Bernard Connolly, global strategist, Banque AIG, warned that the “everything-for-the-best” attitudes of markets and policy-makers were wrong-headed. Some of the problems he foresaw are already appearing. Will the ultimate effect of what he sees as Fed mismanagement in the second half of the 1990s be the destruction of a global free-market financial system?

The world experienced the two fastest years of economic growth on record in 2005 and 2006, and most forecasts for this year point to performance hardly less stellar. Yet inflation remains low in most parts of the world, as do inflation expectations. The consensus view is that this performance is no fluke. Thanks to structural change, strong productivity growth and wise central-bank management, the world is on a path of sustained and stable non-inflationary growth.

Imbalances are, in this view, starting to be righted, via “rotation” in U.S. growth from housing (where subprime problems are well-contained) to business investment, and via “de-coupling” of the rest of the world from the United States as it experiences a brief, mild and healthy corrective slowing in growth. This decoupling also has the desirable effect of somewhat reducing the U.S. current account, as does the orderly decline in the dollar seen over the past few years. And there is no hurry: there is not, and will not be, any difficulty for the United States in financing the deficit. In a secular view, countries such as China, India, Russia, Brazil, Mexico and Turkey are re-invigorating the global economy and will fuel strong growth for years to come.

Given such a golden scenario, it is no surprise that stock markets worldwide have been bounding ahead, yet without reaching the inflated valuations of the tech boom, and long-term interest rates remain comfortably low. Nor is it any surprise that financial market volatility has been exceptionally low, or that brief sell-offs, such as those of May last year and late winter this year are soon reversed – an experience that simply creates more confidence and nourishes risk appetite.

With volatility, risk-free long rates and risk premia all low, there is enormous liquidity in financial markets – liquidity eagerly used, though never exhausted. And financial innovation not only creates liquidity but also diffuses risk and adds to systemic financial stability.

Worrying anomalies: cause for concern?
But, below the skin of this organism, seemingly glowing with health, is there a malignant tumor rooting and spreading? There are certainly anomalous features in financial markets that need investigation. Why are yield curves flat or inverted in so many countries? This is something that in the past has often been a signal of coming recession. Why have money and credit been rising so rapidly, again in many countries simultaneously? That has often been a signal of coming global inflation. Why are current account imbalances among so many mature economies so large? In the past, that has often been a signal of coming currency and/or debt crises. Why do some central banks worry about the globally high ratio of asset prices to the prices of currently produced goods and services? In the past, such a ratio has often been a signal of a coming asset price crash or a rapid acceleration in inflation. Why does the foreign exchange market engage massively in “carry trades” that weaken the currencies of low-inflation, large-currentaccount surplus countries such as Japan and Switzerland? In the past that has often been a signal of coming sudden, disruptive reversals. Why do financial markets so readily finance – with virtually zero risk premia – the vast current-account deficits of countries whose firms and households appear to have no obvious means, either through unusually rapid productivity growth or through an ability and willingness to constrain future consumption, to service their debts in the future? In the past, that has often been a signal of coming financing crises and even social and political crises.

Given all these perplexities, is it not somewhat surprising that risk premia are so low? Former Federal Reserve Chairman Alan Greenspan said that history has not treated kindly those who accept unusually low-risk premia. Will history again be harsh?

The Fed's “New Paradigm”: benign or malignant?
The Fed, and the dominant economic theory, cannot give consistent explanations of these puzzles simultaneously. But there is a clue that helps explain them. Financial markets once again believe in a “New Paradigm,” just as they did in the South Sea bubble, the British railways booms of the 1830s and 1840s, the United States and global booms of the 1920s, the somewhat less frenetic U.S. stock-market boom of the 1950s, the Japanese bubble of the late 1980s and the global tech boom at the end of the last century. In all of these episodes, except perhaps the first, there were certainly elements of a “New Economy.” But in all of them, the idea of a New Paradigm was deserving only of withering contempt.

Now, in contrast, the idea of a New Paradigm has some merit. Unfortunately, though, this particular New Paradigm is malignant rather than benign.

All except one of the past episodes mentioned here had something in common: financial policy during the boom, the period of belief in a New Paradigm, was incapable either of restraining the boom or of preventing the bust. The one exception was the tech boom of the late 1990s. True to form, financial policy did not restrain the boom. But it did prevent the bust – or, though a two-thirds fall in the NASDAQ, for instance, was certainly a bust, it mitigated the economic effects of an asset-price bust. Certainly there was no liquidation of physical capital after 2000.

This is what constitutes a New Paradigm now: the world is, for the first time ever, in a state in which capital liquidation after an excessive boom has been avoided, or at least deferred, by financial policy.

That recognition helps explain the coexistence of flat or inverted yield curves around the world, normally a signal of coming recession, and fast rates of growth of money and credit, normally a signal of coming inflation. In the United States, for instance, liquidation of capital after 2000 was avoided by the Fed's policy (followed by other central banks) of slashing rates. That policy eventually helped produce a revival of business investment after a period of pronounced weakness in 2001 and 2002, and stimulated household spending on consumption and housing investment.

Interest rates can defer but not cure
But changes in interest rates cannot increase the total amount of current and future consumption – they just change the allocation of consumption over time. So low interest rates today mean high consumption today but low consumption tomorrow. To prevent tomorrow's consumption from being lower than today's, tomorrow's interest rates must be even lower than today's, and the same is true for the day after tomorrow, and so on. That is, in these circumstances an inverted yield curve signals not a recession tomorrow but what is necessary to keep on deferring that recession.

But what markets observe is not that recession must come at some undefined point in the future. They simply observe globally that recession has not happened despite the 2000-2003 market crash. And they also observe extremely high and apparently stable corporate profitability. The economy, it seems, has taken everything an unkind fate could throw at it over the past six or seven years, and it is not only still standing but skipping and dancing gaily.

In a liquidity bubble, who worries about debt?
Given the signal the market thinks it sees in this, macroeconomic risk seems to have been dramatically reduced. So risk premia have fallen. Low risk premia and low volatility, combined with financial innovation, have produced enormous “liquidity,” driving mergers and acquisitions and leveraged buyouts. The huge growth in credit derivatives has increased the demand for underlyings, pushing up their prices and thus further reducing risk premia. This process is largely disintermediated, but cannot be totally so. At the base of this leveraged system there has to be lending by banks. So bank credit has, at a world level, grown rapidly, and in consequence so has the global money supply.

The perception that macroeconomic risk has been abolished has also meant that countries whose firms and households have been saving much less than they have been investing (in housing and capital expenditures) have been able to behave as though their creditors (who, for the aggregate of U.S. firms, households and government, are foreigners, not least the monetary authorities of Asian countries) would never exercise their claims on the future income of those households and firms – and governments.

In the U.S. case, one might put forward flimsy arguments about the special geopolitical and financial status of the country. But even more blatant examples can be found in countries such as Spain. And that country faces what should be the additional disadvantage of not having its own currency and central bank, so that if ever market pricing did reflect an expectation that foreigners would exercise their claims, the result would not be currency depreciation, as it would be in the U.S. case – but recession, deflation and widespread default.

In short, the precarious equilibrium in the world, in which low long yields and fast growth of money and credit are necessary to keep on deferring the liquidation postponed in 2001, has created what looks very much like a Ponzi game, in which debtors simply roll over interest as well as principal.

Can this last forever?
In the United States, subprime problems and the housing meltdown suggest that it does not go on forever in any single sector. But the demand for underlying assets to support the credit derivatives and LBO booms – perhaps the fastest-growing source of financial sector earnings – keeps long yields low and boosts equity prices around the world, supporting both consumption and investment.

Central banks worry, but it may be too late
The biggest risk to this ongoing boom is that some central banks – though probably not the Fed – decide to call the party over for fear of inflation.

Low yields and fast money growth are necessary to defer liquidation – but no one can say a priori just how low or how fast. The European Central Bank or the Bank of England might look at rapid money growth and decide, on the basis of past relationships, that inflation is on its way. If they try to slow the growth of money, the whole financial boom in Britain and the euro area could collapse – and “carry trades” with it. Currencies such as the yen and the Swiss franc would subsequently jump in value against the pound and the euro. If the shock to financial market assumptions were great enough and risk aversion increased, the U.S. financial boom might itself collapse even without Fed tightening, sending the dollar, too, down against the currencies of surplus countries (and against gold).

If all that happened, central banks would rapidly turn tail, with the Fed in the vanguard. But if monetary loosening then succeeded in stabilizing the global economy, that would reinforce the market belief that central banks can never follow through on an attempt to halt the financial boom, for fear of allowing a tremendous crash and even provoking something like the 1930s depression.

But if the financial boom – and the associated Ponzi game – resumed (or, for that matter, were never interrupted), the assets held by creditor countries would ultimately become worthless. Many of those assets are held by countries such as China, Middle Eastern oil exporters, Russia, Norway and even Brazil – countries that account for a large proportion of global commodity production or control over it. For them to have to worry that their claims on future U.S. output might ultimately not be exercisable would pose serious questions for the globalized economic and financial system.

A grim choice: collapse or regulation
So, it seems, either the financial boom collapses, bringing capital liquidation, depression and, as in the 1930s, an end to globalization, or, more likely, central banks are forced to keep it rolling along – risking an end to globalization through a different route.

Is there a third possibility?

Yes, perhaps less bad than the others, but hardly welcome. The choice between depression and, in effect, debt repudiation is analogous to the problem, as expounded by Greenspan, of Fannie Mae and Freddie Mac. There is a distortion: in the Fannie/Freddie case, market belief in an implicit Treasury guarantee; in the broader case, market belief that central banks will have to keep yields and volatility low and asset prices high.

The ultimate effect of the distortion – an ever-increasing weight of Fannie and Freddie in U.S. financial markets; a Ponzi scheme and ultimate debt repudiation – are unacceptable; but the risks involved in removing it are, starting from here, judged too great.

Greenspan's answer in the Fannie/Freddie case looks likely in the end to be the answer of governments around the world to the global Ponzi scheme: regulation. In the local case, it would be regulation of the size of the Fannie/Freddie portfolios; in the global case, regulation of credit derivatives markets, of private-equity funds and hedge funds, and even of firm and household borrowing.

The tumor is inoperable, but fatal if nothing is done. Chemotherapy can halt the progression of the disease; but at the cost of severe damage to the overall health of the organism – the global free-market capitalist financial system.

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