Why the Great Moderation is a Great Big Lie

Yesterday, RBA Assistant Governor Guy Debelle spoke at the “Risk Australia Conference” in Sydney.

The one-day conference, which would have cost those interested, up to USD$2,800 to attend, was held at the plush surroundings of the Hilton Hotel in Sydney.

Among the sponsors of the “Risk Australia” conference was Credit Suisse. Credit Suisse, of course, is the Swiss banking firm that rejected the offer of a Swiss government bail-out in 2008, but which happily accepted USD$8.8 billion from “a small group of major global investors”, including – according to the New York Times – “the Qatari authorities.”

Nice risk management that is!

But that’s not the first time Credit Suisse has found itself in a spot of, erm, risk trouble. In 2002 the investment bank bailed out its own insurance firm, Winterthur Insurance to the tune of Sfr4 billion – about AUD$1.5 billion at the time.

And not to mention the indirect bailouts all banks – including Credit Suisse – have received over the last couple of years thanks to the involuntary financial support by taxpayers and the voluntary support by central bankers.

Take this report from the Wall Street Journal in February 2008 as a classic example:

“The banking industry, struggling to contain the fallout from the mortgage debacle, is urgently shopping proposals to Congress and the Bush administration that could shift some of the risk for troubled loans to the federal government.

In other words, the banks would get their money whatever happens. From the borrower if the loans didn’t go bad, or from the taxpayer if they did.

Although granted, Credit Suisse has come out of it smelling only slightly less worse than the other major Swiss banking firm UBS which required a direct cash injection by the government of Sfr6 billion.

Other sponsors at the Risk Australia conference included the admirable fellows at KPMG. You know KPMG. They were the mob that took a paycheque from the Australian government to say how marvellous the Resource Super Profits Tax (RSPT) was, and then took a paycheque from the Minerals Council to say how rubbish the RSPT was.

We’re certain risk played a large part in those reports. The risk of not getting paid if they didn’t write what their paymasters were after.

And to cap it off, well, who else would sponsor a risk conference than one of the firms that was involved with aiding and abetting the global financial meltdown – the credit ratings agencies. In this instance, it’s Moody’s.

According to the blurb on the Risk Australia website:

“Moody’s Analytics helps capital markets and credit risk management professionals worldwide respond to an evolving marketplace with confidence. The company offers unique tools and best practices for measuring and managing risk through expertise and experience in credit analysis, economic research and financial risk management.”

That would be the same Moody’s that gave top ratings to the subprime mortgage debt that was packaged and sold by investment banks to investors. Thanks for the analysis, but, er, no thanks.

Considering the event and considering who was attending – “investment banks, commercial banks, hedge funds, asset managers, lawyers, consultants and regulatory bodies” – it makes sense that Mr. Debelle would title his presentation, “On Risk and Uncertainty”.

So, what do we make of Debelle’s speech? Rubbish, that’s what we make of it. In fact, if we were Debelle’s commanding officer we’d rip off his sergeant’s stripes and bust him down to private.

Oh sure, it starts off as you’d expect, fairly pedestrian. Falling into the category of stating the blinding obvious:

“Risk was mis-assessed by financial institutions, risk managers, investors and regulators. There was a false comfort taken from a misplaced belief that risk was being accurately and appropriately measured.”

In other words, all the folks sat around him, munching on muffins and slurping percolator coffee, stuffed up.

He went on, possibly making the chaps at Moody’s Analytics feel slightly uncomfortable in their seats:

“To some extent, the technology provided risk managers with a false sense of security. Risk may have been accurately measured for the particular regime that the economy and financial markets were operating in. But the risk assessment was not robust to a regime change that took the models out of their comfort zone.”

And we’re sure the co-sponsors of the event, Numerix and Sophis, were equally fidgety. According to their blurbs:

“Numerix is the leading provider of cross-asset pricing and risk solutions for derivatives and structured products… [Numerix provides] speed and accuracy in valuing and managing the most sophisticated financial instruments.”

While:

“Sophis is a leading provider of cross-asset portfolio and risk management solutions for capital markets…”

Obviously Mr. Debelle couldn’t have been referring to these two fine companies when he said, “There was a false comfort taken from a misplaced belief that risk was being accurately and appropriately measured.”

No, he must have been referring to some other risk assessors.

But there was one thing that struck us as we read through Debelle’s presentation. And that was the singular absence of any reference to interest rates. OK, that’s not entirely true, he mentions interest rates once. But only to ask whether Brazil’s high interest rates during hyperinflation should be taken into account when measuring interest rate trends in Brazil.

Right then. Thanks for that.

So aside from that one irrelevant reference, not a single mention of interest rates is made. Not one. Which is strange when you considering that interest rates are perhaps the best signal of risk in any market.

How is it possible to talk about risk without mentioning interest rates?

I mean, it would be like not mentioning the jelly when describing to someone what a trifle looks like. It’s just plainly ridiculous to miss out the main ingredient.

But of course, there’s a reason why he wouldn’t mention interest rates isn’t there? Yes, that’s right. To mention interest rates would mean dragging the role of central bankers into the discussion.

Naturally enough, if you know the institution you work for is guilty of a crime against the economy the last thing you’re going to do is mention it.

But not only does Debelle not mention interest rates but he’s decided to kick-start the slide into revising history.

His use of the term the ‘Great Moderation’ is a perfect example.

What is the ‘Great Moderation’? We didn’t know, we hadn’t recalled hearing of it before. So we got onto our trusty friend, Google and asked it to help us out. According to our other friends, the folks at Wikipedia:

“The term was coined by Harvard economist James Stock in his 2002 paper, ‘Has the Business Cycle Changed and Why?’”

And would you believe it, it was also the title of a speech by… US Federal Reserve Governor Ben S. Bernanke in 2004. A speech in which the ‘Gov’, now chairman, is happy to take the credit for the supposed ‘Great Moderation’:

“My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation. In particular, I am not convinced that the decline in macroeconomic volatility of the past two decades was primarily the result of good luck…”

But aside from the self-congratulations, the term Great Moderation is surely the biggest misnomer going around. In a nutshell, Debelle, and Bernanke before him, are arguing that the 1990s and 2000s was a period of stability and low volatility, and dare we say it, lower risk.

The argument from Debelle is that this period of stability “lulled investors and risk managers into a false sense of security. The decline in volatility led many to conclude that a new, more stable, regime had been established.”

Including Mr. Bernanke if his 2004 speech is anything to go by.

But here’s where Debelle really does get his facts muddled, he claims:

“I do not subscribe to the somewhat Austrian view that the stability and decline in volatility sowed the seeds of its own destruction.”

By implication, Debelle is making the fallacious argument that the Austrian school of economics has argued that low volatility and stability are the cause of the current economic disaster.

Look, your editor won’t claim to be a scholar of the Austrian school, although we have read the odd book or two by Mises, Rothbard, Hayek and Block. But the idea that the Austrians have blamed the meltdown on a lack of volatility and increased stability is absurd.

What’s even more absurd is the use of the term Great Moderation to describe the 1990s and 2000s. Is he serious? Has Debelle not looked at the data compiled by his own organisation, the Reserve Bank of Australia?

Has he not seen the following chart:

You’ve seen it. We’ve printed it several times. It shows the increase in bank lending over the last thirty-odd years, with the big ramp-up beginning… yep, you guessed it from the early 1990s, the period of the so-called Great Moderation.

Has he not figured out that the investment banks were doing all their leveraging up during this period? I mean, it wasn’t as though subprime loans suddenly appeared on bank balance sheets in September 2008.

Of course they didn’t. Subprime loans and other dodgy financial instruments have been stewing on bank balance sheets for the last thirty years. During the heyday of the Great Moderation.

If he’s not convinced I’d suggest he spends $20 and reads Liar’s Poker. That should help him figure out when the trouble started.

Come on, let’s be serious, the 1980s, 1990s and 2000s wasn’t a period of great moderation at all. It was a period of the biggest credit-inspired drunken booze up in the history of mankind.

Banks and bankers gorging and drowning themselves on cheap, central bank induced debt and implicit government guarantees.

The 1980s through to the mid 2000s was when, as the Austrian economists rightly say the problems gathered place. Without necessarily speaking for those from the Austrian school, our reading of their argument is that it was the period of excess credit, easy money and artificially low interest rates – caused by governments and central banks – that led to the collapse of the financial system in 2008.

All of which happened from the 1980s onwards.

It wasn’t the apparent low volatility that they blame. It was the chronic and criminal mismanagement of interest rates and money that caused the problems.

For Debelle to misrepresent the Austrian position is very disingenuous, bordering on misleading.

But as we say, Debelle doesn’t see that it was the credit-party of the 1990s that has caused the problems. And Debelle doesn’t admit that central banks had any role to play in the economic meltdown.

And furthermore, he doesn’t admit that the US Federal Reserve and its low interest rate policy of the early 2000s was one of the direct causes of the meltdown.

The fact is, the ones that are sowing the seeds of the next economic disaster are the central bankers and the governments. The likes of Glenn Stevens, Ric Battelino and Guy Debelle at the RBA included. The current period of artificially low interest rates are now creating another set of problems.

And just as the central bankers didn’t recognise it during the so-called Great Moderation, they have completely failed to recognise it now.

If anyone seriously thinks the current economic mess is anywhere near the end, then they’re going to be shocked when they finally realise the worst is yet to come.

Cheers.
Kris Sayce
For Money Morning Australia