What Philip Larkin tells us about Central Bankers

Sometime in the coming autumn, or “Fall” as Americans call it, perhaps more appropriately, the US Government’s total debt will exceed 100% of US GDP for only the second first time in history (see the chart below). Furthermore, taking into account the recent stimulus and the prospect of more to come, it seems likely that by the end of 2022, US Government debt will reach nearer 125% of GDP. This is an extraordinary, unprecedented and unwelcome milestone.

Larkin 1

At the same time, US stocks markets continue to trade close to, or at, their all-time highs. There is a relationship between these two measures and Central Bankers provide the link.

Almost twenty-four years ago, while addressing the American Enterprise Institute as an after- dinner speaker, Alan Greenspan, who at that time was Chairman of the US Federal Reserve Bank, posed a question that has become part of financial markets folklore: “how do we know when irrational exuberance has unduly escalated asset values…?”. We will return to this connection shortly but before we do, it is worth reflecting on what happened after Greenspan made his speech.

The Japanese markets were already open when Greenspan was speaking and moved sharply downwards, losing about 3% of their value. However, the day after Greenspan made his comments, US stock markets barely moved: The Dow Jones Industrials Index drifted off slightly to close at 6,382, the S&P 500 closed a shade down at 740 and, NASDAQ, the Technology-stock orientated index, closed just 12 points lower at 1,288. Over the following four years, NASDAQ went on to rise by almost 400%, peaking at just under 5,000. It took until March 2001 before it began its spectacular crash. Soon afterwards (prompted by another dose of Fed stimulus) it resumed its upward path.

Today, the comparable figures for the Dow Jones Industrials, the S&P 500 and NASDAQ are: 25,016, 3,009 and 9,757, equating to increases of 391%, 407% and 757% respectively since Greenspan first uttered his famous phrase. These are enormous increases: in a period stretching comfortably in excess of 20 years, the compound annual growth rate for the S&P 500 approximates to 9%. This is somewhere between 30% and 50% in excess of the estimated average equity risk premium of 6-7% over the past hundred years. It seems genuinely astonishing that in an era that included the Dot.com crash, the Global Financial Crisis and now, the worst pandemic since 1918, we have witnessed one of the most remarkable rises in equity markets ever recorded - the chart below illustrates the scale of this nicely.

Larkin 2

If Alan Greenspan was concerned with the ‘irrational exuberance’ of stock markets back in December 1996, what might he be thinking now? And do the returns of the past quarter century provide evidence of the ‘irrational exuberance’ to which Greenspan referred? If so, why have equities behaved like this? Put (only slightly) simplistically the answer is that, if Central Bankers cut interest rates and flood the market with liquidity then all that new money must find a place to go. For the past twenty-five years, it has found its way into stock markets. Call it whatever you like, what is indisputable is that Central Bankers, starting with Greenspan, provided the environment and the means for these rises.

By putting a floor under markets, Greenspan created a precedent for subsequent policy mistakes, and with it, incalculably high levels of moral hazard. We are still living with the effects. Greenspan will, most likely, be memorialised in Economic History books for “The Greenspan Put” which enabled generations of financiers to rely on Central Banks coming to their aid at inappropriate moments. When the numbers were relatively small, this was reversible. It isn’t so easy, or possible, today. That’s the problem with debt: when you owe a little, it’s your problem, when you owe a lot, its everyone’s problem. Far from eradicating the irrational exuberance to which he had referred, Greenspan stoked it.

Nonetheless, back in the roaring 1990s, because he made people feel good about markets, Greenspan was a popular hero, lionised by the financial and mainstream media. His familiar features - the big glasses, the heavy set brow, his magisterial stoop (as if his shoulders struggled under the weight of supporting such a huge brain) - appeared in more cartoons than almost any other public figure at the time. He was characterised overwhelmingly in positive ways. The exhibit below is typical:

Larkin 3

Cartoonists provide useful perspectives but, when we consider the rot that Greenspan started, it is the bleak humour of Philip Larkin that might be more appropriate. One of Larkin’s most famous poems poked fun at how parents inadvertently afflict their children. Economically, speaking, we are all Greenspan’s children now so here’s an adaptation of Larkin’s poem that might resonate with readers:

They fuck you up those Central Banks
They may not mean to but they do
They give you all the cash they had
And add some extra, just for you

There are alternative views but it is getting hard to resist the notion that, in their attempts to stave off immediate but manageable crises, Central Bankers have repeatedly doubled-down on unwarranted stimulus packages. Here’s an analogy: if your car blows a tyre when you are cruising up the freeway and sends you lurching dangerously towards the central barrier, you might press the throttle and steer in the opposite direction to try and accelerate out of trouble. You might even manage to avoid the immediate crash, but the danger is that, as you desperately try to bring the car back under control, it twists and swerves in the other direction, where it eventually collides with other cars also moving at high speed. This risks causing a much bigger crash – and far more widespread misery - than the one you just avoided.

So far, despite a number of burst tyres, a terrible crash causing untold suffering has been avoided (for sure the Global Financial Crisis presented another huge risk but another ‘pedal to the metal’ moment from Central Bankers got us out of it). The results of these progressively larger stimulus packages pose very real, and very significant, dangers for the longer-term health of the global economy; the faster you travel, the greater the risks you run.

It is also highly significant that the enormous rise in indebtedness referred to in the opening paragraph has been facilitated by a vast increase in the money supply (the numbers for other developed countries are as bad or in many cases far worse than in the USA but the scale and influence of the USA’s capital markets explains why that is such a great concern). Of even greater note, the levels of Governments’ indebtedness have risen without a concomitant rise in interest rates because the principal buyers of debt have been…Central Banks. The result has been the formation of an extraordinarily large bubble in US stock markets that no amount of rationalisation about low discount rates, or the value of ‘long duration stocks’, can obscure.

Central banks’ balance sheets are already enormous. At some point, perhaps not that far away now, investors will demand higher returns for the risks they are taking when buying government debt. This spells trouble for stock markets where valuations rely on low rates persisting for over a decade ahead or more. (As Milton Friedman crisply observed: “Inflation is always and everywhere a monetary phenomenon”. And, while he wasn’t right about everything, he was almost certainly correct about that). The trouble for Central Bankers today is that they are still dealing with the economic and political consequences of Greenspan’s policy errors. As Larkin might have said:

But they were fucked up in their turn
By fools like Greenspan and his mates
Who missed the dread ‘exuberance’
And kept on cutting interest rates

And here’s another thing to think about: although markets have risen very substantially and rapidly over the past few months, the money fuelling this seems to be coming from the most dangerous source of all: the naïve retail investor.

In an ironic twist, increasing numbers of commentators are voicing concerns about the ‘irrationality’ of some of today’s investors. Recent activities of those on the Robin Hood trading platform are a case in point. This group of self-appointed stock market gurus have invested in all manner of speculative stocks. A particular favourite was Hertz, after it had filed for bankruptcy (when equity investors lose everything). As sage old market-hands in New York might say: ‘Go Figure’.

We saw similar ‘frothy’ behaviour not only in early 1929 but also at the height of the Dot.com Bubble when conventional valuation measures were deemed to be worthless - by the same sort of investor that populates the Robin Hood platform today - whereas in fact, it wasn’t the valuation measures that matched that particular description but many of high-flying Dot.com stocks themselves. That’s the paradoxical thing about bubbles: you tend to see them much more clearly after they burst, especially if you disregard conventional valuation metrics in favour those that appear to demonstrate that you are far more au courant with investing in the new paradigm than some old timer like, say, Warren Buffett.

What can be done to minimise the likely fallout from here? We can certainly begin the process of planning for a more prudent approach in future and there are some tentative signs that Central Bankers are unwilling to go on funding further Government spending once the worst economic effects of the Pandemic have passed (take a bow Messrs Powell and Bailey).

Notwithstanding any belated restraint from Central Bankers, while this piece isn’t intended as a prediction of an imminent collapse in markets (more stimulus is probably on the way and should keep things going for a little while longer) there can be little doubt that stock markets are even more overdue for a reckoning than they were at the start of the millennium or prior to the Global Financial Crisis in 2008/9. As and when this occurs, Central Banks will find they have limited capacity for manoeuvre precisely because they have already stretched their credibility to the hilt. The implications are sobering; it is worth recalling that after NASDAQ reached its high of 4,963 in March 2000 it fell by 77% to 1,139 by October 2002; which made for quite a ‘Fall’ that year.

The more literary-minded of you may recall that Larkin’s original poem had a third stanza which offered his customarily bleak advice. In closing, perhaps we should leave him with the last word (adapted of course):

Man hands on misery to man.
Markets teeter on a shelf
Sell out as early as you can,
And don’t go into debt yourself

By Quintin Price, Chair of CapGen's Asset Allocation Committee