Unintended consequences as crises trigger huge centralised policy measures

The decline of Communism was heralded by the West many years ago, for many reasons. One of the key reasons was that the “invisible hand” of the market was a much better way to allocate capital than the centrally planned approach favoured by Communist economies.

However, those same Western economies and their asset markets are increasingly centrally planned. It has been a slow but relentless journey, starting back in the 1980s, when central banks became less concerned about inflation and more concerned about growth and, by implication, market levels. The logic being that higher markets generated wealth and increased consumer confidence.

The phrase “Greenspan put” was coined; a concept which refers to the US Federal Reserve (Fed) then chairman Alan Greenspan and the belief that the Fed could and would underwrite asset markets. This mission creep was largely unchallenged by subsequent Fed chairmen and was embraced by other countries’ central banks, to a greater or lesser degree. Since then, crises have come and gone and each one saw the concept increasingly embraced, with official interest rates lowered and turning negative in some countries.

The global financial crisis (GFC) in 2007/08 then saw a revolutionary change in monetary policy, with the dawn of quantitative easing: a focus on the quantity of money, rather than the price of money. This was an important moment philosophically, a time when central banks took another step towards influencing the free market.

There is now broad agreement that the experimental post-GFC monetary policy has been much less effective in driving real economic growth than initially hoped by central banks. Instead, the policy has had much of its impact within financial markets, with the impact on the real economy creating “unintended consequences”, such as propping up zombie companies that previously would have folded and had their assets recycled by the market into more productive areas.

The recent volte-face in fiscal policy, from austerity to massive stimulation, is a natural progression of this policy. The crisis this time is Covid, and the related lockdowns, but it has also been instigated due to the reduced impact of monetary policy which meant that something like massive fiscal policy was always going to be necessary to support the economy in a significant new crisis.

As a result, we are facing a situation where increasing parts of asset markets and economies are controlled centrally, rather than left to market forces. It might well have been the right thing to do in the face of Covid but it appears to be causing inefficiencies in the allocation of capital in the economy which in turn appears to be reducing productivity as investment by companies is also reduced. In addition, the build-up of debt means that increasing amounts of economic output will go into servicing the debt, particularly when interest rates rise. Hence inflation is beginning to weigh on investors’ thoughts as interest rate increases are usually the main tool to rein back inflation.

Some have commented that the traditional economic cycle is dead, as economic activity is increasingly manipulated. While it may not be dead it is much less driven by market forces and increasingly by centralised policy. For shares, this has meant that share-specific factors seem less important, with the sector, or theme, increasingly important. This has favoured index-tracking funds as macro factors have more impact and markets are supported while the difference between the best and worst companies has less impact. This too may result in a misallocation of capital with cash directed towards larger companies rather than the smaller growing companies where it could be of most use.

David Thomson is chief investment officer at VWM Wealth