I just read Devil Take the Hindmost- A History of Financial Speculation by Edward Chancellor and I am rereading The Forgotten Depression- 1921: The Crash That Cured Itself by James Grant.
Speculative bubbles have been with us since the infancy of finance, we seem to repeat common mistakes although the terminology changes. Unlike wisdom in science which is cumulative; in economics and finance (not to be confused) it seems to be cyclical.
Bubbles are inflated by unrealistic projections and promises, sustained through hubris and fraud, and are brought back to earth with the exhaustion of real assets that can no longer support the promised returns. Reality returns with a vengeance. Illusions of newfound wisdom, paradigm shifts, unlimited growth, and other versions of ‘this time it’s different’ are shattered.
The government deficit and debt look like an inflating bubble but is also unique. Past bubbles were eventually punctured by firewalls; limits of some sort. Lyndon Johnsons refusal to choose guns or butter hit the wall of a gold standard and the fixed exchange rates of Bretton Woods. The government debt would hit a wall if nobody would buy it, and exactly who would buy zero interest bonds over the long haul. This would only make sense in the private market if every other asset or investment opportunity carried unacceptable risk. The debt is being bought by other sovereigns and agencies. This may explain why this money creation has not caused the inflation as historically expected. The low velocity counteracts the increased monetary volume.
It seems that this can go on indefinitely because we cannot envision the central banks losing control of interest rates, but absence of evidence is not evidence of absence. Believers in Modern Monetary Theory mistake this trend for a true principle. Central banks will remain active in controlling interest rates because the debt is so large that any spike in interest rates would be disastrous. We are stimulating a zombie economy reliant on low interest rates provided by a central government even more dependent on low interest rates.
James Grant in The Forgotten Depression notes that the Federal Reserve Act on 1913 created a central bank in the US for the first time since 1836. It was designed during a period of peace and prosperity and it immediately was faced with the massive disruption of WWI and the international monetary order. The Fed was soon called to buy Treasury Bonds, create credit and provide other services its founders wished to avoid. Inflation soon followed and its resolution brought the Depression of 1921.
We are now addicted to both economic growth and low interest rates. This dynamic has persisted in Japan for nearly three decades. Lower rates of growth make it hazardous to ever raise interest rates because the consumption of capital to pay higher interest costs would squeeze an economy already at anemic levels.
Record low interest rates are not a sign of a strong economy. Neither are record deficits at the top of an economic cycle. A 2% growth in GDP is anemic under these conditions. The real problem is out of control spending that neither party is willing to address.