At the 64th CFA Institute Annual Conference in Edinburgh last week, Gavyn Davies, chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners, delivered an eloquent analysis of economic theory before, during, and after the credit crisis. Policymakers’ response to the crisis prevented the “Great Recession” from turning into an outright depression, Davies argued, and in the process upended the conventional economic wisdom at the time. The challenge now, he said, is returning to a sustainable growth path. The combination of fiscal and monetary policy might well pave the way, he told delegates, “but there is still a huge challenge ahead.”
To say that economists were blindsided by the credit crisis would be an understatement, Davies argued. The general consensus in the pre-crisis era was that economies were best managed by monetarist policies. The belief that markets were rational, financial regulation should be light, and central banks should set interest rates while the market sets the money supply had taken hold. Keynesian economics and its focus on fiscal policy had fallen by the wayside. But when the so-called NICE decade of “Non-Inflationary Consistent Expansion” ended in 2007 with the onset of the subprime market debacle, this monetarist consensus collapsed in a “profound shock,” said Davies, a former chief economist at Goldman Sachs and a past adviser to both the U.K. prime minister and HM Treasury.
Market participants should have paid more attention to the teachings of Hyman Minsky, Davies argued. Minsky, an American economist, postulated that stable markets create insatiable markets. This observation was borne out by the increasing risk tolerance displayed by investors throughout the 2000s, fueled in part by the belief that financial “innovation” had spread risk across the financial system. As we now know, this false sense of stability encouraged risk to build to unsustainable levels — and the deregulated financial system turned out to be far more dangerous than investors and regulators had assumed. (For a prescient take on the lessons of Hyman Minsky, read “Ponzi Nation” by Edward Chancellor.)
As central banks responded to the crisis over the past three years, their balance sheets have swelled. Meanwhile, government budgets are in turmoil as the advanced economies struggle to return to sustainable growth amid private sector deleveraging. Davies noted that Japan’s stagnant economy is weighed down mostly by corporate deleveraging. The EU and U.S. economies, conversely, are challenged by household deleveraging.
Davies believes the threat of inflation is not imminent because most of the liquidity provided by central banks to commercial banks still remains in the financial system. Fiscal tightening is by far the biggest exit strategy challenge facing both the EU and U.S. economies, he contended. For its part, the U.S. needs to cut spending by over 10% of GDP by 2020 in order to reduce its public debt ratios. Economic studies suggest public debt ratios exceeding 90% of GDP cause long-term economic problems. The U.S., U.K., and EU are all currently at those levels — and will either stay there or move higher in the coming years, he said.
What is the biggest risk to the global recovery? It’s the possibility that China might stop purchasing U.S. debt, Davies contended. However, he noted that it is not in China’s national interest to precipitate a U.S. debt crisis.