Stephen King: Gold prices are a dead giveaway

For all these reasons, investors are increasingly focused on so-called “exit
strategies”. How and when should economic life-support policies be
removed? After all, interest rates in the developed world are at their
lowest levels ever, the gentle hum of the monetary printing press can still
just about be heard and budget deficits are huge. Are these policies still
necessary, or is it time to expect the world economy to stand up on its own
two feet?

It’s easy to be seduced by what I might cheekily call “straight-line
economics” ? the idea that when the worst appears to be over, the best
is just around the corner. Straight-line economics assumes that strong
economic growth is a “normal” state of affairs, interrupted only
occasionally by pesky recessions. If the rules of straight-line economics
are applied today, it’s obvious that policymakers should be raising interest
rates and reducing budget deficits because, with animal spirits now
rebounding, we’re returning to straight-line predictability.

Sometimes, however, economies end up in a different place, based on the
physics of bungee jumping. The economy falls off a cliff. Activity drops a
long way. Then there’s a rebound. For a while, the rebound looks very good
and it’s easy enough for economists to stick to their straight-line
thinking. But the economy never returns to normal; instead it is left
dangling by a thread. The straight line simply doesn’t apply.

If we’ve learnt anything over the last two or three years, it’s that
straight-line thinking is pretty hopeless. For the economics profession,
it’s been a bruising experience. At the beginning of 2007, some economists
recognised downside risks, but the consensus view was that, if there was to
be an economic slowdown, it would be a so-called “soft landing”.

For the forecasting community, it was one of the biggest errors ever made. The
economic models that were routinely used to churn out projections for growth
and inflation were poorly designed to handle the housing and financial
crises which bubbled over on either side of the Atlantic. Even worse, the
models fostered the illusion of policymaking invincibility. Most of the
models were “self-correcting”, assuming that the straight-line
approach was appropriate and that recessions were a thing of the past. This,
of course, was rubbish. But the weaknesses of the approach should give us
pause for thought today. While it’s true that the world economy is now in
much better shape than it was last year, is this enough to guarantee that
we’re getting back to normality?

Central bankers are mostly proud of their efforts to “fix” the
global economy. But if the fix is to continue working, the rise in animal
spirits since the spring needs to be maintained. That’s no easy task, partly
because it’s not clear what is causing it. The standard claim from
policymakers, particularly in the UK, is that equity and corporate bond
markets have risen in part because of the benefits of unconventional
policies.

If the central bank buys lots of government bonds, the yield on those bond
drops, thereby encouraging investors to buy other, riskier, assets. The
increase in the value of equities and corporate bonds which follows makes
life easier for companies looking to raise funds in the capital markets. It
also makes households feel a lot more confident that the worst is over,
thereby reducing the desire to hoard cash for a rainy day.

Imagine, however, that the increases in asset prices we’ve witnessed over past
months fail to translate into a lasting recovery in economic activity.
Earlier in the year, investors were beginning to price in a “Great
Depression Mark II” ? a view which proved to be overly-pessimistic. In
a world of bungee economics, it’s just as likely that the current hopes of a “Great
Recovery” will prove overly-optimistic. Rising asset prices may say
something about the success of unconventional policies, but they could just
as easily be part of the regular volatility of financial markets and, in
fact, say hardly anything about longer-term growth prospects.

Throughout the 1990s, economists following Japan had to cope with similar
problems. Every so often, the economic data would show modest signs of
improvement. In their haste to declare recovery, investors would pile into
Japanese equities, triggering a stock-market rally. The rally gave
economists the confidence to revise up their forecasts for future economic
growth. These upward revisions led to an even bigger rally. Then came the
shocking discovery. The Japanese economy wasn’t really recovering at all: it
was the ultimate bungee economy, with occasional signs of rebound followed,
as night follows day, by yet another setback. The mistake was to assume that
financial markets provided an accurate forecast of future economic
developments. As it turned out, the best they could do was to offer an
occasional bout of wishful thinking.

The danger for policymakers today is that, again, financial markets are
offering not much more than wishful thinking. Indeed, disappointed with the
absence of any effect on money-supply growth, the Bank of England is engaged
in its own wishful thinking, arguing that the best way of gauging the impact
of its quantitative easing programme is via the performance of financial
assets ? a claim which could easily go wrong given the fickle nature of
investors.

The unfortunate reality is that unconventional policies are unconventional
because no one really understands how they work. Whisper it quietly, but
these policies may be no more than the ultimate economic placebo. Placebos
can, of course, work wonders, but their best work is in the mind. Our
central bankers are re-inventing themselves for a “new age”
economy. They are no longer economic scientists but, instead, mystics who
are hoping to persuade the rest of us of their miraculous powers.

If we return to a straight-line economy, central bankers’ mystique will be
justified. If, however, we’re in a bungee world, their mystique will slowly
be undermined. I suspect the costs will be seen mostly in increased currency
volatility. Those central banks which have engaged in unconventional “funny
money” policies need to see sustained results. If those results fail to
materialise, we’ll be left with weak economies and a broken printing press.
The strength of the gold price in recent months suggests that investors
still have their doubts about unconventional policies. They’re buying
insurance in case of failure. They’re right to do so.

stephen.king@hsbcib.com

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