No one knows how long the spectacular stock market rally we've been seeing over the past six years will continue. It may go on for a while, stoked by a combination of a not-too-hot, not-too-cold Goldilocks economy and healthy corporate profits. Inflation remains historically low and structural changes in the economy suggest that no sudden inflationary explosion can be expected.
Meanwhile, uncertain growth prospects around the world — in China, Western Europe and commodity producing nations — limit the room for a meaningful monetary policy tightening by the Federal Reserve.
Underpinning investor confidence on Wall Street is the Fed's commitment to avoid any asset price deflation, especially a selloff in stocks. This commitment, in effect since the late 1980s, is known as the "Greenspan put" after the former Fed chairman.
However, if the party in stocks — and an even longer bull market in bonds — continues unabated, excesses will be allowed to accumulate, exacerbating speculative overhangs that are already evident in financial markets. As a result, we may end up dumping a whole lot of massive financial problems onto the next generation of Americans.
Healthy Recessions
Economic theory suggests that a healthy market economy is cyclical for a reason. Periodic recessions eliminate imbalances and punish those who got overextended during the good times. William McChesney Martin, the longest-serving Fed chairman in history, who oversaw formidable U.S. economic growth during the early post-World War II decades, defined the Fed's job as "taking away the punch bowl just as the party gets going."
In a way, Martin's job was made easier because consumer price inflation during that era of tighter regulation acted as an alarm bell. Production of goods and services couldn't keep up with rising demand during upswings in the business cycle, while a less competitive environment allowed business more leeway to raise prices, creating inflationary pressures relatively quickly. Plus, the Keynesian inverse correlation between unemployment and inflation was thought to be ironclad. Whenever the jobless rate declined toward its "natural" minimum level, the Fed acted to raise interest rates, creating an economic correction.
The relationship between unemployment and inflation described by the Phillips curve broke down in the 1990s, and inflation as measured by CPI has not been a concern for a generation. Lowering rates to historically unprecedented levels and keeping them at zero for extended periods of time became possible. It also turned out that money could be almost literally tossed out of helicopters — as the Fed and other major central banks did in their quantitative easing programs — without having much impact on consumer prices.
In this new environment, economic upswings could be extended for an almost unlimited time while eventual downturns could be dealt with by dousing them with massive quantities of money. Speculators and other overextended economic actors were salvaged, reckless behavior was rewarded and imbalances were thus kicked down the road for the next administration to deal with.
Preventive Fires
In the early 1970s, the U.S. Forest Service began adopting a "let burn" policy in managing local forest fires. Research had shown that such fires play a crucial role in regenerating growth, whereas USFS's previous efforts to fight all forest fires everywhere actually resulted in a dangerous accumulation of dead wood, eventually leading to destructive mega-fires that could burn out of control.
Allowing the economy to go into a recession is an exact equivalent of letting smaller forest fires burn. Just as the USFS had the equipment and technology to put out all the forest fires, so the Fed now has the wherewithal to combat cyclical recessions. In the case of the economy, the deadwood is represented by asset price bubbles, which is where excess liquidity now flows, and mega-fires are financial calamities such as the technology bust of 2000 and the subprime mortgage crisis of 2008.
Since the Great Recession, the recovery has been slow, creating a sense of complacency as far as asset price bubbles are concerned. But that doesn't mean that this financial tinder is not accumulating. By some measures, financial imbalances in the U.S. economy are already as bad — and even worse — than they were eight years ago, at the onset of the last financial calamity.
Incidentally, China's authorities have been doing a similar thing, but using different tools. Having struck a bargain with its people, promising steady growth and improved living standards in exchange for continued one-party control, the Chinese Communist Party has been working to avoid economic recessions at all costs. Since the Tiananmen Square protests were put down in 1989, China has seen nothing but growth while the government poured its substantial reserves into the economy whenever there were signs of a slowdown. China survived unscathed the "Asian flu" in 1997–98 and a larger financial conflagration a decade later.
