#Centralbanks: The #legacy of #monetarymandarins https://t.co/P12unEzhKZ
— Guillermo Ruiz Zapatero (@ruiz_zapatero) November 19, 2024
Who created #serialspeculativebooms to sustain the illusion of prosperity & of #governments who deflected #shifting #hardpolicymaking to #unelected and largely #unaccountable central banks#satyajitdas
The rulebook expanded after the 2001 dot-com problems and the 2007/8 financial crisis. The staple was interest rates. When they approached zero, central banks innovated with negative rates and implemented quantitative easing (QE), purchasing securities, government bonds, but later including mortgage-backed securities, corporate bonds and shares, using newly created reserves.
Central banks implemented yield curve control (YCC) to target specific rates. Policymakers introduced financing arrangements to provide funds to banks to bolster liquidity and also on-lend to clients. Critics joked that central bankers would deploy these tools to even combat an alien invasion.
But labour market changes—particularly the shift away from permanent work and reduced wage bargaining power in part due to reduced unionisation and industrial overcapacity—especially in China, kept prices in check. Inflation remained stubbornly low until the supply shock of the pandemic and military conflicts. The use of low rates to devalue the currency to increase export competitiveness floundered because every country followed similar strategies.
The real effect was on asset markets. As values reflect future cash flows discounted back to the present, an upward shift in prices was natural. Near zero rates meant the adjustment was exaggerated.
Low rates drove a search for higher returns, causing investors to overpay for long-duration bonds, high- and low-quality corporate debt, equities and real estate. It enticed investment in illiquid assets like infrastructure, private debt and equity, and venture or start-up capital. It encouraged increasing leverage to enhance available returns.
Intervention by the authorities and their underwriting of risk-taking suppressed volatility. This encouraged investors to sell options to enhance their returns through the premiums received. Asset managers employed investment strategies, often camouflaged under innocent names such as ‘risk parity’. There were pernicious feedback loops, with falling returns leading to more risk-taking, compressing yields and margins boosting prices further.
These developments have significant costs. First, the policies encouraged rapid growth in private and public debt. It facilitated fiscal indiscipline of governments who ran large budget deficits. An economic model of consumption and investment using borrowed funds became entrenched.
Second, capital was misallocated. Easy money allowed the survival of ‘zombie’ enterprises—indebted businesses that generated sufficient cash to cover costs and loan interest but not sufficient to invest in operations or repay the debt itself.
Third, asset prices became detached from intrinsic values, creating the constant spectre of financial instability. Rising prices for financial assets favoured high-income, wealthy cohorts exacerbating inequality.
Fourth, it fundamentally altered financial markets. Abundant cash, low rates and YCC artificially reduced risk. The US Federal Reserve, the Bank of Japan, the Bank of England, and the European Central Bank hold around 16, 53, 27, and 30 percent of outstanding government debt. The Bank of Japan holds around 7 percent of the stock market. The Swiss National Bank has a share portfolio (consisting mainly of US stocks) of around $200 billion (around 20 percent of GDP). This overhang and potential central bank activity distorts prices and liquidity.
Fifth, speculation and risk-taking are now underwritten by the ‘Greenspan Put’. Investors assume in case of problems, central banks will step in to ensure survival of banks and institutions deemed ‘too big to fail’.
Sixth, the ability to normalise policy settings—increasing rates or selling asset holdings—is restricted. Higher interest costs would increase the risk of financial distress for the growing numbers of over-indebted borrowers. Governments with high debt levels face larger financing expenses and must raise taxes or cut spending elsewhere. This, combined with falling collateral values, threatens lenders. The current pressure on central banks to cut rates reflects, in part, these pressures.
Finally, the policies generated toxic interest rate exposures that damaged balance sheets. QE created an asset liability mismatch as central banks purchased longer maturity securities with modest fixed rate coupons, funding them with reserves paying short-term rates. When rates rose in 2021 to counter inflationary pressures, the value of these bonds fell sharply. Central banks now have large unrealised losses that would be crystallised on sale. Their income is affected by the higher interest paid on reserves, below the earnings on the bonds.
Major central banks are now nursing Major central banks are now nursing large market-to-market losses and some have negative shareholder’s funds—not ideal for the guarantor of the financial system. The mismatch affected commercial banks, who used the liquidity provided by central banks similarly, investing in long-dated assets to boost income. This was behind the problems of US regional banks in 2023.
History will not be kind to central bankers fixated on financial economy and who created serial speculative booms to sustain the illusion of prosperity. It will also be critical of governments unwilling to address weaknesses, who deflected shifting hard policymaking to independent, unelected and largely unaccountable central banks.
(Views are personal.)
Former banker and author
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