The reopening of the fire hoses of credit and capital that occurred during the bubble years will happen again and intensify the boom-and-bust cycles. Driven by ever-more- desperate policymakers in the U.S., Europe and Japan, these cycles will both shorten and magnify. Political, policy and regulatory uncertainty will increase, and as a result, financial crises will become more frequent and costly, while risk aversion, volatility and uncertainty will rise. The illusions of the Great Moderation — a phrase coined by Harvard University economist James Stock to describe the two-decade period that started in the late ’80s, with its quasireligious embrace of market efficiency and infinite American power — will have created the era of the Great Financial Instability. And nothing could hasten the decline of American influence more than another self-inflicted catastrophe of global market capitalism.
Investors don’t even need to believe this; they just need to protect against it in order for it to start becoming self-fulfilling. The dot-com crash came from people taking too much risk, and was relatively harmless. The recent financial crisis was a consequence of too much risk-aversion — everybody piling into paper carrying the magical “AAA” branding. That kind of crisis is much more damaging. And risk-aversion is at least as prevalent now as it was during the Great Moderation: just look at the disconnect between fluffy bond prices and modest stock prices.
In order for capitalistic animal spirits, especially in fast-growing economies, to rescue us all from a series of horrible financial earthquakes, everybody’s going to have to become a lot less risk-averse. And I don’t see that happening any time soon.