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The legacy of central banks

Published at: 28-09-2018

Posted on: September 28th, 2018 by RaduC No Comments

The crisis that started in 2008 has put to the test the ability of central banks to put aside traditional economic wisdom and try their hand at the most unorthodox measures, instead, to prevent economies from slipping into a depression similar to that in the `30s. The world`s great chance may have been the fact that at the time the reins of the Fed were held by an expert in the   the 1930 Great Depression who realized the extreme danger faced not only by the US economy, but also by the global economy.

Ben Bernanke, the chairman of the Fed pointed out: “September and October of 2008 was the worst financial crisis in global history, including the Great Depression”. Of the 13 “most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.” “AIG’s demise would be a catastrophe” and “could have resulted in a 1930s-style global financial and economic meltdown, with catastrophic implications for production, income, and jobs.”

Why haven`t the implications been as catastrophic as they were in the 1930s? Because the chairman of the Fed reckoned that it was the central bank`s lack of action at the time, waiting for the free market to rebalance the game, that collapsed the American economy. As a result, he decided that that time around the Fed had to take action instead of being patient.

There will clearly be a long debate as to what extent it is ethical to use public money to bail out privately-owned financial entities. From an ethical perspective, the answer is straightforward. It is harder, however, to answer whether any other alternatives existed. At no point did the responsibility ever lie with the kibitzers posing as champions of justice as they claimed from the sideline or after the fact that they would have left the financial institutions to crumble.

The domino effect would have been a fact. And not only across America. It would have engulfed many continents since it was the transcontinental connections of financial institutions that laid the ground for the largest crisis ever.  Interconnections that did not exist in 1930.

And so the question arises: Who would have been so reckless to let the financial system melt down knowing that there is a high likelihood (not the certainty, I admit) that the consequences would be greater than those of the Great Depression? The US solution was later replicated by other relevant central banks.

And here we are today, witnessing overheating tendencies in the US economy kept in check by gradual interest rates hikes, reasonable growth in Europe, excellent stock exchange performance  in developed economies, low inflation rates and dropping unemployment. Should we crack open a bottle of champagne alongside central banks?

I think that it`s too early in the day for that. By their size, the unorthodox measures, though they helped avoid a crisis, carried perverted effects which will continue to linger for a long time and whose economic but also political implications  can already be seen.

Let us sum up. Since 2009 to this day, four of the largest central banks, the Fed, the ECB, the Bank of England and the Bank of Japan have been printing money worth 13,000 billion US dollars. A huge amount, the bulk of which continues to be in the global economy. The first step back will happen in 2019 when around 100 billion dollars are expected to be taken out of the system. Yes, 100 out of 13,000 billion…

Obviously, the newly printed money could only be withdrawn from the financial and economic system to a very limited extent and that will depend on the timing of the next recession.

A much subtler way of “extracting” it, however, is already underway: a tolerance of negative real interest rates by central banks which slowly pushes the value of the existing money supply closer to the value of goods and services on the market. This development hits those who put their money in banks or into bonds, but first and foremost those who are not financially literate enough to protect themselves.

This is something that we also witnessed during the crisis when financial elites profited from public money or from more sophisticated investments of their own capital. The consequences? A thinner middle class and higher financial polarization. And the phenomenon does not seem to be winding down.

This takes us to the first legacy. Economies bounced back at the cost of social polarization. Admittedly, social division in developed countries does not stem from central banks` policies alone. Some of it was caused by globalized economies which have left many in the rich world unemployed in favor of emerging countries. But I do think that the fact that during and after the crisis, a limited number of the population was better equipped to cope and even more protected than the majority is partly to be blamed.

There was just a small step to nationalism, populism and calling into question mainstream politics. All that the migration crisis did was to add fuel to an already smoldering fire.

The second legacy is inflated financial assets (shares, bonds) and property markets (again!) where a good part of the money injected into the economy went. The amount of cash pumped in exceeded by far the banking system`s ability to pass it on or the economy`s absorption capacity. This created a disconnect between the asset price and inherent risk, in the end distorting capital allocations.

A study by one of the largest wealth & asset manager, Pictet, shows that every USD 1,000 billion printed corresponds to a 20-point rise in the MSCI global index. Such a correlation stands a good chance of backfiring as money is being taken out the market.

To conclude, there is still a long way for the snowball rolled down and increased by the main central banks to come to a halt. It does have economic and political implications and the problem is that we don`t know where it will finally stop.

At the coming crisis? And will we then be creating a new cash snowball? For how long?

Have a nice weekend!

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