Back to Normal Financial Times

Just under 10 years ago much of the world economy fell into a great recession. Things are finally starting to get back to normal.

What ensued after the collapse of Lehman Brothers was one of the greatest policy experiments in a hundred years. The experiment was the fruit of assiduous study of the world wide depression that started after another financial cataclysm, namely the stock market crash which began on October 24, 1929.

At the time of what in Australia became known as the Global Financial Crisis (GFC), the Federal Reserve in the United States of America had as its president an academic who had spent much of his career studying the great depression. He did this in some of the finest universities in the US with the final one being Princeton. His name was Ben Bernanke.

His great insight was to figure out how to mitigate the impact of the ravages of one of the greatest recessions that the US economy has had to contend with. The approach he used was to attempt to quarantine it to the financial economy rather than let it spread to the real economy.

Although there have been many derisive words spoken and written about mountains of debt, bubbles and the distortions to asset prices wrought by quantitative easing it is much better to have to contend with the fallout of these things than the sheer human misery that comes with having up to half of the working age population out of work. To get a feeling of the misery that accompanies staggeringly high unemployment simply read one of the great American Classics – The Grapes of Wrath. This is what the world was looking down the barrel of nearly a decade ago.

The essential contribution towards minimising the impact of the great recession as it has been coined in the US was to figure out what to do when you would like to lower interest rates but they are already at zero percent.

The method used to achieve the desired outcome has come to be known as quantitative easing. It is a method of stimulating the real economy that works in a far less direct route than the traditional method of lowering short term interest rates. It aims to lower long term interest rates and requires a great deal more interference in financial markets to get a result.

A complicating factor is that it had never been tried before so the amount of interference that would be required was unknown. Experience would be no guide in implementing this policy so someone with a good grasp of the theory of how it works needed to be in charge. Luckily that just happened to be the case. Long term interest rates came down this played an important role in arresting the deterioration in the real economy.

A year or so ago the decision was made to start reversing this policy in a gradual way. Weeks ago the financial markets started to see the reversal show up in the data and reacted to it. The yield on long term US government bonds rose to a level that led the bond markets to believe that the long term decline that had been occurring in bond yields had reversed and interest rates were on their way up in a fundamental way. It was taken as a signal that the fall in bond yields that began many years before the global financial crisis had come to an end.

There is finally the prospect that a risk free rate of return will be available to financial markets in order to help them properly price financial assets.  Market participants will be able to opt out of purchasing risky assets in the chase for a return on their funds and simply settle for a lower but positive risk free rate of return.

This is analogous to the breaking of a drought. The consequences for the management of economies will be profound. It is also a time of caution. The most demoralising time in a drought is the day before it rains because you don’t know when it will end. The most dangerous time is the day it rains because those left standing are feeble and now they have to summon up the strength to walk through the mud and the flood waters while waiting for the green shoots to arrive.

In real terms it means that those who are the fittest in terms of the costs they carry and the debt they have taken on will survive to prosper into the future. Those who have taken on an excessive burden of debt when the cost of carrying it was negligible will be sorely tested as interest rates start going back to normal. The rate at which they go back to normal will be critical. With the US starting to undertake an immense stimulation of its economy by way of a massive reduction in its tax rate it may be a case of moving from drought to flooding rain in fairly quick time.

Welcome back to normal times.