Does the Road to Global Serfdom Lie Ahead?
In the spring 2007 issue of CME Group Magazine, Bernard Connolly predicted the collapse of the global market boom. He was right. Here's why - along with his views on the implications of today's global financial crisis.
By Bernard Connolly Global Strategist, Banque AIG
In this magazine a year ago, I wrote that a complacent consensus held by the central banking, political, media and financial market worlds was totally wrong. I wrote that credit conditions that formed the "fundamentals" of the U.S. economy were likely to deteriorate dramatically, with profound effects both on the U.S. financial system and the worldwide real economy.
The U.S. and world economy had been massively distorted by then-Federal Reserve Chairman Alan Greenspan's mistaken reaction to the technological innovation and entrepreneurial dynamism transforming the U.S. economy in the mid-1990s. Greenspan rightly praised this free-market capitalism but totally misread the appropriate monetary policy response. A year ago, I warned that Greenspan unwittingly might have delivered free-market capitalism into the hands of its enemies. Sadly, that prediction was horribly accurate.
Has the financial crisis opened the door to world government? Now, we should have grave fears about the future organization of the global financial system and the global economy. It is clear that the U.S. authorities are prepared to do whatever it takes to fend off the risk of depression. Unfortunately, "whatever it takes" will be very unwelcome to all of us who recognize the moral and practical superiority of a free-market capitalist system. Those who do not admit that superiority are undoubtedly gleeful about the present mess. They see it as an opportunity to increase government control.
The global Financial Stability Forum, though a worthy body in itself, is seeking to issue instructions to the U.S. Securities and Exchange Commission and, ultimately, to Congress. British Prime Minister Gordon Brown is talking about a vision of "a global covenant... to build the truly global society." Brown and some European Union allies may even view the financial crisis as an opportunity to try to impose elements of the bureaucratic E.U. model on the United States.
In April, Greenspan wrote in the Financial Times that, "Free competitive markets are the unrivalled way to organize economies. We have tried regulation ranging from heavy to central planning. None meaningfully worked." He is absolutely right in that. But he ended, "Do we wish to retest the evidence?" There are many who wish to do precisely that, with a worrying risk that they will get their way. Why?
Has Greenspan killed free-market capitalism in the United States? I wrote a year ago that, "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." The tumor is a level of real long rates of interest far below reasonable guesses of the economy's potential growth rate. Greenspan wrote in April that "the dramatic fall in real long-term interest rates" between 2001 and 2006 created housing bubbles and thus a credit boom-bust in many countries. He is quite right. But he will no doubt claim that the reason long real rates fell was some alleged "global savings glut" and that Fed [Federal Reserve] policy had nothing to do with it.
The reality is very different. In March 2000, the Treasury inflation-protected securities (TIPS) curve was virtually flat at about 4.4 percent. In June 2007, the 10-year TIPS yield reached 2.83 percent. In both episodes, the peaks in long rates were "normal" somewhat above the expected trend rate of growth. But both were immediately followed by a burst bubble - NASDAQ in spring 2000, credit in summer 2007. In both episodes, long rates subsequently plunged - not because of a "global savings glut" but because markets became pessimistic about the U.S. economy's growth prospects.
The U.S. economy is still structurally excellent but simply cannot operate except with real long interest rates significantly below "normal." That conclusion is deeply disturbing - indeed, tragic. It implies that free-market capitalism no longer can work properly in the United States. The real long rate of interest is the single most important regulator of a capitalist economy. If it once goes seriously "wrong," getting it "right" again will be extremely painful and dangerous. The 1930s showed that, bringing a retreat from free markets even in the United States.
The Fed implicitly shares the judgment that the risks involved in trying to put real long rates "right" are just too horrible. But avoiding them requires real long rates to stay aberrantly low indefinitely, bringing misallocated capital, lower productivity growth, and depressed confidence about the future. Asset prices would have to go back to substantially overvalued levels to sustain U.S. domestic demand in line even with reduced potential growth rates. Without a new credit bubble, that will require real interest rates to move ever lower on a secular basis. The alternative is to allow U.S. real rates to normalize, but to offset the U.S. growth impact by encouraging further massive dollar depreciation. That is probably neither financially nor politically feasible, either for the United States or the rest of the world.
In short, the United States is, at best, likely to become an economy with inefficiently allocated capital, distorted risk-reward incentives, a low rate of productivity growth, inflated asset prices and ever-increasing financial vulnerability, all as part of a Ponzi game. Income-distribution questions will become more and more politically pointed. Even worse, this unsatisfactory outcome can be achieved only if the financial system is bailed out, possibly by taxpayers. In such circumstances, it is almost inevitable that financial regulation will become more intrusive, onerous and harmful to economic efficiency and economic freedom.
Euro-barbarians at the gate - but don't blame markets If there had not been a credit bubble, even lower real rates would have been needed. Those lower rates would have produced a credit bubble. Ponzi games and bubbles are symptoms of an underlying problem - distorted intertemporal price signals - for which central banks, not the private financial markets, are squarely to blame. It is pointless to worry about "price discovery" in financial or property markets unless the central banks are prepared to eliminate the underlying distortion. To do that, central banks would have to try to engineer a very sharp rise in real long rates - particularly in U.S. real long rates. That would be the most irresponsible action of all at this time.
Policy needs to find a middle way. At one extreme are the fundamentalists who abhor any government intervention, however dangerous the liquidation that could result. At the other extreme are those who want a more statist financial and economic system. The U.S. authorities should certainly take no notice of advice from Europe. Any unavoidable government intervention should be done by people who hate doing it, not by people who do it gleefully.
What we most admire in Greenspan is his devotion to free-market capitalism. He would be well-qualified to advise on the least harmful form of intervention. However, he now seems to have reverted to the fundamentalist camp. That is ironic, given his disastrous, anti-"Austrian" reluctance in the mid-1990s to prevent asset-price booms, which are clear indications of distorted intertemporal price signals. Did Greenspan's failure to act come from his close association with the preposterous novelist and philosopher Ayn Rand, who held the great Austrian-British economist Friedrich von Hayek in contempt for being insufficiently individualist and too open to an altruistic ethic that supposedly opened the door to collectivism?
Hayek identified and warned against the road to serfdom in the world. One has to hope that the journey will not turn out to have been routed from Rand via Greenspan.
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