For the cause of the next financial crisis, look to central banks’ overextended balance sheets
Published: 1:00am, 26 Dec, 2019
Traders work at the New York Stock Exchange as a screen shows US Federal Reserve chairman Jerome Powell’s press conference after the central bank announced it would cut interest rates for the third time this year, on October 30. Photo: Reuters
Predicting the next crisis – financial or economic – is a fool’s game. Yes, every crisis has its hero who correctly warned of what was about to come. And, by definition, the hero was ignored (hence the crisis). But the record of modern forecasting contains a note of caution: those who correctly predict a crisis rarely get it right again.
The best that economists can do is to assess vulnerability. Looking at imbalances in the real economy or financial markets gives a sense of the potential consequences of a major shock. It doesn’t take much to spark corrections in vulnerable economies and markets. But a garden-variety correction is far different from a crisis. The severity of the shock and the degree of vulnerability matter: big shocks to highly vulnerable systems are a recipe for crisis.
In this vein, the source of vulnerability that I worry about the most is the overextended state of central bank balance sheets. My concern stems from three reasons.
First, central banks’ balance sheets are undeniably stretched. Assets of major central banks – the
US Federal Reserve, the European Central Bank and the Bank of Japan – collectively stood at US$14.5 trillion in November 2019, which is down only slightly from the peak of around US$15 trillion in early 2018 and more than 3.5 times the pre-crisis level of US$4 trillion.
A similar conclusion comes from scaling assets by the size of their respective economies: Japan leads the way at 102 per cent of nominal gross domestic product, followed by the ECB at 39 per cent and the Fed at a mere 17 per cent.
Bank of Japan governor Haruhiko Kuroda (left), then US Federal Reserve chair Janet Yellen and former European Central Bank president Mario Draghi meet in August 2017, in Jackson Hole, Wyoming, at a global central bankers’ symposium. Central bank balance sheets have ballooned in the post-crisis era. Photo: Kyodo
Second, central banks’ balance-sheet expansion is essentially a failed policy experiment. Yes, it was successful in putting a floor under collapsing markets over a decade ago, in the depths of the crisis in late 2008 and early 2009. But it failed to achieve traction in sparking vigorous economic recovery.
Central banks believed that what worked during the crisis would work equally well during the recovery. That didn’t happen. The combined nominal GDP of the United States, euro zone and Japan increased by US$5.3 trillion from 2008 to 2018, or only about half their central banks’ combined balance-sheet expansion of U$10 trillion over the same period. The remaining US$4.7 trillion is the functional equivalent of a massive liquidity injection that has been propping up asset markets over most of the post-crisis era.
Third, steeped in denial, central banks are once again upping the ante on balance-sheet expansion as a means to stimulate flagging economic recoveries. The Fed’s late 2018 pivot led the way, first
reversing the planned normalisation of its benchmark policy rate and then allowing its balance sheet to grow again (allegedly for reserve management purposes) following steady reductions from mid-2017 through to August 2019.
Asset purchases remain at elevated levels for the Bank of Japan as a critical element of the “Abenomics” reflation campaign. And the recently installed ECB president, Christine Lagarde, the world’s newest central banker, was quick to go on the record stressing that European monetary authorities will “turn [over] each and every stone” – which presumably includes the balance sheet.
So why is all this problematic? After all, in a low-inflation era, inflation-targeting central banks seemingly have nothing to fear about continuing to err on the side of extraordinary monetary accommodation, whether conventional (near zero-bound benchmark policy rates) or unconventional (balance-sheet expansion).
The problem lies, in part, with the price-stability mandate itself – a long-standing, but now inappropriate, anchor for monetary policy. The mandate is woefully out of sync with chronically below-target inflation and growing risks to financial stability.
The potential instability of the US equity market is a case in point. According to the widely cited metrics of Nobel laureate economist Robert Shiller, equity prices relative to cyclically adjusted long-term earnings are currently 53 per cent above their post-1950 average and 21 per cent above the post-crisis average since March 2009.
Barring a major reacceleration of economic and earnings growth or a new round of Fed balance-sheet expansion, further sharp increases in US equity markets are unlikely. Conversely, another idiosyncratic shock – or a surprising reacceleration of inflation and a related hike in interest rates – would raise the distinct possibility of a sharp correction in an overvalued US equity market.
Shoppers look at T-shirts at a Levi’s store in Times Square in New York in June. In a low-inflation era, inflation-targeting central banks seem to have a green light to pursue extraordinary monetary accommodation. Photo: AP
The problem also lies in weak real economies that are far too close to their stall speed. The International Monetary Fund recently lowered its estimate for world GDP growth in 2019 to 3 per cent – midway between the 40-year trend of 3.5 per cent and the 2.5 per cent threshold commonly associated with global recessions.
As the year comes to a close, real GDP growth in the US is tracking below 2 per cent, and the 2020 growth forecasts for the euro zone and Japan are less than 1 per cent. In other words, the major developed economies are not only flirting with overvalued financial markets and still relying on a failed monetary policy strategy, but they are also lacking a growth cushion just when they may need it most.
In such a vulnerable world, it would not take much to spark the crisis of 2020. Notwithstanding the risks of playing the fool’s game, three “Ps” are at the top of my list of concerns: protectionism, populism and political dysfunction. An enduring tilt toward protectionism is particularly troubling, especially in the aftermath of a vacuous “phase one” trade accord between the US and China.
US and China reach ‘phase-one’ trade deal
Prime Minister Narendra Modi’s “Hindu nation” crusade in India could well be the most disturbing development in a global swing toward populism. The great American impeachment saga takes Washington’s political dysfunction further into uncharted territory.
Quite possibly, the spark will be something else – or maybe there won’t be any shock at all. But the diagnosis of vulnerability needs to be taken seriously, especially because it can be validated from three perspectives – real economies, financial asset prices and misguided monetary policy. Throw a shock into that mix and the crisis of 2020 will quickly be at hand.
Source: SCMP
______________________________________________________
If you wish to contact the author of any reader submitted guest post, you can give us an email at UniversalOm432Hz@gmail.com and we'll forward your request to the author.
______________________________________________________
All articles, videos, and images posted on Dinar Chronicles were submitted by readers and/or handpicked by the site itself for informational and/or entertainment purposes.
Dinar Chronicles is not a registered investment adviser, broker dealer, banker or currency dealer and as such, no information on the website should be construed as investment advice. We do not support, represent or guarantee the completeness, truthfulness, accuracy, or reliability of any content or communications posted on this site. Information posted on this site may or may not be fictitious. We do not intend to and are not providing financial, legal, tax, political or any other advice to readers of this website.
Copyright © 2019 Dinar Chronicles
- Assets of the US Federal Reserve, European Central Banks and Bank of Japan stand at 3.5 times their pre-crisis level
- Protectionism, populism and political dysfunction could provide the trigger that tips vulnerable global markets into crisis
Published: 1:00am, 26 Dec, 2019
Traders work at the New York Stock Exchange as a screen shows US Federal Reserve chairman Jerome Powell’s press conference after the central bank announced it would cut interest rates for the third time this year, on October 30. Photo: Reuters
Predicting the next crisis – financial or economic – is a fool’s game. Yes, every crisis has its hero who correctly warned of what was about to come. And, by definition, the hero was ignored (hence the crisis). But the record of modern forecasting contains a note of caution: those who correctly predict a crisis rarely get it right again.
The best that economists can do is to assess vulnerability. Looking at imbalances in the real economy or financial markets gives a sense of the potential consequences of a major shock. It doesn’t take much to spark corrections in vulnerable economies and markets. But a garden-variety correction is far different from a crisis. The severity of the shock and the degree of vulnerability matter: big shocks to highly vulnerable systems are a recipe for crisis.
In this vein, the source of vulnerability that I worry about the most is the overextended state of central bank balance sheets. My concern stems from three reasons.
First, central banks’ balance sheets are undeniably stretched. Assets of major central banks – the
US Federal Reserve, the European Central Bank and the Bank of Japan – collectively stood at US$14.5 trillion in November 2019, which is down only slightly from the peak of around US$15 trillion in early 2018 and more than 3.5 times the pre-crisis level of US$4 trillion.
A similar conclusion comes from scaling assets by the size of their respective economies: Japan leads the way at 102 per cent of nominal gross domestic product, followed by the ECB at 39 per cent and the Fed at a mere 17 per cent.
Bank of Japan governor Haruhiko Kuroda (left), then US Federal Reserve chair Janet Yellen and former European Central Bank president Mario Draghi meet in August 2017, in Jackson Hole, Wyoming, at a global central bankers’ symposium. Central bank balance sheets have ballooned in the post-crisis era. Photo: Kyodo
Second, central banks’ balance-sheet expansion is essentially a failed policy experiment. Yes, it was successful in putting a floor under collapsing markets over a decade ago, in the depths of the crisis in late 2008 and early 2009. But it failed to achieve traction in sparking vigorous economic recovery.
Central banks believed that what worked during the crisis would work equally well during the recovery. That didn’t happen. The combined nominal GDP of the United States, euro zone and Japan increased by US$5.3 trillion from 2008 to 2018, or only about half their central banks’ combined balance-sheet expansion of U$10 trillion over the same period. The remaining US$4.7 trillion is the functional equivalent of a massive liquidity injection that has been propping up asset markets over most of the post-crisis era.
Third, steeped in denial, central banks are once again upping the ante on balance-sheet expansion as a means to stimulate flagging economic recoveries. The Fed’s late 2018 pivot led the way, first
reversing the planned normalisation of its benchmark policy rate and then allowing its balance sheet to grow again (allegedly for reserve management purposes) following steady reductions from mid-2017 through to August 2019.
Asset purchases remain at elevated levels for the Bank of Japan as a critical element of the “Abenomics” reflation campaign. And the recently installed ECB president, Christine Lagarde, the world’s newest central banker, was quick to go on the record stressing that European monetary authorities will “turn [over] each and every stone” – which presumably includes the balance sheet.
So why is all this problematic? After all, in a low-inflation era, inflation-targeting central banks seemingly have nothing to fear about continuing to err on the side of extraordinary monetary accommodation, whether conventional (near zero-bound benchmark policy rates) or unconventional (balance-sheet expansion).
The problem lies, in part, with the price-stability mandate itself – a long-standing, but now inappropriate, anchor for monetary policy. The mandate is woefully out of sync with chronically below-target inflation and growing risks to financial stability.
The potential instability of the US equity market is a case in point. According to the widely cited metrics of Nobel laureate economist Robert Shiller, equity prices relative to cyclically adjusted long-term earnings are currently 53 per cent above their post-1950 average and 21 per cent above the post-crisis average since March 2009.
Barring a major reacceleration of economic and earnings growth or a new round of Fed balance-sheet expansion, further sharp increases in US equity markets are unlikely. Conversely, another idiosyncratic shock – or a surprising reacceleration of inflation and a related hike in interest rates – would raise the distinct possibility of a sharp correction in an overvalued US equity market.
Shoppers look at T-shirts at a Levi’s store in Times Square in New York in June. In a low-inflation era, inflation-targeting central banks seem to have a green light to pursue extraordinary monetary accommodation. Photo: AP
The problem also lies in weak real economies that are far too close to their stall speed. The International Monetary Fund recently lowered its estimate for world GDP growth in 2019 to 3 per cent – midway between the 40-year trend of 3.5 per cent and the 2.5 per cent threshold commonly associated with global recessions.
As the year comes to a close, real GDP growth in the US is tracking below 2 per cent, and the 2020 growth forecasts for the euro zone and Japan are less than 1 per cent. In other words, the major developed economies are not only flirting with overvalued financial markets and still relying on a failed monetary policy strategy, but they are also lacking a growth cushion just when they may need it most.
In such a vulnerable world, it would not take much to spark the crisis of 2020. Notwithstanding the risks of playing the fool’s game, three “Ps” are at the top of my list of concerns: protectionism, populism and political dysfunction. An enduring tilt toward protectionism is particularly troubling, especially in the aftermath of a vacuous “phase one” trade accord between the US and China.
US and China reach ‘phase-one’ trade deal
Prime Minister Narendra Modi’s “Hindu nation” crusade in India could well be the most disturbing development in a global swing toward populism. The great American impeachment saga takes Washington’s political dysfunction further into uncharted territory.
Quite possibly, the spark will be something else – or maybe there won’t be any shock at all. But the diagnosis of vulnerability needs to be taken seriously, especially because it can be validated from three perspectives – real economies, financial asset prices and misguided monetary policy. Throw a shock into that mix and the crisis of 2020 will quickly be at hand.
Source: SCMP
______________________________________________________
If you wish to contact the author of any reader submitted guest post, you can give us an email at UniversalOm432Hz@gmail.com and we'll forward your request to the author.
______________________________________________________
All articles, videos, and images posted on Dinar Chronicles were submitted by readers and/or handpicked by the site itself for informational and/or entertainment purposes.
Dinar Chronicles is not a registered investment adviser, broker dealer, banker or currency dealer and as such, no information on the website should be construed as investment advice. We do not support, represent or guarantee the completeness, truthfulness, accuracy, or reliability of any content or communications posted on this site. Information posted on this site may or may not be fictitious. We do not intend to and are not providing financial, legal, tax, political or any other advice to readers of this website.
Copyright © 2019 Dinar Chronicles
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