Back in 2017, at an event in London, Janet Yellen, then the Federal Reserve chair at the time, made an extraordinary prediction: “Would I say there will never, ever be another financial crisis? … Probably that would be going too far. But I do think we’re much safer, and I hope that it will not be in our lifetimes, and I don’t believe it will be.”
Now I know what your first thought was when you heard her say this: “No crisis within our lifetime? She must not expect to live long!”
And, indeed, it only took a year for financial markets to come mighty close to proving her wrong. In 2018, stock markets had their worst performance since 2008 and bond markets were roiled.
But I can’t help wondering if we might’ve misunderstood the real meaning of Yellen’s statement. Perhaps she wasn’t predicting that there would be no financial crisis in her lifetime. Perhaps she was promising it…
You see, central banks like the Federal Reserve and Bank of England were often originally founded to prevent financial crises. Strictly speaking, that used to mean banking crises: however, these days banks are active in financial markets in ways that only investment banks used to be.
The central bankers’ job was to provide liquidity against good collateral at times when a panic was making people question the value of that collateral. If that’s confusing, don’t even think about reading the famous book Lombard Street which explains the concept.
The point is that central bankers were a sort of financial firefighting institution which used liquidity to put out fires before they could burn down the City.
So, when a central banker says something like, “There won’t be a financial crisis in our lifetimes,” that’s not like me opining on GB News that interest rates won’t go up much. It’s a statement coming from the horse’s mouth. Actually, it’s even better than that. The very people who have the power and the mandate to prevent such a crisis are declaring there won’t be one.
But hold on a minute! Why do we ever have financial crises then?
If the central bankers really are omniscient, omnipresent and omnipotent, as I told an investment conference audience years ago, then why did 2008 happen at all? And that’s not to mention a long list of other debacles.
Well, you probably know my view on the capabilities of government institutions by now… If any omniscient, omnipresent and omnipotent being can muck things up regardless, it’s a civil servant.
But the question is actually far more intriguing than that. Why do we have crises if central banks can print money and dish it out willy nilly, as they have been since 2008?
Well, first of all, 2008 was so unusually bad because central bankers didn’t rescue Lehman Brothers as had been anticipated.
Ask yourself what the 2008 crisis would’ve looked like if Lehman had been bailed out, like a long list of other firms. I don’t think it would’ve been half as bad.
More interestingly, there’s the problem of moral hazard. When people believe that a benevolent central bank will save them, they simply take on more risk. And so risk inherently outgrows the safeguards which everyone is relying on.
Another angle is that central bank rescues are actually the fuel for the next crisis. Here’s a famous comment from the economist Paul Krugman in 2002:
To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan [i.e. the then Chairman of the US Federal Reserve] needs to create a housing bubble to replace the Nasdaq bubble.
And a housing bubble is exactly what we got. And then we got a sovereign debt bubble when central banks had to clean up the consequences of that.
So, in a way, the history of central banks preventing crises is also the history of them creating crises.
But here’s my real message for you today. When a central banker stands up and says they’ll do “whatever it takes,” as the European Central Bank’s Mario Draghi did in relation to the salvation of the euro, or “there will be no financial crisis in our lifetime,” as Janet Yellen did, then that’s a promise, not a prediction.
But there is no free lunch in economics. And even central banks cannot alter this reality.
They can, however, redistribute our lunch. So, where are the resources coming from to rescue financial systems and prevent crises?
The answer is all over the news right now. It’s called inflation.
You see, central banks have so much clout because they effectively have infinite budgets. They can create as much money as they want and buy as much as they need to in order to prevent a financial crisis.
But more money means each unit of money is worth less. And that’s inflation.
So, the price we pay for preventing financial crises is inflation. Conversely, central bankers are willing to destroy the value of our money to prevent a financial crisis. That’s what they’re really telling you when they make their promises to do “whatever it takes” to make sure there is no financial crisis “within our lifetimes”.
This is not a new idea. In the past, governments resorted to the printing press to finance their deficits in especially dire situations. Wars are the most common examples of dire situations. In dire situations, the existence of the nation takes precedence over the value of the currency.
But wars end. Many of the challenges that central bankers have adopted do not end.
I’m thinking of climate change, especially. Central bankers have become desperate to join the fight against plant food (aka carbon dioxide or CO2). Consider this extraordinary headline from Bloomberg: “ECB Says Climate Efforts Haven’t Been Derailed by War in Ukraine”. Do you see any mention of spiralling inflation in that headline anywhere?
Remember, back in the early 2000s, the US government declared its attempt to promote home ownership. And the Federal Reserve helped out with incredibly low interest rates. The result was a housing boom of epic proportions.
So, when central bankers declare they’re in the business of solving climate change, can you guess which investments will be booming this time?
Actually, you don’t need to guess. Green – or climate – tech analysts James Allen and Kit Winder are on the case for you.
But back to our topic. While few people would begrudge the government’s use of the printing press to try and win a war, persistent use of this tool is quite another matter.
The risk of financial crises persist. And, given the nature of moral hazard, the longer you don’t have a crisis, the bigger they get.
That has been the transition of the past few decades during which central banks have been busy preventing crises. They’ve gradually gotten bigger each time.
Not necessarily in terms of what actually happened. After all, sometimes central bankers acted faster and more dramatically than others to prevent a crisis. But the risks at hand kept growing.
We went from an Asian financial crisis to a tech bubble to a housing bubble to a banking crisis to a sovereign debt crisis. Each one has more dangerous potential should central bankers fail to get it under control quickly enough.
The big question is whether a crisis eventually overwhelms central banks, or whether inflation eventually gets out of control. Which will happen first?
That is what makes the present bout of inflation so extremely incredibly pivotally important. It is the first time that the promises of central bankers have been put into question. It’s the first time their commitment to those promises is questionable.
Will they really be willing to ignore their inflation mandate and prevent a financial crisis? Will they really resort to more quantitative easing (QE) and interest rate cuts when inflation is running at triple or quadruple their mandate?
Until now, inflation has evaporated each time we faced a crisis. And so central bankers had a free hand during the crisis.
Their one constraint, the one price we must pay for their rescue effort, was a distant concern when they needed to put out the fire. Indeed, the central bankers had to continue the crisis fighting policy of QE to try and get some inflation going.
But now, the game has changed. The consequences of endless QE have arrived. There is now a price to pay for successive rescues of the global financial system.
And central bankers will have to choose between their promise to save the financial system from a crisis or save the currency from inflation.
While they’re busy making their choice, I think you need to begin preparing for the consequences. And taking a look at this should be top of your list.
Nick Hubble
Editor, Fortune & Freedom
