18 months. In essence, the Federal Reserve and its counterparts around the world have eased the economic and financial pain relative to what would have occurred in the absence of government intervention. If you give the patient enough morphine, he feels better. But what happens when the nurse visits cease? Or will they cease?
The first phase of the Great Intervention has generally drawn cheers and high marks. Certainly the capital and commodity markets in 2009 have registered their approval by way of higher prices. The risk of deflation has been materially reduced. Meanwhile, economic growth has returned. News that that U.S. GDP expanded in the third quarter, for instance, is widely celebrated as proof that the monetary and fiscal stimulus have been a success.
But having scored a victory in the first round, the question arises: At what price?
It’s asking too much to assume that the intervention of the past year is cost free. Economic logic tells us that for every action there’s a counter action. Maybe not immediately, or in obvious ways. But it comes. You can control prices or quantity, but not both. The notion that governments can intervene in the global economy without repercussions requires ignoring history.
To some extent, the market correction of 2008 and early 2009 was a reaction to excess that had been allowed to build in the prior years. As it turns out, the government aided and abetted the excess in a variety of forms, including keeping interest rates too low for too long and promoting market-distorting incentives for owning real estate. The private sector, responding to what amounted to a state-financed boom, exacerbated the excess, which ultimately led to the correction of 2008.
Now we have what amounts to a government-engineered rally in markets and economies. The rebound is certainly welcome, but it comes with caveats and lots of questions. First and foremost is deciding how much of the apparent recovery is self-sustaining. If the government intervention of the past 18 months deserves credit for buoying the global economy and financial markets, reason suggests that taking away some or all of the stimulus creates a new obstacle in the months and years ahead.
The devil’s in the details of the exit strategy that awaits. There are many ways to remove the liquidity that minimizes the negative repercussions. But make no mistake: We are in unprecedented times. Governments have embraced Keynesian economics like never before, particularly on the monetary front. The immediate results include higher asset prices, growing economies and a sharp increase in government debt.
We know how this relationship has fared in 2009. It’s not obvious what it’ll bring in 2010 and beyond. The Great Experiment has only just begun.