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From the FT: Central banks have prepared a recipe for monetary overkill and liquidity crises
While bankers are keen not to repeat 1970s mistakes, the financial environment and debt burdens are different now
Having badly misjudged the strength of inflation over the past year, central bankers are now anxious to convey the message that they are determined not to repeat the mistakes of the 1970s. So much the better, you might think, because that era told us that the long-term costs of allowing inflation to become entrenched far outweigh the short-term ones of bringing it under control.
Yet while the current threat of stagflation rhymes with the 1970s, the wider economic and financial context when Federal Reserve chair Paul Volcker started tightening policy in 1979 differed notably from today. Inflation was much higher and the advanced economies looked very different. It is important, then, to ponder the likely new mistakes of the 2020s.
The single most important difference, in terms of steering a course back to stable prices, relates to the huge accumulation of debt since that time. In the US, gross public debt as a percentage of gross domestic product rose from 34.3 per cent in 1982 to 127.0 per cent in 2021. A similar trend was apparent across the developed world. Debt levels in the corporate and household sectors were also on a rising trend during that period. But why?
One fundamental cause was the supply-side shock whereby China, India and the eastern Europeans joined the world economy, cheapening labour relative to capital. This resulted in less investment and weaker demand in the advanced economies. Central banks compensated for this with looser monetary policy that distorted asset prices upwards relative to goods prices while securing debt dependent growth. Meantime, inflation remained quiescent, making it easy for central banks to keep within inflation targets introduced in the post-Volcker era.
Morally hazardous low interest rates encouraged further borrowing — an effect that ratcheted up after the 2007-09 financial crisis on the back of ultra-low and negative interest rates across the world, along with the central banks’ asset purchasing programmes. And then fiscal support during the pandemic resulted in the largest one-year debt surge since the second world war. The IMF estimates that public plus non-financial private debt rose by 28 percentage points in 2020 to 256 per cent of global GDP.
Such borrowing was relatively painless with ultra-low rates. It now becomes a debilitating vulnerability as pandemic-induced deficits rise and central banks raise interest rates and shrink their balance sheets to address burgeoning inflation. In the public sector borrowing costs naturally increase. Where central banks have engaged in large-scale asset purchases, higher interest rates will also reduce central bank remittances to governments.
The central banks have in effect replaced long-term debt with debt pegged to the overnight interest rate — the rate on bank reserves that financed their asset buying. The Bank for International Settlements says that as a result, in the largest advanced economies, as much as 30-50 per cent of marketable government debt is in effect overnight. In the process, losses on the sale of assets as bond yields rise and prices fall could raise politically awkward questions around whether central bank balance sheets should be strengthened with taxpayers’ money.
In the private sector, tighter policy brings rising debt servicing costs, with falling house and securities prices. The globalisation of capital flows since the 1980s also means that over-indebted emerging markets will be particularly hard hit by rising rates.
Changes in financial structure since Volcker’s day point to looming financial instability. The growth of the opaque derivatives markets, the rise of under-regulated shadow banks and a post-crisis regulatory environment that constrains banks’ ability to take securities on to their balance sheet in times of stress are unnerving features of modern markets. As Michael Howell of CrossBorder Capital has pointed out, the chief role of the financial system is no longer to take deposits and make loans but to refinance the debt that sustains global growth and consumption. This complex system is increasingly dependent on shaky collateral.
The successful control of inflation requires pre-emptive action. Yet central banks declare that they are data dependent and focus closely on inflation and employment numbers, which are lagging indicators. Fed chair Jay Powell, like most other central bankers, has minimal interest in money supply numbers, which are forward indicators. Tim Congdon of the University of Buckingham, whose forecasting record in relation to the current inflation is much better than that of the central banks, has noted that broad money growth in the US came to an almost complete halt in the six months to this July.
We have here the perfect recipe for monetary overkill and liquidity crises.
Copyright The Financial Times Limited 2022
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