The financial crisis that many believe we have just come through is one of those episodes in history after which nothing quite remains the same. At the highest level it will change the way we look at financial markets; at the role of the government in the functioning of markets; even at the independence of one of our most venerated institutions, the US Federal Reserve.
At a more personal level it will transform the way we manage our investments by forcing us to shield our portfolios from the effects of a shifting macro landscape. Yet as we come to grips with the real nature of this crisis we do not have to adopt a defensive posture. But first, we must open our eyes to what's really happening.
We are misdiagnosing the crisis as fundamentally as economists and policymakers misdiagnosed the Great Depression eighty years ago. How so? The response led by the Bernanke Fed – and by every other major central bank in the developed world – is to treat it as if it were a large-scale banking crisis. Restore the solvency of the banking system, these policymakers say, and we will be on our way to recovery.
This not enough. In fact, it demonstrates a failure to understand the root cause of this crisis. In a global economy the notion of a business cycle needs to be restructured so radically as to view production as something resembling a long assembly line traversing national borders with commodities and raw material at one end and services at the other end.
I call this a SuperCycle and when we view the peaks and troughs of the global economy in this way we notice that booms and busts travel through the pipeline with booms building on busts sequentially. The busts in turn leave a strong deflationary tendency in that part of the pipeline.
Well, the rolling deflation has now reached the services end of the production pipeline, which is where economies like the US and the UK sit. In these economies financial services play a particularly large role, employing a large number of workers and also lending to them. The boom in these economies gave rise to huge excesses, and now the forces of deflation are producing a ferocious drag.
The US Fed's preferred approach of putting a safety net under the banking system is a necessary but hardly sufficient condition to achieve a turnaround. In fact, it will give us an outcome more like that of Japan since the early 1990s – several decades of near-stagnation, getting a lift every time the currency weakens and foreign demand picks up.
Interestingly, that is exactly how the US economy has behaved. The feeble, jobless growth that we have seen in the last two quarters of 2009 has been wholly dependent on a weak dollar.
The only way to counter the forces of deflation is to actively follow a pro-inflation monetary policy. This means sacrificing the independence of the central banks in places like the US and UK. The risk is that we won't. If so, then we should be prepared for a fate very much like Japan's.
So then inflation should be in our future, but there is a risk that a Japan-like deflation will be instead. How do we arm ourselves for those two outcomes – and to that we may wish to add a third one as well where a confused response by policymakers gives us stagflation instead?
Inflation, though horrifying as it seems to us now, is the better outcome. It helps debtors, hurts creditors. That is good because our debt overhang is what's weighing us down.
Deflation and stagflation, on the other hand, are the worst results. The former, as we know from the Japanese experience, means that we will be content with zero returns since prices are negative, while stagflation is the most difficult to protect against.
So whichever outcome we get the challenges that will face us will be unlike anything we have experienced in the recent past. Errors will be severely punished but getting it right will bring substantial rewards.