Monday, September 14, 2009

Where do we go from here: "Old Normal" or "New Normal"

This NaviMap tells two stories. One, how overwhelming government funds were employed to rescue the near collapsing financial system and succeeded. Box 1, Box2, Box A. and Box B. The the story continues with Box 3. (increasing asset inflation) because once fear is driven out liquidity naturally seeks higher return.

Ideally policy makers are trying to achieve one or two virtuous loops of economic growth. This is the hope for reinforcing loop joining Box 2, 3, 4, 2 and/or 2, 3, 4, 5, 2. This is the return to the "old normal" as opposed to the low growth "new normal" PIMCO is planning to live with.

Most economists do not think it is possible to return to the old rate of economic growth any time soon. The hope of politicians is that the printed money would be successful at helping them grow out of their troubles. What is to prevent this from happening?

Firstly the amount of debt is just humongous. Secondly, the financial sector has gone far off the course from lubricating the wheels of commerce. Instead lot of bankers spend most of their time on how to obtain a bigger bonus, and how to pass the tab to someone else if things go wrong. That this misaligment of purposes can somehow end up achieving our socio-economic objectives defies imagination

If given the fairly narrow window of opportunity the two virtuous loops did not appear, then Box 7 will eventually appear. It will effectively abort any possibility for the virtuous loop. Central banks will be forced to drain the liquidity from the system the way Paul Volcker had done before. It would be an environment aptly described in PMICO's "new normal" scenario.

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