You’ve seen them plastered all over the news. The long list of crises which threaten to wreak havoc on financial markets. And I bet you’re wondering which one will morph into a financial crisis that takes down stocks.
China Evergrande Group, one of the largest real estate developers in that country, is supposedly the new Lehman Brothers – an institution that is too big to fail until… it fails, sparking a massive financial crisis.
Covid has surged in nations with high vaccination rates like Seychelles, Iceland, Israel, Bermuda and Singapore. Many of them were forced to reintroduce restrictions after declaring they’d live with Covid.
Compliance with lockdowns is falling fast, all around the world.
Commodity prices are either plunging or surging.
Rising gas and electricity prices are causing crises in Europe.
America’s debt ceiling is back on the agenda.
So, there’s no shortage of flashpoints right now. By flashpoints, I mean things that could cause meltdowns in the stock market, or worse, the bond market. At least, in normal circumstances they might…
But today, instead of investigating the many possible crises, I’d like to ask whether you think there can even be a crisis any more. More precisely, do you think that central banks and governments will allow one?
For example, when people ask whether Evergrande is China’s Lehman Brothers, they are likely missing the point. What made Lehman Brothers so important is that it was allowed to fail.
But what is the lesson to be learned from this? Is it that markets can plunge when the likes of Lehman Brothers or Evergrande fail?
I don’t think so…
I think the real lesson is that nothing since Lehman Brothers was allowed to fail. Because the failure of that investment bank caused a much bigger crisis.
So, do you think anyone will be making the same policy mistake anytime soon?
I doubt it.
Most of the time, anyway…
Because the lesson of Lehman Brothers was to not allow anything to fail in the first place. At least, not in an uncontrolled manner which risks contagion.
But what if the crisis is just too big, I hear you ask?
Well, we’ve also learned that the central banks’ and governments’ capability to prevent a crisis is nigh on unlimited. Actually, it is unlimited, in a particular sense we’ll get to below.
Do you think the Evergrande crisis is worse than the last 18 months of pandemic mayhem? I doubt it very much.
Stocks, bonds, real estate and other investment assets have soared during a pandemic, which shut down global travel and economies. Well, the lockdowns did the shutting down…
Similarly, GDP has recovered in many places, despite continuing restrictions and Covid cases.
Think about that for a moment. It’s bizarre.
Meanwhile gold – the asset which outperforms when you can’t trust the monetary, financial or economic system – has fallen. This usually signals rising trust in the system.
Look back at financial markets and you’d think the pandemic ended way back in mid-2020.
Perhaps markets were pricing in a much more severe pandemic back when they crashed in February and March 2020. They were looking at the sort of pandemic that doesn’t need advertising.
But I suspect the real story is that governments and central banks are willing and able to save financial markets. And markets are now pricing this in. They are arguing that no crisis is big enough to overwhelm the governments and their sidekicks, the central bankers.
But let’s make sure…
The overall question I’m asking has two parts to it. Whether central banks and governments have the power to save us and whether they’re willing to.
The third question is the bit everyone is avoiding – the consequences of saving us from all these crises. Back to that in a moment. First, we need to make sure you’ve got a handle on the first two bits.
I think the consequences of the 2008 crisis were that governments cannot allow another Lehman Brothers.
This meant that the fallout from 2008 was transferred on to the government’s balance sheet by means of bailouts.
Next came the European sovereign debt crisis of the 2010s, when Greece technically defaulted, but not before the crisis had been contained.
During that sovereign debt crisis, the risk was transferred to central banks instead, by way of limiting the yields on European bonds and quantitative easing.
Central banks have limitless resources, but are supposed to be constrained to managing macroeconomic conditions like inflation, unemployment and financial stability. They’re also supposed to be politically disinterested.
Yes, I know, I can hear you laughing…
Well, conveniently, when it’s a government that’s about to go bust, bailing out the government shifts into the central banks’ mandate because it would supposedly cause chaos to let it default.
This is where things get interesting. Especially if you take a step back and consider the direction that we’re heading into.
After bailouts during the Asian financial crisis, the housing bubble and the European sovereign debt crisis, we’re finally approaching the endgame. That is the same endgame which all governments and central banks end up with once they abandon sound money.
You see, central bank independence from government, the prohibitions against central banks’ financing of governments and the primacy of inflation targets over all other targets have been exposed to be nothing more than a mirage.
When governments need central banks to finance them, that is exactly what the central banks will do.
And that’s where we are now. In a world where governments prevent a crisis and central banks prevent a sovereign debt crisis. Neither rescue effort need stop and neither has an inherent limit once they’re combined. And so, that means that no crisis is too large for them to save us from.
But where does the buck stop then? And why haven’t we just done this all along? Why did we have any crises in the past if central banks and governments can fix everything? Indeed, why do we have problems like homelessness and poverty if the government has the power to paper over a pandemic?
The answer is that our ancestors learned this lesson the hard way and tried to impart us with institutions that prevent the government from intervening in everything and the central bank from paying for it. Central bank independence, inflation target primacy and the prohibition on monetising deficits were there for a reason. But we’re ignoring them now.
The (very) likely consequences are stagflation and hyperinflation. That is where the buck stops, ironically.
Inflation is the only crisis which more money printing and more deficits do not fix. That’s why, once governments get into the crisis fighting business, which leads them into debt up to their eyeballs, and once the central bank agrees to finance governments beyond this point, you always get inflation in the end.
But we’ve lost them – the institutions which prevent us from going down this path. And now the world is on track to repeat some of history’s nastier episodes.
Our best hope is that we manage to escape the worst of it by changing course, as we did after the 1970s. Inflation was brought under control, sacrificing employment and GDP to do it.
Do you think that’ll happen again? Because how you answer that question determines the answer to my first: do you think we’ll have another crisis?
If not, I think we can expect inflation to get out of hand… and far more than it already has in much of the world.
Nick Hubble
Editor, Fortune & Freedom
