Will ‘The Big Change’ Macro Theory Go Bust?

In “Trial By Fire: Are Corporate Profits About To Plunge?” I made a casual observation about the size of earnings declines witnessed during recent recessions.

Outsized EPS drops in 2001, 2008 and 2020 don’t suggest we’ve been particularly successful in “smoothing out” the business cycle. You can have a look for yourself in the linked article, but long story short, peak-to-trough earnings declines are getting larger and the rebounds more cartoonish.

There’s widespread agreement that the latitude afforded to central bankers by the firewall between monetary policy and politics in most advanced economies has led to better economic outcomes, where “better” is almost always defined in terms of lower macro volatility and a less cyclical cycle, if you will.

I don’t disagree. Central bank independence is probably a good thing, and while it’s obviously not the case that the Fed, or any other developed market monetary authority for that matter, is completely immune to political pressure, the US isn’t Erdogan’s Turkey. There is a wall between the executive and the central bank, porous though it may sometimes be. If you wanted to argue that developed markets would be better off reverting to overtly politicized monetary policy, the burden of proof would rest squarely on your shoulders.

The figure (below), is a 30,000-foot view of macro volatility over the past century. Goldman this month described the period from the 1980s to 2020 as the “Modern Cycle.”

“Geopolitical tensions eased and supply side reforms accompanied waves of deregulation, the end of capital controls, deeper capital markets and stronger world trade growth,” Peter Oppenheimer wrote, of the last four decades, adding that “a new era of globalization drove profit shares of GDP to record highs [and] independent central banks and forward guidance contributed to longer and less volatile economic cycles.”

Most of that is true. It’s just a retelling of the hyper-globalization years and a recap of the Great Moderation. Within that story, I often wonder if we give central banks too much credit. In the grand scheme of things — taking account of well-documented trends in demographics, debt and technology, as well as the disinflationary impact of wave after wave of globalization — it’s not obvious that central banks deserve anything more than a polite acknowledgement in a footnote.

Paul Volcker beat inflation into submission with a blunt object, he didn’t finesse it lower by way of strategic brilliance. An alternative history of central banks’ contribution to disinflation thereafter might assign more credit to the spectacular busts they inadvertently facilitated than to political independence, forward guidance or inflation targeting.

Goldman certainly didn’t suggest any such interpretation, but Oppenheimer wrote that (emphasis mine),

The downward trend in inflation, aided by the move towards independent central banks and inflation targets in the 1990s, accelerated following the collapse of the technology bubble in 2000 and the entry of China into the WTO in 2001. Inflation took another leg down following the financial crisis in 2008 which, with the deleveraging of the private sector, prompted another major negative demand shock.

While I’m loath to assign all the blame for the dot-com bust and the subprime crisis to the Fed, they certainly share some of the blame.

Letting it all burn so every last vestige of misallocated capital is purged and the system can be rebuilt in the “correct” proportions from the ground up isn’t an option in modernity. So, each crisis is met with a forceful policy response. If the last three crises are any indication, the amplitude of the policy response is destined to be larger each time, precipitating even larger bubbles with every turn.

Deutsche Bank’s Aleksandar Kocic talked about that in 2017. Bubbles are subsumed by bigger bubbles, until the damage from the most recent bust becomes irreparable.

Arguably, central banks’ (and in particular the Fed’s) response to the pandemic, however well-meaning, facilitated one of the largest asset bubbles in recorded history. All recorded history.

Currently, consensus expects a prolonged period of elevated inflation, generalized scarcity and higher yields. But if this really is the most spectacular bubble in modern world history, why should its demise not be accompanied by an equally spectacular negative demand shock? And all the disinflation that comes with it?

There are answers aplenty. Between the war, the lingering effects of the pandemic and the energy crunch, the world is experiencing an acute negative supply shock. Labor is getting more expensive, not less. We’re “entering a period of more regulation, bigger government, higher taxes and potentially lower profit shares of GDP,” Goldman wrote, on the way to suggesting the world is also “entering an era of greater regionalization,” more on-shoring and persistent geopolitical tensions.

BofA tells a similar story. “The larger story of the 2020s is higher inflation, higher rates, higher volatility and lower asset valuations, driven by trends in society (inequality), politics (populism/progressivism), geopolitics (war), the environment (net-zero) and the economy (de-globalization),” the bank said last week.

Goldman calls their version “The Postmodern Cycle.” BofA calls theirs “The Big Change” (see the familiar figure above). Zoltan Pozsar has several iterations of a “new world order.”

Whatever you want to call it, the thesis seems irrefutable. Self-evident, even. But, as the old saying goes, it’s tough to make predictions, especially about the future. What seems obvious today often seems obviously ridiculous a few years later when, without irony, we chastise ourselves for not recognizing the obvious. “Of course the pandemic was inflationary,” we say, in 2022.

So, in the interest of having at least one article to which I can refer in the event what seems obvious turns out to be wholly misguided, I’ll ask again: If we really did just witness the most spectacular asset bubble in modern world history, why should its demise not be accompanied by an equally spectacular negative demand shock? Will the factors listed under the “2020s” column in the figure (above) be sufficiently powerful to offset the bursting of what Jeremy Grantham has called a “superbubble”? Complicating matters, the fallout from such an event would surely invigorate some “Big Change” catalysts (e.g., redistribution) while negating others entirely.

The point here is straightforward, even as I’ve taken a characteristically circuitous route to make it. Whether you call it “The Postmodern Cycle,” a “new world order” or simply “The Big Change,” virtually every bank and economist on Earth has adopted some version of the same general macro outlook. And consensus is never wrong, right?