The next crisis isn’t coming…not li ke you think

Saturday, 25 September 2021 — Albert Park

[4 min read]

Dear Reader,

You’ve seen the news. China’s Evergrande is the new Lehman Brothers. COVID has surged in nations with high vaccination rates like Seychelles, Iceland, Israel, Bermuda, and Singapore. Many of them were forced to reintroduce restrictions after declaring they’d live with COVID. Compliance with lockdowns is falling fast all around the world. Gas and electricity prices are causing crises in Europe. The iron ore price is plunging, worsening Australia’s terms of trade. The US’s debt ceiling is back on the agenda.

So, there’s no shortage of flashpoints right now. Things that could cause meltdowns in the stockmarket, or worse, the bond market. At least, in normal circumstances they might…

But today, instead of investigating the many possible crises, I’d like to ask whether you think there can even be a crisis anymore. Specifically, whether central banks and governments will prevent one.

For example, when people ask whether Evergrande is China’s Lehman Brothers, they are likely missing the point. What made Lehman Brothers so important is that it was allowed to fail. But what is the lesson to be learned from this? Is it that markets can plunge when the likes of Lehman Brothers or Evergrande fail?

I don’t think so…

I think the real lesson is that nothing since Lehman Brothers was allowed to fail. Because the failure of that investment bank caused a much bigger crisis.

So, do you think anyone will be making the same policy mistake anytime soon?

I doubt it.

Most of the time, anyway…

Because the lesson of Lehman Brothers was to not allow anything to fail in the first place. At least, not in an uncontrolled manner which risks contagion.

But what if the crisis is just too big, I hear you ask?

Well, we’ve also learned that the central banks and governments’ capability to prevent a crisis is nigh on unlimited. Actually, it is unlimited, in a particular sense we’ll get to below.

Do you think the Evergrande crisis is worse than the last 18 months of pandemic mayhem? I doubt it very much.

Stocks, bonds, real estate, and other investment assets have soared during a pandemic that shut down global travel and economies. Well, the lockdowns did the shutting down…

Similarly, GDP has recovered in many places, despite continuing restrictions and COVID cases. Think about that for a moment. It’s bizarre.

Meanwhile, gold — the asset that outperforms when you can’t trust the monetary, financial, or economic system — has fallen. This usually signals rising trust in the system.

Look back at financial markets and you’d think the pandemic ended way back in mid-2020.

Perhaps markets were pricing in a much more sever pandemic back when they crashed in February and March 2020. The sort of pandemic that doesn’t need advertising.

But I suspect the real story is that governments and central banks are willing and able to save financial markets. And markets are now pricing this in.

The overall question I’m asking has two parts to it. Whether central banks and governments have the power to save us and whether they’re willing to? The third question is the bit everyone is avoiding — the consequences of saving us from a crisis, back to that in a moment. First, we need to make sure you’ve got a handle on the first two.

I think the consequences of the 2008 crisis were that governments cannot allow another Lehman Brothers. And so the risk was transferred onto governments’ balance sheets. Next came the European Sovereign Debt Crisis of the 2010s, when Greece technically defaulted, but not before the crisis was contained.

During that sovereign debt crisis, the risk was transferred to central banks instead, by way of limiting the yields on European bonds and quantitative easing. These institutions have limitless resources but are supposed to be constrained to managing macroeconomic conditions like inflation, unemployment, and financial stability.

Well, conveniently, when it’s a government that’s about to go bust, bailing out the government shifts into the central banks’ mandate because it would supposedly cause chaos to let it default.

This is where things get interesting. After the Asian Financial Crisis, the tech bubble, the housing bubble, and the European sovereign debt crisis, we’re finally approaching the endgame. The same endgame that all governments and central banks end up with once they abandon sound money.

You see, central bank independence from government, the prohibitions against central banks’ financing of governments, and the primacy of inflation targets over all other targets have been exposed to be nothing more than a mirage. When governments need central banks to finance them, they will.

And that’s where we are now. In a world where governments prevent a crisis and central banks prevent a sovereign debt crisis. Neither need stop and neither has an inherent limit. And so no crisis is too large to save us from.

But where does the buck stop then? And why haven’t we just done this all along? Why did we have any crises in the past if central banks and governments can fix everything? Heck, why do we have problems like homelessness and poverty if the government has the power to paper over a pandemic?

The answer is that our ancestors learned this lesson the hard way and tried to impart us with institutions that prevent the government from intervening in everything and the central bank from paying for it. Central bank independence, inflation target primacy, and the prohibition on monetising deficits were there for a reason. But we’re ignoring them now.

The consequences are stagflation and hyperinflation. That is where the buck stops, ironically.

Inflation is the only crisis that more money printing and more deficits do not fix. That’s why, once governments get into the crisis fighting business, which leads them into debt up to their eyeballs, and once the central bank agrees to finance governments beyond this point, you always get inflation.

But we’ve lost them — the institutions that prevent us from going down this path. And now the world is on track to repeat some nasty little bits of history.

Our best hope is that we manage to escape the worst of it by changing course, as we did in the ‘70s. Inflation was brought under control, sacrificing employment and GDP to do it.

Do you think that’ll happen again? Because how you answer that question determines the answer to my first: do you think we’ll have another crisis?

If not, expect inflation to get out of hand. Far more than it already has in much of the world.

Until next time,

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend