26 Aug 2019
The Cause of the Next Economic Crisis: Central Bankers
The media is full of predictions of a recession in 12 months’ time. No-one knows of course when and if it will happen, although as night follows day it is likely there will be a downturn at some point. Globally we have entered a new world where the price of money is basically free while there is a cost for holding cash. So what behaviours is this combination driving. All those that can borrow will do so; whereas some of those with cash may seek riskier investments in seeking income (yield) and driving up asset prices rather than being penalised for holding cash. Those staying in cash will reduce their investment in new ventures and expenditure due to a lack of confidence in the economy.
Unless central banks reverse course there will be a solvency crisis (loss in confidence) in those borrowers (governments, corporates and individuals) that cannot (real or perceived) service their debt. Central Banks may be able to create liquidity; however they have no control over solvency.
The Global Financial Crisis (GFC) required aggressive global fiscal and monetary policy with significant government and central bank intervention, as there was a real threat of a global melt down. In Australia, the Federal Government created fiscal stimulus with a major spending package that was broken down into 33% (cash handouts), 33% (short term projects) and 33% (infrastructure projects) and it guaranteed bank deposits while allowing banks to use its AAA credit rating when accessing the debt capital markets. The RBA played its part by cutting interest rates. It worked, as Australia did not go into a recession.
It was apparent that by 2014/2015 these and similar policies had worked and most governments and central banks took steps to return to more traditional policy settings. By the start of 2019 the US Federal Reserve had reduced its balance sheet through Quantitative Tightening (QT) from $4.5 trillion to about $3.5 trillion and had increased interest rates as they wished to return them to more normalised levels. The US budget deficit was trending down.
Although US GDP growth was weaker in 2016 at 1.6%, compared to 2.6% and 2.4% in 2015 and 2004 respectively, it was not a dire situation. Despite this, in 2017/18, the US Government reversed course and implemented policies to further stimulate their economy increasing the budget deficit. Specifically, US Congress passed tax cuts and increased government expenditure and more recently the US Federal Reserve reduced interest rates.
Current key US economic indicators reveal the US Federal Budget deficit is USD1 trillion and increasing while its accumulated national debt is USD22 trillion all of which must be funded while interest rates (US10 year treasury is 1.56% on 23 August 2019) and unemployment is 3.7% (July 2019) are at record lows. There is talk that the US Federal Reserve may introduce 100 year bond (as have some other countries) and it appears that it will start Quantitative Easing (QE) again, re-joining the Europeans and Japanese that have been doing it for years now. The Eurozone and Japan interest rates (after inflation) are zero or negative, economic growth is sluggish and there is uncertainty over BREXIT. One important consequence of the US/China trade war is that China is no longer the major buyer of US treasuries which is something we predicted. In the immediate term, the trade war could create significant economic disruption. A not so obvious implications of the trade war is the changing world trade flows as both countries seek new markets, as to whether this is a long term outcome, only time will tell. The US consumer will be the loser.
The Japanese Budget deficit is now 3.8% of GDP, up from 3.7% in 2018 and GDP growth at 0.8%. The Eurozone GDP growth is estimated to be 1.4% in 2019 down from 2.0% in 2018. This is partially explained by BREXIT.
In summary, there was no threat of a global melt down in the same way there was in 2007/08 when central banks (notably the US Federal Reserve) changed course. Unless central banks reverse course there will be a solvency crisis (loss in confidence) in those borrowers (governments, corporates and individuals) that cannot (real or perceived) service their debt. Central Banks may be able to create liquidity; however they have no control over solvency. It’s their baby although the average punter will wear it!