Financial crisis 4.0

Published in Insights, The New Zealand Initiative’s newsletter, 9 February 2018

The Global Financial Crisis now seems such a distant memory, it is easy to think of it as an historical episode. But this week’s stock market troubles are a timely reminder that the world economy is not in a healthy state.

In a sense, the ‘flash crash’ that started on Wall Street was just a partial correction of recent exaggerations. In part fuelled by expectations of President Trump’s tax reform, US stocks had rallied. Now some of that exuberance disappeared again.

So a technical correction and nothing else to see here? Not quite.

The problem is fundamental. A decade ago, the world witnessed a crisis in the US subprime lending market. This then became a banking crisis on both sides of the Atlantic. Then it turned into a sovereign debt crisis for many European countries.

In each phase, the policy response was stimulus. Governments were spending more money, and central banks were flooding markets with cheap money. But while fiscal measures were phased out after a few years, central banks are continuing their loose monetary policies.

In the US, the Federal Reserve has only cautiously tried to wean the economy off cheap money. However, the European Central Bank and the Bank of Japan are still showering the markets. The combined balance sheets of these three major central banks have never been larger.

There is a saying that when things cannot go on forever, they will eventually stop. It applies to monetary policy.

At some stage, emergency measures such as ultra-low interest rates and quantitative easing must end. They are hard to justify when most developed economies are growing at a reasonable pace. Their side effects, eroding savings and price level increases, require a monetary rethink.

The modest drop in our stock markets this week signals that markets realise this. But after ten years of cheap money, it is difficult to imagine the return to a world of ordinary monetary conditions.

Like drug addicts used to a life on speed, markets have happily absorbed the sweet poison of low interest rates. Getting them off it would be healthy. But the withdrawal symptoms could be so bad they could trigger the next crisis.

Then again, perhaps the biggest mistake was thinking of the Global Financial Crisis as history. In fact, it never ended. It just morphed. We are waiting for the next stage.

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