Submitted by Brendan Brown, the Head of Economic Research at Mitsubishi UFJ Securities International via Mises.org
The profound question which transcends all this day-to-day market drama over the holidays is the nature of the economic slowdown now occurring globally. This slowdown can be seen both inside and outside the US. In reviewing the laboratory of history — especially those experiments featuring severe asset inflation, unaccompanied by high official estimates of consumer price inflation — three possible “echoes” deserve attention in coming weeks and months. (History echoes rather than repeats!)
Will We Learn from History — And What Will Soon Be History?
The behavioral finance theorists tell us that which echo sounds and which outcome occurs is more obvious in hindsight than to anyone in real time. As Daniel Kahneman writes (in Thinking Fast and Slow):
The core of hindsight bias is that we believe we understand the past, which implies the future should also be knowable; but in fact we understand the past less than we believe we do – compelling narratives foster an illusion of inevitability; but no such story can include the myriad of events that would have caused a different outcome .
Whichever historical echo turns out to be loudest as the Great Monetary Inflation of 2011-18 enters its late dangerous phase. Whether we're looking at 1927-9, 1930-3, or 1937-8, the story will seem obvious in retrospect, at least according to skilled narrators.
There may be competing narratives about these events — even decades into the future, just as there still are today about each of the above mentioned episodes. Even today, the Austrian School, the Keynesians, and the monetarists, all tell very different historical narratives and the weight of evidence has not knocked out any of these competitors in the popular imagination.
The Stories We Tell Ourselves Are Important
And while on the subject of behavioral finance’s perspectives on potential historical echoes and actual market outcomes, we should consider Robert Shiller’s insights into story-telling (in “Irrational Exuberance”):
Speculative feedback loops that are in effect naturally occurring Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere….. The path of a naturally occurring Ponzi scheme – if we may call speculative bubbles that – will be more irregular and less dramatic since there is no direct manipulation but the path may sometimes resemble that of a Ponzi scheme when it is supported by naturally occurring stories.
Bottom line: great asset inflations (although the term "inflation" remains foreign to Shiller!) are populated by “naturally occurring Ponzi schemes,” with the most extreme and blatant including Dutch tulips, Tokyo golf clubs, Iceland credits, and Bitcoins; the less extreme but much more economically important episodes in recent history include financial equities in 2003-6 or the FANMGs in 2015-18; and perhaps the biggest in this cycle could yet be private equity.
It is troubling that the third possible echo — that of the Great Depression of 1930-2 — could be the most likely to occur.
The Great Depression from a US perspective was two back-to-back recessions; first the severe recession of autumn 1929 to mid-1931; and then the immediate onset of an even more devastating downturn from summer 1931 to summer 1932 (then extended by the huge uncertainty related to the incoming Roosevelt Administration and its gold policy). It was the global credit meltdown — the unwinding of the credit bubble of the 1920s most importantly as regards the giant lending boom into Germany — which triggered that second recession and snuffed out a putative recovery in mid-1931.
It is possible to imagine such a two-stage process in the present instance.
Equity market tumble accompanies a pull-back of consumer and investment spending in coming quarters. The financial sector and credit quakes come later as collateral values plummet and exposures come into view. In the early 1930s the epicentre of the credit collapse was middle Europe (most of all Germany); today Europe would also be central, but we should also factor in Asia (and of course China in particular).
And there is much scenario-building around the topics of ugly political and geo-political developments that could add to the woes of the global downturn. Indeed profound shock developments are well within the normal range of probabilistic vision in the UK, France and Germany — a subject for another day. And such vision should also encompass China.
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