Yesterday we looked at why the government’s policies won’t resolve the energy and inflation crisis. Well, they could, but only by creating bigger problems elsewhere. Yes, you can solve an energy shortage by mandating a reduction in energy usage. But I’m not so sure the consequences will be less bad than the initial problem…
That’s probably one of the enduring lessons of economics, which goes right back to the creation of the field by Richard Cantillon back in the early 18th century. Government policies can transfer problems elsewhere, but they can’t really solve them.
In yesterday’s example, energy policies will shift the energy crisis into an economic one. Sure, cutting energy consumption cuts energy prices. But that happens overwhelmingly at the expense of whomever is going without the energy they need.
Ironically enough, the inflation consequences are likely to remain the same on balance. They’ll just shift from high energy prices to high industrial goods prices.
Shutting down factories and smelters will just cause shortages in the goods they produce instead of energy, after all. But, if you’re a politician who is getting berated for energy prices specifically, that still looks like a “job done”.
Today we tackle the same phenomenon in monetary policy. You see, central banks are fighting to bring down inflation. But, even if they succeed, they’ll only cause a different problem instead. And that problem is one that is worse.
What’ll it be? That’s easy, once you become aware of the context. It’ll be nothing new, after all. In fact, you’re probably getting used to it by now.
Having distorted the world with more than a decade of absurdly loose monetary policy, leading to an impossible burden of debt, central banks are now embarking on a rapid tightening of monetary policy.
Last week alone, an extraordinarily long list of central banks increased interest rates. The Bank of England, the South African Reserve Bank, the Swiss National Bank, the US Federal Reserve, Sweden’s Riksbank and its counterpart in neighbouring Norway all tightened policy in this way.
It is unusual for so many central banks to be (aggressively) hiking rates at the same time. Tomorrow, we will look at the central banks and countries that are the exception to the trend – and what is happening in those places.
But for today, consider what the consequences of all this will be. Will central bankers bring down inflation with higher interest rates, with the result that everything is wonderful? Or will they keep hiking interest rates until someone (meaning a government or two, a banking system or two or an enormous corporation or two) goes bust and causes a new financial crisis?
In this context, the new financial crisis will be titanic in scale. We are talking about an epic situation such as the collapse of sub-prime mortgage securities in the United States (in 2008-09), the Asian financial crisis (in 1997), the European sovereign debt crisis (which raised its ugly head in different places and in different times from 2009 to around 2014) or a total meltdown of Japan’s financial system (which has not happened yet).
But those are examples of what happened when central bankers raised rates to bring down inflation. The point is that rate hiking cycles don’t end with inflation just coming back down with the result that the story arrives at a happy ending. That outcome only happens in economics textbooks.
In reality, hiking cycles almost invariably end in a financial crisis of some sort. The hiking of rates does bring inflation down, but not without causing a bigger problem than the inflation itself.
It is important to ask which part of the market will snap first this time around: put another way, who is the weakest link that can afford higher rates the least?
Nevertheless, it is always very difficult to get the answer right.
In any event, in an epic financial crisis, contagion from one actual disaster area to another, previously potential, disaster area makes contagion in – say – a global pandemic look pretty boring.
In a global pandemic, it is usually possible for actuaries and medical statisticians to model what is likely to happen next as a result of contagion. In a financial crisis, it is generally impossible.
But here’s the deeper worry. If you accept that the past four decades of “prosperity” have basically just been a cycle of ever looser monetary policy burdening financial markets and economies with ever more debt, then you have to wonder where the next upcycle will come from.
Can central bankers cut rates much? Or are still stuck so close to zero that another round of central bank stimulus will fail to engineer much of a boom?
Is debt so high that we can’t embark on another round of borrowing to finance another boom?
Or perhaps inflation is here to stay, preventing central banks from being able to boost the economy again.
Either way, its plausible that the entire global economic model of the past forty years has hit some sort of roadblock that necessitates a complete change of direction.
Whenever people say, “this time is different”, they are often met with a simultaneous chorus of heckling, sighs and laughter.
But consider that times really do change, if you go back far enough.
The idea of floating exchange rates was once considered bizarre. Inflation targeting is quite a new idea. Global reserve currencies change. And hyperinflation does happen in developed countries.
Just because something is rare doesn’t mean that it won’t happen. A sea-change in the financial system is less rare than a pandemic…
My point is that the next forty years could – in fact, probably will – look radically different to the last forty. And those investors working off the presumptions of the past forty could find themselves in trouble.
Bonds might be dangerous instead of safe. Inflation might be rising instead of falling. The United States might be a dangerous place to invest instead of a safe one. And so on.
For now, though, I think we’re all waiting for a financial crisis to begin. And then we’ll get to ponder what comes next.
Editor, Fortune & Freedom