It’s instructive to read Mervyn King, former governor of the Bank of England, in his book The End of Alchemy: Money, Banking and the Future of the Global Economy, to grasp why a repeat is so likely. He recalls that in the run-up to the global financial crisis of 2008-09, “interest rates, both short-term and long term, were at all-time lows”, which led spending along unsustainable paths.
Bank balance sheets, he further notes, “exploded”. With interest rates so low, “financial institutions and investors started to take on more and more risk, in an increasingly desperate hunt for higher returns”.
If that sounds eerily similar to events of late, another of his observations underlines the view that if history does not repeat itself, it still sometimes rhymes. Asset prices have soared amid low interest rates, encouraging a surge in global debt. This is as true now as it was before the 2008 crisis.
If we boil this down to its essentials, it means that low interest rates encourage irresponsible amounts of borrowing. The surge in stock and property prices that also comes with low rates encourages people to borrow and spend more.
Then the central banks weigh in to fight the ensuing inflation and the seeds of a recession are sewn. But before that sometimes protracted boom and bust cycle is completed, financial institutions such as banks can stumble or collapse under the weight of their own debt and inadequate capital.
This slide into collapse appeared to be under way a year ago in both the United States and Europe when Silicon Valley Bank suffered a sudden death along with others such as First Republic Bank and Signature Bank. Even the venerable Credit Suisse was forced to merge with UBS. Although that appeared to stem the tide of collapse despite rumours of trouble surrounding Deutsche Bank, officially orchestrated bailouts do not a healthy banking sector make.
Banks are greedy for more business in the same way that their executives – especially in senior echelons – are greedy for bonuses. According to US government data cited by William Cohan in the Financial Times, the four biggest US banks now have a record US$4 trillion of loans and leases.
The US authorities are pushing to increase capital requirements for 100 major banks under the Basel III regulatory regime. However, as the Bank for International Settlements has observed, banks tend to use increased capital to lend more rather than reduce leveraging.
We can assume that lending will go on rising until it stops or until something puts a stop to it. That something is more likely to be force majeure incidents such as corporate and institutional bankruptcies as opposed to official regulation.
The lesson now, as from the run-up to the global financial crisis 16 years ago, is that it is not a prevalence of exotic financial instruments such as subprime mortgages that trigger systemic crisis – they are a symptom rather than a cause. The real cause is excess lending on the back of low interest rates.
Yet even as we speak, banks and other lenders are clamouring for an early cut in recently raised rates by the US Federal Reserve, the European Central Bank and others. The Bank of Japan is an exception.
International Monetary Fund Managing Director Kristalina Georgieva speaks during the China Development Forum in Beijing on March 24. Photo: AFP
Central banks are under political pressure to cut rates, as International Monetary Fund managing director Kristalina Georgieva observed in a recent blog post: “Calls are growing for interest rate cuts, even if premature, and are likely to intensify as half the world’s population votes this year. Risks of political interference in banks’ decision making and personnel appointments are rising. Governments and central bankers must resist these pressures.”
Central bankers, she said, steered the world effectively through the Covid-19 pandemic, unleashing aggressive monetary easing that helped prevent a global financial meltdown and sped up recovery. Then they switched to restoring price stability by tightening monetary policy. These central bank actions have brought inflation down to more manageable levels and reduced the risks of a hard landing.
She is right to resist the political pressure to change course, but without a drop in rates a bankruptcy-driven financial crisis also seems certain. Central banks face the dilemma that inflation will take hold in earnest if they lower rates too fast, but raising them too rapidly could bring a financial system meltdown.
The responsibility for maintaining a strong financial system is supposed to lie with governments as well as central banks, but many banks are so big now as to be able to thumb their noses at officialdom – until they need a bailout. Meanwhile, they are free to increase lending without regard for systemic safety. This has to change, and the next crisis could change it. That would be some consolation at least.
Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs
