"?Repeating the Future
Having studied engineering and finance in college and graduate school, the last history class I took was my senior year of high school "“ U.S. history, with Mrs. Horgan. I remember class discussions about mistakes past leaders had made and becoming quite pleased with myself: "I would never make those mistakes. I know history and would surely do better". I don't think I was alone in my overconfidence. Implicit in Edmund Burke's famous line is that people who do know history will avoid repeating it. They are wise. They can view what has happened in the past, and project it into the future. Recognizing potential pitfalls, they will succeed where earlier generations failed.
But this leads me to a question that philosophers have debated "“ and Hollywood has exploited "“ for years: If we could see the future, would we be bound to it? Would we be able to change course to materially affect the outcome?
Remember the Terminator series of movies about a woman, Sarah Connor, who learns that machines controlled by a military computer system, Skynet, take over the planet in the future? She tries desperately to stop it from happening. Yet, despite all of her efforts, she fails. The machines take over the planet.
Is it possible that certain events have already happened that have put us on a path whose destination we can not alter, despite all of our wisdom and effort?
Perhaps the historical leaders that Mrs. Horgan taught us about who made those mistakes didn't simply lack wisdom. Perhaps they were trying to prevent an outcome that was rendered unavoidable based on decisions and events that had already taken place. Perhaps with all the knowledge we have gained in the ensuing decades we could have done no better.
Today, economists studying the Great Depression are quick to identify obvious policy mistakes: The Federal Reserve raised interest rates when it should have kept them low. Congress passed the Smoot-Hawley Tariff Act enacting trade barriers when it should have encouraged free trade. With all that we know now, we tell ourselves that the Great Depression wouldn't have been so great.
Experts look at Japan, their real estate bubble, banking crisis, and lost decade of no growth and deflation and conclude Japanese policymakers were timid. The Bank of Japan should have been much more aggressive to battle deflation. Knowing what we know now, we wouldn't have made those mistakes. Japan's lost decade was avoidable, we tell ourselves.
Perhaps.
Or perhaps in each case there were a series of events, conditions, and constraints that predetermined the outcome. Perhaps the wisest people today, transported to the past, wouldn't have done much better. Perhaps when society massively misallocates its resources, profound economic consequences inevitably follow.
Perhaps today policymakers are trying desperately to prevent a painful economic adjustment that is likely inevitable after our society spent some 30 years accumulating debt to fuel consumption, rather than saving to drive investment. Perhaps the housing bubble and resulting financial crisis was largely unavoidable given our culture of debt. Perhaps the ballooning of our government's balance sheet was inevitable in response to the crisis. Perhaps we really are in for a lengthy, multi-year period of slow growth and private sector deleveraging, and there are no policy tools to prevent that from happening.
Washington has certainly tried to prevent it: Quantitative Easing. Stimulus. Cash for Clunkers. Homebuyer tax credits. None have led to sustainable economic growth.
Is this really surprising? It is easy to generate strong economic growth when we are borrowing money to boost consumption. But now the private sector is paying down debt -- a good thing, yet it results in slower economic growth, and painful, sustained unemployment. How could we expect a short-term boost of government spending (of virtually any magnitude) to make up for a long-term reduction in private sector demand?
The economy needs to continue adjusting, and frantic activity by policymakers won't change that, any more than Sarah Conner's years of planning were able to stop Skynet.
In their comprehensive historical review of financial crises, This Time is Different, Ken Rogoff and Carmen Reinhart document that financial crises often lead to sovereign debt crises, as governments borrow heavily to try to mitigate the fallout. Governments often default on their obligations, either explicitly, by not paying back creditors on time, or implicitly, by devaluing their currency or inflation. Economies then go through five- to ten-year adjustment periods causing severe hardship for their citizens until debts are worked off and sustainable growth restored.
Today the Federal Reserve continues to pursue aggressive policies to meet its dual objectives of price stability and maximum employment. Operation Twist is its latest initiative. With unemployment stuck at 9%, its aggressiveness is understandable. Chairman Bernanke has been clear that the Federal Reserve will not inflate away America's debts. He will be aggressive so long as inflation expectations remain anchored.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011, PIMCO.
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