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The fuse is lit at the next global crash, which is going to explode first is the real question

The fuse is lit at the next global crash, which is going to explode first is the real question

A general view of the Bank of England – REUTERS/Maja Smiejkowska

Taken one at a time, it might be reasonable to downplay the events of the past week.

You can say that the smaller US banks – such as Silicon Valley Bank (SVB) – are outliers because they are niche players and are not subject to the same liquidity rules and stress tests as the larger banks.

Similarly, Credit Suisse has been extremely poorly run for many years. It should survive, with better management and a huge cash injection.

In the meantime, will central banks come to the rescue with more bailouts and rate cuts?

I wouldn’t bank on it. For starters, history has taught us that bank failures are like London buses: you wait ages for one, and then three come at once.

SVB did nothing particularly outrageous. The bank made the classic mistake of not matching the maturities of its assets and liabilities.

But on the face of it, the bank was doing little more than prudently reinvesting its clients’ money in government bonds.

All it took to trigger the latest crisis was the return of official interest rates to what would historically be considered normal levels. Worryingly, in real terms – taking into account the pick-up in inflation – they are still relatively low.

In the UK, for example, the Bank of England raised its policy rate to 4%, the highest since the outbreak of the global financial crisis (GFC) in 2008.

Interest rates were below 1 percent for most of this period. The authorities embarked on an experiment that now appears to have disastrous consequences. Rates of 4 to 6 percent, on the other hand, were normal for the pre-GFC rate.

Money hasn’t just been cheap. Thanks to years of quantitative easing by the world’s largest central banks, there is now much more of it.

It is no surprise that many have become addicted.

This is the core of the problem. Even if interest rates do not rise any further, the effects of unwinding the long period of practically free money could drag on for years and manifest itself in many different ways.

The crisis culminating in the collapse of the SVB is not even the first in a long line of unfortunate events. The Bank of England, of course, had to intervene in the gold market last autumn when the rise in interest rates threatened to inflate the ‘liability-driven investment’ strategies employed by many British pension funds.

The obvious question is where the problem might arise next – and it’s not hard to come up with candidates.

If they start big, how long can Italian government bonds be supported by low interest rates in the Eurozone and backstops from the European Central Bank?

And what about Japan’s even higher mountain of debt, where the central bank is only just on its way to the end of decades of ultra-easy monetary policy?

Outside the financial sector, significant parts of the UK economy have yet to feel the full impact of last year’s rate hikes and the tightening of financial conditions.

For example, many smaller businesses are just emerging from Covid support schemes and could soon be paying much higher rates.

And closest to home, what about house prices? Rising mortgage payments and increased economic uncertainty have already led to a sharp downturn in the housing market and residential construction, both in Europe and the US.

But this could be the tip of the iceberg as more homeowners come off their current low fixes and need to refinance.

Bank of England analysis has suggested that a sustained rise in real interest rates of 1% could lower equilibrium house prices by as much as 20%.

So the bigger picture is that we need to adjust to normal interest rates, and that’s going to be painful. Weaker companies and those with riskier business models may struggle the most, but they won’t be alone.

This presents central banks with two dilemmas.

First, to what extent should they be prepared to rescue failing institutions? If they do too little, the entire financial system could collapse.

If they offer too much support, they can only encourage risky behavior in the future (the classic problem of moral hazard), or give the impression that the problems now run even deeper than people thought.

Second, on interest rates, how will central banks reconcile their responsibility for financial stability with a commitment to monetary stability, that is, to get inflation back down?

This is not an impossible choice. Central banks could argue that averting a financial crash would prevent inflation from falling too far. The authorities also have many different tools they can use to achieve their different goals.

But this is a difficult balancing act.

The European Central Bank (ECB) has already shown where its priorities lie. On Thursday, it went ahead with another half-point hike in key interest rates, despite the crisis engulfing European banks.

Admittedly, the threshold for the ECB to pause (or raise only a quarter point) was higher than for other central banks, because the ECB had already committed to another half point step.

It would therefore be wrong to read too much into this move ahead of the Bank of England’s own decision on UK interest rates next week. Our Monetary Policy Committee takes each meeting as it comes (rightly so in my opinion), which gives them more flexibility to respond to new events.

There have also been some pretty good reasons to pause, including signs that pipeline cost pressures are easing and wage inflation has peaked. So I would expect a quarter point increase at most on Thursday, and personally I would vote no change.

Nevertheless, it would be wrong to rely on central banks to solve problems caused by a prolonged period of very low interest rates by keeping those same rates low any longer, let alone rushing them to lower them again.

The chickens have come home to roost. We need to go cold turkey and stop banking on free money.

Julian Jessop is an independent economist. He tweets @julianhjessop.



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