The investment landscape appears tranquil. Global equity markets are trading near all-time highs. Bond yields have stopped falling. Currency markets are calm. The market’s ‘fear signal’, implied equity volatility, is trending lower, a sign that investors don’t anticipate ructions.
Yet fault lines typically run miles below the surface, hidden from view. Occasional tremors remind us of their presence and can even evoke fears of ‘the big one’.
Economies and markets have fault lines, too. They can take many forms. In the 1960s and 1970s, excessive government spending and lax monetary policies erupted into high inflation. From the mid 1980s until 2008, unfettered borrowing and questionable financial practices precipitated the market crises of 1987, 1992, 1995, 2001 and ‘the big one’ of 2007-2008. Last year, a pandemic exposed fragilities of inadequate public health provision.
In many cases, small quakes precede bigger ones. Those fractures contain valuable information about what lurks beneath. Often, a few observers see the ground shifting. But for the rest, the tremors are small enough to be ignored—sometimes at great cost.
In his American Economic Association presidential address in 1968, Milton Friedman highlighted how flawed economic analysis and misguided public policy could result in surging inflation, which duly came to pass in the following decade. In the early 1990s, Alwyn Young noted that the Asian growth ‘miracle’ was built on excessive investment, a vulnerability exposed by the 1997 Thai baht devaluation and ensuing waves of emerging market crises.
In relative obscurity, economist Hyman Minksy spent a career building a thesis that stability leads to instability. His work went unheeded by most financial professionals, including in the 1990s by the brain trust behind Long Term Capital Management, whose models failed to recognize that by applying massive leverage they would create catastrophic instability, ultimately to the demise of their firm. Minsky was also ignored by exuberant bankers and homeowners, as well as overly confident central bankers, who participated in, or idly stood by, in the run-up to the largest ‘Minksy moment’ of our lifetimes – the 2007-2008 global financial crisis.
Today, underneath the calm surface of the world economy and markets, a myriad of seemingly unrelated vibrations is gathering — a global pandemic, unprecedented biodiversity loss and climate change, populism, anti-globalization, and the rise of authoritarianism. Or perhaps, as the historian Niall Ferguson has recently pointed out, they manifest a common fault line, one that challenges the viability of society, its norms, and its rules.
All markets, including financial markets, are rooted in trust, ultimately backed up by the rule of law. Buyers and sellers meet to exchange goods and services, in the expectation that commitments will be honored. Courts offer recourse for enforcement in the event of non-delivery, but when markets function properly relatively few cases burden the legal system.
Yet while law underpins markets, law arises from government. In democracy, law reflects the consent of the governed. In autocracy, law reflects the will of the powerful. Since the rise of liberalism and democracy in the 18th century, democracies and even many autocracies have found it useful to support markets by establishing norms, rules of conduct, and laws that protect property rights and support the liberty to trade.
Yet democracy, based on the principle of one person, one vote, sits uncomfortably alongside capitalism, where ‘voting’ power is proportionate to income or wealth. Autocrats govern by the tip of the bayonet and may resent, or even fear, the power of accumulated capital. Capitalism creates the prosperity that liberalism craves, as well as the economic power that strengthens the autocrat’s hand. But capitalism also rivals the authority of those who govern it.
In normal times, governance appears robust, but history suggests it is fragile. World War I shattered illusions of balance of power, globalization, colonialism, and empire. In the 1920s and 1930s, communism and fascism decimated the ideals of Wilsonian democracy. None of those cataclysmic outcomes was foreseen by markets, even though some contemporaries—above all John Maynard Keynes (The Economic Consequences of the Peace)—felt the tremors.
Brexit, Trumpism, authoritarian China, vaccine skepticism, and climate change denial are the contemporary tremors of a world that has lost faith in the moorings of the enlightenment—democracy, freedom, the scientific method, empiricism, and economic liberalism.
Globalization, the most effective anti-poverty ‘program’ in human history, is now pilloried. President Biden is eager to undo many of Trump’s policies, with the notable exception of restoring the US as the hegemonic leader of free trade. Xi Jinping’s China has gone beyond suppressing political dissent—it can no longer tolerate economic or financial rivalry to its supreme power. Great Britain sees itself, once again, as outside Europe, despite its immense historical, cultural, economic, and financial ties to the continent. Europe is in the throes of its own political change, with rivals bickering over the small stuff, seemingly oblivious to the risks posed by autocracy to its East and demagoguery within.
And yet, asset prices appreciate, underpinned by strong corporate earnings and monetary policy, driving low borrowing costs. Equities enjoy the privilege of being the only asset offering positive returns net of inflation. Stability, as Minksy might have put it, offers the reassurance of stability. Tremors are simply opportunities to buy more equities at cheaper prices.
Perhaps this is justified. Perhaps enlightenment rationality will prevail. Data and logic may win over vaccine skeptics. Democracies and autocracies may gently curb the excesses of capitalism, without doing excessive harm. The commons may become our focal point just in time to limit the near-existential threats of biodiversity loss or climate change.
Or maybe not.
The past renders few verdicts for what the future may look like. Change is sometimes evolutionary, sometimes revolutionary. Continuity is not a given, abrupt shifts are not uncommon.
The ideas of Keynes, Friedman, Minsky, Young, and Ferguson have little in common. They did not tread the same political, economic, or ideological ground. But they shared something arguably more important. They knew when to listen, when to look. And they knew not to ignore what they heard and saw.
Markets behave today as though normality will persist. We hope they are right. But hope is not a strategy—prudence demands that we observe, listen, and retain healthy respect for what could go wrong.