Fuse lit for the next financial crisis

Money wasn’t just cheap. There’s a lot more of that now, thanks to years of quantitative easing by the major central banks. No wonder many have become addicted.

That’s the crux of the matter. Even if interest rates stop rising, the fallout from the unraveling of the long run of virtually free money could drag on for years and manifest itself in many different ways.

The crisis marked by the collapse of the SVB is not even the first in a long line of unfortunate events.

Of course, the Bank of England had to intervene in the gilt market last autumn when rising interest rates threatened to disrupt the ‘liability driven investment’ strategies pursued by many UK pension funds.

The obvious question is where the problem might appear next – and it’s not hard to think of candidates.

If you start big, how long can Italian government bonds be supported by low eurozone interest rates and bailouts provided by the European Central Bank? And what about Japan’s even higher debt burden, where the central bank is just beginning to exit decades of ultra-loose monetary policy?

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Outside of the financial sector, much of the UK economy has yet to feel the full impact of last year’s interest rate hikes and tightening financing conditions. For example, many smaller companies are just emerging from Covid support programs and could soon be paying much higher rates.

And closest to home, what about house prices? Rising mortgage costs and increasing economic uncertainty have already caused a sharp decline in the housing market and construction in both Europe and America. But this could be the tip of the iceberg as more homeowners need to shed their currently low fixes and refinance. Analysis by the Bank of England has found that a sustained 1% rise in real interest rates could lower equilibrium house prices by up to 20%.

So the bigger picture is that we need to get back to normal interest rates, and that will be painful. Weaker companies and those with riskier business models may struggle the most, but they won’t be the only ones.

This presents central banks with two dilemmas. First, how far should they be willing to bail out failing institutions? If they do too little, the entire financial system could collapse. If they offer too much support, they can simply encourage riskier behavior in the future (the classic moral hazard problem) or give the impression that the problems are now deeper than anticipated.

The chickens have come home to sleep. We need to go cold turkey and stop betting on free money.

Second, on interest rates, how will central banks balance their responsibility for financial stability with their obligation for currency stability, ie bringing inflation back down?

This is not an impossible choice. Central banks could argue that avoiding a financial crash would prevent inflation from falling too far. Public authorities also have many different tools at their disposal to achieve their various objectives. But that’s a difficult balancing act.

The European Central Bank (ECB) has already shown what its priorities are. On Thursday, despite the crisis in European banks, it pushed ahead with a further increase in key interest rates by half a point. Admittedly, the ECB’s hurdle to pausing (or just a quarter-point hike) was higher than other central banks because it had already committed to another half-point hike.

It would therefore be wrong to read too much into this move ahead of the Bank of England’s own decision on UK interest rates next week. Our monetary policy committee takes each meeting as it comes (rightly so, in my view), giving it more flexibility to react to new events.

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There have also been some pretty good reasons for a pause already, including signs that cost pressures in the pipeline are easing and wage inflation has peaked. So next Thursday I would expect at most a quarter point hike and personally vote for no change.

Still, it would be wrong to rely on central banks to fix problems caused by a prolonged period of very low interest rates by keeping interest rates low longer, let alone cutting them again quickly. The chickens have come home to sleep. We need to go cold turkey and stop betting on free money.