Will Monetary Policy Trigger Another Financial Crisis?

Originally published on Project-Syndicate.org

Sustained unconventional monetary policies in the years after the 2008 global financial crisis created the conditions for the second-longest bull market in history.

But they also may have sown the seeds of the next financial crisis, which might take root as central banks continue to normalize their policies and shrink their balance sheets.

LONDON – Former US President Ronald Reagan once quipped that, “The nine most terrifying words in the English language are: I’m from the government and I’m here to help.” Put another way, policymakers often respond to problems in ways that cause more problems.

Consider the response to the 2008 financial crisis. After almost a decade of unconventional monetary policies by developed countries’ central banks, all 35 OECD economies are now enjoying synchronized growth, and financial markets are in the midst of the second-longest bull market in history. With the S&P 500 having risen 250% since March 2009, it is tempting to declare unprecedented monetary policies such as quantitative easing (QE) and ultra-low interest rates a great success.

But there are three reasons for doubt. First, income inequality has widened dramatically during this period. While negative real (inflation-adjusted) interest rates and QE have hurt savers by repressing cash and government-bond holdings, they have broadly boosted the prices of stocks and other risky financial assets, which are most commonly held by the wealthy. When there is no yield in traditional fixed-income investments such as government bonds, even the most conservative pension funds have little choice but to pile into risk assets, driving prices even higher and further widening the wealth divide.

According to a recent Credit Suisse report, America’s richest 1% now own about half the national wealth in investment assets such as stocks and mutual funds, while the bottom 90% of Americans derive the majority of their wealth from their homes – an asset class that took a big hit from the recession. In fact, the wealthiest Americans now own nearly as large a share of national wealth as they did in the 1920s. And at the global level, the top 1% owns half of all assets, and the top 10% owns 88%.

Moreover, though monetary stimulus has allowed companies to borrow and refinance at record-low costs, they have felt little pressure to raise wages. In the US, real wages in 2017 were just 10% higher than they were in 1973. And, despite the size and duration of monetary stimulus, central banks have consistently fallen short of their inflation targets. Today’s missing inflation may reflect deflationary pressure from demographic aging; globalization and the availability of low-cost labor abroad; the spread of automation and labor-saving technologies; energy-sector productivity gains that neutralize price increases; or other factors. Whatever the case, the net effect of low inflation in the developed world is a less stable social fabric, and an expanding wealth gap that fuels populism.

A second reason to worry about the policy response over the past decade is that the rising tide of risk assets, driven by QE, has supercharged passive investing. This trend has introduced a host of new risks. Since the crisis, markets have been tightly correlated, dispersion rates have been exceptionally low, and investing has largely followed a risk-on, risk-off pattern, all of which is perfect for low-cost passive investing to outperform active management. Accordingly, since January 2006, investors have put more than $1.4 trillion into passive vehicles such as index funds, while withdrawing $1.5 trillion from active mutual funds.

Yet even as investment managers have launched thousands of new products to meet rising demand, the environment that supported passive strategies has begun to change. For starters, central banks are, or will soon be, normalizing monetary policy by rolling back their bond purchases. With dispersions between assets and within asset classes on the rise, the performance pendulum has already started to swing back toward active management. And at the same time, the huge accumulation in passive investments over the past decade has heightened the potential for capital misallocation and asset-price distortions, while raising concerns about fiduciary duties of care and other systemic issues.

A third reason for caution is that central banks have yet to reverse fully their unconventional policies and unwind their giant balance sheets. If managing the financial crisis and rolling out unprecedented policies seemed difficult, just wait for what has to come next: withdrawal of unprecedented levels of liquidity from the economy. The balance sheets of the US Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England, and the Swiss National Bank have swelled to a combined $15.5 trillion – a fourfold expansion since the end of 2007.

The great unwinding that awaits the world economy will introduce a slew of major new risks. The size of central banks’ balance sheets is a function of the demand for money, and of the supply created by monetary expansion. Even if central bankers can gauge the demand for money accurately enough to ensure a stable balance-sheet adjustment in 2018 and beyond, additional challenges will remain. For example, if market participants, having never witnessed such a monetary normalization, were to misread central bankers’ intentions, they could end up reprising the 1994 bond-market crash. With new leadership at the Fed, effective communication will be more of an uncertainty.

Moreover, pension funds, having taken on ever more risk in their search for yield, will have to reconcile lower future market returns and increased volatility with the needs of an older population. In 2015, one-eighth of the global population was age 60 or over. According to the United Nations, that ratio will increase to one-sixth by 2030, and to one-fifth by 2050.

If pension funds cannot meet their obligations in the future, governments will have to step in to provide a safety net. And yet total government debt as a share of global GDP has increased at an annual rate of over 9% since 2007, putting it at around 325% of GDP; as a result, the bond market may not be there to back-stop indebted governments. If pensions and governments in advanced economies cannot provide for the elderly, social instability is sure to follow.

As we enter 2018, we must hope that central banks will be as adept at reducing their role in the global economy as Reagan was in restoring the market to the center of the US economy. Success will depend on two factors. First, central banks will have to resist politicization, and maintain their independence and extraordinary technical know-how. And, second, they will need to pursue the great normalization gradually and avoid abrupt moves. Of course, to do that, they will have to maintain the tricky balance of sustained moderate growth and low inflation that has characterized 2017.