The Fed risks being caught hopelessly flat-footed by a global credit crisis — again.
The Fed risks being caught hopelessly flat-footed by a global credit crisis — again.
I t might seem cliché to say that those who do not learn from history are doomed to repeat it, but the adage is particularly pertinent to today’s Federal Reserve. Seeming to have learned little from the Lehman Brothers bankruptcy in September 2008, the Fed is now tightening monetary policy at a rapid pace, at a time when the world is as indebted as it has ever been. It is also doing so when clear signs are emerging that major debtors are having trouble servicing their debts, and equity bubbles are bursting.
The late American economist Hyman Minsky taught that there was a regularity to credit cycles that always ends in tears. Many years of financial stability and low interest rates induce investors to take on excessive risk, lenders to make increasingly risky loans, and borrowers to take on too much leverage. That sets the stage and, eventually, euphoria gives way to panic when interest rates are increased or when the economy succumbs to recession, leaving debtors to service their debt mountains.
Recent examples of this cycle are the easy-money policies that spawned the 1997 Asian currency crisis and the 1998 Russian debt default. That cycle claimed as its primary victim Long Term Capital Management: a highly leveraged hedge fund that shook financial markets. More recently and more dramatically, the 2006 U.S. credit- and housing-market bubble that was spawned by years of easy monetary policy by the Fed claimed Lehman Brothers as its main victim. That in turn triggered the 2008–09 Great Recession.
It bears emphasizing that such Minsky moments do not come out of the blue. There were clear, early warning signals about the September 2008 Lehman bankruptcy. In 2007, two large Bear Stearns hedge funds blew up, and Merrill Lynch experienced massive mortgage-debt write-downs, while in April 2008 Bear Stearns had to be bailed out by the government.
Fast-forward to today: As a result of years of very easy monetary policy, the world has very much more debt in relation to the size of the global economy than it did in 2008. Also, unlike during the run-up to the 2008–09 recession when economic bubbles were largely confined to the U.S. equity and housing markets, by the end of last year we had an “everything” bubble in the world’s equity, housing, and credit markets.
It is against this background that the world’s central banks should be concerned about the many warning signals that are now flashing that suggest we could be heading toward another Minsky moment.
In China, Evergrande, the world’s largest property developer, and 20 other Chinese property developers have defaulted on their debts. In the U.K., the pension companies had to be bailed out by a $75 billion Bank of England intervention in the gilt market. In Europe, Credit Suisse Bank has run into serious liquidity problems. Emerging market economies such as Argentina, Sri Lanka, and Zambia have all defaulted on their debts (as, of course, has Russia, although that can be seen as something of a special case), and many others are on the cusp of default. Meanwhile, in the United States, the equity and bond markets have declined by more than 20 percent as that bubble has started to burst.
All of this makes the Fed’s current, aggressive monetary-policy tightening difficult to understand. The Fed is now committed to raising interest further in 75-basis-point steps even when the economy is showing clear signs of slowing and when interest rates have already been raised at the second-fastest pace in the post-war period. Equally troubling is that the Fed is now withdrawing market liquidity through quantitative tightening at the unprecedented pace of $95 billion a month even when there are growing signs of strain in the world credit and equity markets. According to the Atlanta Federal Reserve, such quantitative tightening over a three-year period could be equivalent to as much as a 75-basis-point interest-rate increase.
Unless the Fed dials back the rapid pace of its monetary-policy tightening — and soon — it may be caught, as in 2008, hopelessly flat-footed by a global credit crisis.