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The $200 Trillion Question

Perhaps the most remarkable trend in global macroeconomics over the past two decades has been the stunning drop in the volatility of economic growth. In the United States, for example, quarterly output volatility has fallen by more than half since the mid-1980’s. Obviously, moderation in output movements did not occur everywhere simultaneously. Volatility in Asia began to fall only after the financial crisis of the late 1990’s. In Japan and Latin America, volatility dropped in a meaningful way only in the current decade. But by now, the decline has become nearly universal, with huge implications for global asset markets.

Indeed, the main question for 2007 is whether macroeconomic volatility will continue to decline, fueling another spectacular year for markets and housing, or start to rise again, perhaps due to growing geopolitical tensions. I lean slightly toward the optimistic scenario, but investors and policymakers alike need to understand the ramifications of a return to more normal volatility levels.

Investors, especially, need to recognize that even if broader positive trends in globalization and technological progress continue, a rise in macroeconomic volatility could still produce a massive fall in asset prices. Indeed, the massive equity and housing price increases of the past dozen or so years probably owe as much to greater macroeconomic stability as to any other factor. As output and consumption become more stable, investors do not demand as large a risk premium. The lower the price of risk, the higher the price of risky assets.

Consider this. If you agree with the many pundits who say stock prices have gone too high, and are much more likely to fall than to rise further, you may be right—but not if macroeconomic risk continues to drain from the system. At the end of 2000, at the height of the Internet stock boom and just before the 2001 crash, the economists James Glassman and Kevin Hassett published Dow 36,000 . At the time, the Dow Jones industrial average of US stocks was trading at around 11,000, so the book’s premise seemed outrageous. Certainly the timing was bad: global stock prices began to collapse a few months later, and it took years for them to fully recover.