Should we continue to live with the assumptions that we have lived with so far?

The dotcom bubble was formed in part and legitimized in the public eye because of the implicit narrative in people’s minds about the benefits of technology. The valuations soared higher than the value they provided and become speculative in nature. The asset price increases in turn, increased the wealth on paper but soon it become removed to its fundamentals. The underlying assumption was regarding the benefits of internet and technology that will be accrued.

The global financial crisis was due to asset price increases fuelled by the increase in mortgage debt and low interest rates. The market relied on the implicit assumption that house prices will go up and the underwriting standards for the loans made are good. Ben Bernanke had remarked in an interview that house prices have never gone down on a nationwide basis but may slow down.

The global financial crisis led to an increase in risk profile of all countries and triggered crises across the world. This sparked a rush towards safe assets i.e. U.S treasuries. The yield on US treasuries is low because of its low perceived risk. Thus, the implicit assumption here is that the U.S treasuries is the safest asset and dollar is the reserve currency due to the quality of investable assets in US and liquidity of US treasuries.

When we take debt it is against future output that we borrow. The future economic condition will dictate our ability to pay and so the perceived risk profile in the eyes of the lender will rise as growth stagnates. So a lot depends on the confidence of the lender to get back his money. If the debt is of short maturity, then the situation gets more difficult as the debt has to be rolled over.

Investors all over the world relied on the economics of the Federal Reserve and believed that a recovery is around the corner. The Federal Reserve was able to embark on a lot of quantitative easing and the interest rates were low for a long time. This low interest rate was possible because the world was accepting low yields of the US treasuries due to low risk profile and reserve currency status. The Federal Reserve’s actions have led to one of the weakest “recovery” on the records and even Alan Greenspan now says increased government spending has crowded out private investment and led to slower economic growth1.

While the Federal Reserve has been announcing since the spring of 2013 that there would be rate hikes, we have seen only one rate hike and the whole market narrative and focus has shifted on whether the Federal Reserve is dovish or hawkish and not observing the fundamentals. It is worth remembering Goodharts law that says when a measure becomes a target it ceases to be a good measure. When we look at the yield curve for information about what the market is expecting to happen to the US economy. We should keep in mind that because the Federal Reserve is through its policies affecting the yield curve so it may not represent the true picture. The US economy is a networked economy and so has properties of a complex system2.

Chart 1: Complex System3

A complex system can be extremely robust as well as fragile at the same time. The current economic system is a highly networked economy and thus susceptible to formation of feedback loops which amplify responses to events in the market. The amplification works in a way so as to reinforce a trend through feedback loops until it reaches a critical point. The system is extremely robust as it can sustain positive or negative trends beyond its existence through feedback loops for a long time until it reaches a critical phase transition point. But, once it reaches this critical point it can extremely fragile as the opposite trend can be reinforced and amplified in the complex system. This complex system has been observed everywhere in nature and all sciences and it would be arrogant to think humans are exempt from it. The other property of such a system is that connections between agents in such a system expand by more than increase in size of the system. Thus risk in such a system increases non linearly making the system fragile.

One needs to just observe what happened to the run up to the Global financial crisis, as the system looked the most robust the crisis hit. It is similar to the phase transition of water at 373 kelvins. At temperatures below 373 kelvins and even at 372 kelvins the water is in liquid state, but once we have that 1 kelvin increase the system reaches its critical point water turns into steam. Similarly, once certain beliefs about the trajectory of the US economy changes the cost of raising funds for the Federal Reserve will increase. Before we reach the critical point we will observe as to how robust the system is and even news adverse to the US economy will not have the intended impacts reinforcing the image of strength and ressilience of the US economy.

As Hyman Minsky had rightly said stability leads to instability, the stability provided to the US based on the implicit assumption in the minds of the investors about US being the reserve currency and US treasuries being the safest asset is what will ultimately create instability.

Chart 2: GDP estimates vs actual for 2011-20174.

The long run GDP growth forecast has been lowered to 1.8% from 2% by the Federal Reserve5. Keeping in mind the Federal reserve track record of forecasting the GDP growth rate it is safe assume that the above figure might still be an overestimation. The consistent negative news about the American economy has potential to trigger the feedback loops in the reverse direction as confidence in the ability of US to pay back its debt decreases. One can say that the probability of a fat tail event that may trigger loss in confidence in the US has increased significantly.


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