Have you ever seen an avalanche control team looking up into the sky? Do they spend their time trying to spot which snowflake will cause the avalanche? Or do they look down and study the slopes and the snowpack beneath their feet?
And in the aftermath of an avalanche, do the rescue teams try to establish which snowflake was the culprit? Which one triggered all the chaos? Or do they wonder why those charged with managing the snowpack didn’t prevent the dangerous build-up in the first place?
It’s an age-old metaphor which financial newsletter writers like me have used for decades. Sure, it’s fun to dig into the furore of sub-prime mortgages, tech stock overvaluations, currency pegs and European debt-to-GDP levels.
But pinpointing the starting point of a crisis is sort of missing the point. For a problem to spread, and become a proper crisis, you need an entire snowpack that’s teetering on edge. One that only needs a snowflake, whatever that snowflake might be, for the whole mountainside to come rumbling down.
Economists from the Austrian School of Economics – a label intended to be an insult from the German School of Economics – call this a “cluster of errors”.
Usually, the economy has a reasonable amount of tumult in it, after all. New companies booming, old companies going bust, people changing jobs and spending time in unemployment between jobs, technology disrupting everything and management teams making mistakes.
But a crisis is a much more generalised phenomenon, where a crisis spreads to places that didn’t seem to be vulnerable, sometimes even in hindsight.
How do you explain this?
Well, a cluster of errors – when many parts of the economy go haywire at the same time – is caused by a stimulus which affects all parts of the economy. It’s an external interference which leads everyone astray at the same time.
Can you think of one? What single factor affects all parts of our economy?
The answer is of course money and interest rates. It’s the lever that central banks yank around to try and impact us all into changing our behaviour.
But, when they get it wrong, which they inherently do for the same reason that all price controls are flawed, they trigger a cluster of errors.
This usually starts as an artificial boom, when central banks try to engineer prosperity. But they really just fool people and companies into too much debt. The boom before the Asian financial crisis, the sub-prime lending boom and the current bond bubble, for example.
But such booms eventually bust, exposing the cluster of errors as errors all along. And then there’s hell to pay.
It’s the clustering of the errors that’s dangerous, in other words. It impacts otherwise healthy and prudent people and firms.
But enough Austrian Economic Theory. Let’s return to reality.
If we drag our eyes away from all the specifics which could be our snowflake, what’s the snowpack looking like? Is a financial crisis possible? Are the clusters of errors being made, which will suddenly be exposed?
Well, we’ve certainly had excessively low interest rates and a boom in the money supply. And asset prices that benefit disproportionately from such low rates and loose money certainly boomed beyond all reasonable proportions.
House prices, stock market valuations and government debt levels are incredible – literally in-credible. That was our boom.
But now, it’s snowing heavily.
Interest rates are rising. Economies are slowing. And inflation is soaring.
This is the perfect combination for an avalanche. For the cluster of errors to be exposed.
The most dangerous aspect of the snowpack this time is the inability to stop a small avalanche from turning into a big one. That’s a new factor.
Since the bailout of the short-lived capital-mismanagment firm known as Long-Term Capital Management, financial markets have relied on governments and central banks to be active in the market during a crisis. This reliance and presumption of bailouts only increased risk, of course.
If you get to keep the profits and the taxpayer books the loss, how would you behave? How much money would you lend to sub-prime borrowers who are desperate to jump on the housing ladder?
Academics call the incentive to increase risk in the presumption of a bailout “Moral Hazard”. Bankers call it “My Bonus”.
We saw what happened when the presumption of a bailout is disappointed in the aftermath of Lehman Brothers going bust.
Ouch.
A lot of my thoughts about the future since then have been “what would 2008 have looked like if Lehman wasn’t allowed to go bust?” Because the lesson the authorities learned from 2008 is not to let anyone go bust, ever again.
But the emergence of inflation may have changed that game. It raises the risks of a huge avalanche by putting those who usually prevent avalanches into a tight corner.
If they raise interest rates to rein in inflation, they risk triggering a 2008-style debt crisis, a 2010-style European sovereign debt crisis, and a 1997 style Asian financial crisis at the same time. The amount of debt is out of control everywhere this time.
But if they let inflation run amok, well, inflation will only need to be reined in eventually somehow anyway. It’s just a question of how long you want to let it ruin the economy first.
Over the coming months, as we all scramble to try and figure out precisely which part of the financial system will buckle first, never forget that it’s the overall fragility of the system that you should be paying attention to.
Don’t go skiing near dangerous snowpacks, however carefully you might watch the snowflakes.
Nick Hubble
Editor, Fortune & Freedom
