Listen to Mr Greenspan - there's nothing so fragile as a bubble

William Keegan
Sunday March 11, 2007

Observer

After the January World Economic Forum I expressed some concern about the remarkable optimism - nay, complacency - manifested there about the course of the world economy. Earlier in the month I had quoted Herb Stein, an adviser to President Nixon in the 1970s (on economics, not burglary or cover-up). The quotation was: 'If something can't go on forever, it will probably stop.'
An alert reader challenged the 'probably' (which originated via an American economist 'correcting' Professor Wynne Godley, who had used the quotation without 'probably'), and sent me an article written by Stein himself, in which 'probably' does not appear, and 'cannot' (rather than 'can't') does.

You pays your money and you takes your choice. It often happens with famous quotations. Incidentally, Stein quotes Nixon as having once said: 'Honesty may not be the best policy, but is worth trying once in a while.' That may explain quite a lot. Anyway, Stein tells us that 'Stein's Law' was first pronounced in the 1980s, and elaborates thus: 'This proposition, arising first in a discussion of the balance-of-payments deficit, is a response to those who think that if something cannot go on forever, steps must be taken to stop it - even to stop it at once.'

The implication, I take it, is that policymakers don't necessarily have to do anything about what will stop anyway. One does not know whether former Federal Reserve chairman Alan Greenspan had this in mind when saying last week about the so-called 'carry trade' (the huge amounts of money converted from yen to other currencies to take advantage of differentials between interest rates, which have driven the yen down and made Japanese exports more competitive than ever) that 'at some point it's got to turn'. But recent shenanigans in the financial markets seem to indicate that riskier investments are not as popular as they were.

So far, most of my fellow commentators seem to be relaxed about stock markets and the outlook for the world economy, and dismissive of Greenspan's assessment that there is a possibility of a US recession later this year.

The difference between Greenspan now and Greenspan when the great man was chairman of the Fed is that he can now say what he thinks, as opposed to what he thinks he ought to say. The reason for the insouciance of many financial market operators and commentators is that there is an assumption that the central banks (considered all-powerful except by central bankers themselves) can be relied upon to bail the US and other economies out as soon as trouble appears. There is empirical evidence for this in the past decade, and it is quite a contrast with the pre-Keynesian days of the inter-war years.

This is all very well as long as the central banks do not panic about inflation. There has been precious little reason to do so in recent years, because the weakening of the unions and the impact of 'globalisation' have together produced what is known in the trade as a 'benign' inflationary environment. Why, in Japan they have even been trying, without much tangible success, to inject a little inflation into the system.

As Professor Lord Desai puts it in his compulsively readable Marx's Revenge - The Resurgence of Capitalism and the Death of Statist Socialism: 'Democratic power can push the bargaining strength of the worker up to a certain point. If it threatens profitability too much, then capital withdraws or migrates .... Social-democratic parties everywhere [at the end of the 1980s] saw that restoration of profitability mattered once capital became mobile. But once it had become mobile, it demanded co-operation from the workers, not conflict. And it got that co-operation.'

It has become clear in recent months that trade unions are beginning to think they have been far too co-operative. One sees this in the bitter outbursts about the behaviour of hedge funds, private equity groups and senior corporate executives by such models of moderate trade unionism as John Monks, former general secretary of the TUC and now representing the much wider group of European trade unions.

One also sees it in the sporadic outbursts of discontent about low wage deals, not least in the UK public sector. But apart from the factors highlighted by Desai (whose book was published in 2002), we have witnessed the additional disinflationary factor in recent years of the remarkable influx of Continental workers to the UK - and not just from eastern Europe. French is rapidly becoming London's second language.

The small inflationary bubble of recent months has been associated with the lagged impact of earlier rises in the price of energy. Now the prospect is of lower energy prices later this year, and, according to the Governor of the Bank of England, Mervyn King, there is the possibility of quite a sharp fall in inflation. Yet there continue to be noticeable worries among central bankers about 'asset bubbles' - not least in housing.

A vogue phrase among financial regulators has been 'the underpricing of risk'. The convenient reaction to recent upheavals in the financial markets is that there has been a 'healthy and necessary correction'. Has been? All over? One wonders. The problem with the modern phenomenon whereby it is assumed that the central banks will always bail the system out is that there is an inherent bias in favour of bubbles and the traditional excesses of capitalism. There is an uneasy feeling in the air that all is not quite right.

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