The fuse will burn in the next global crash, which will explode first is the real question

A general view of the Bank of England – REUTERS/Maja Smiejkowska

Taken individually, it might make sense to downplay the events of the past week.

You can argue that the smaller US banks – such as Silicon Valley Bank (SVB) – are outliers because they are niche players and are not subject to the same liquidity rules and stress tests as the larger banks.

Similar, Credit Suisse was extremely poorly managed for many years. It should survive, with better management and a huge cash injection.

In the meantime, central banks will ride to the rescue with more bailouts and rate cuts?

I wouldn’t “count” on that. First of all, history has taught us that bank failures are like London buses – you wait forever for one and then three come.

The SVB did nothing particularly disreputable. The bank made the classic mistake of not matching the duration of its assets and its liabilities.

But at first glance, the bank did nothing other than prudently reinvest its customers’ money in government bonds.

All it took to trigger the latest crisis was for official interest rates to return to historically normal levels. Worryingly, they are still relatively low in real terms, after accounting for the rise in inflation.

In the UK, for example, the Bank of England has raised interest rates to 4%, the highest since the global financial crisis (GFC) erupted in 2008.

Interest rates were below 1 percent for most of this period. Authorities have launched an experiment that now looks set to have disastrous results. By contrast, prior to the GFC, rates of 4 to 6 percent were commonplace.

Money wasn’t just cheap. There’s a lot more of that now, thanks to years of quantitative easing by the world’s major central banks.

No wonder many have become addicted.

That’s the crux of the matter. Even if interest rates stop rising, the fallout from the unraveling of the long run of virtually free money could drag on for years and manifest itself in many different ways.

The crisis marked by the collapse of the SVB is not even the first in a long line of unfortunate events. The Bank of England, of course had to intervene on the gilt market last fall as rising interest rates threatened to disrupt the “liability investing” strategies pursued by many UK pension funds.

The obvious question is where the problem might appear next – and it’s not hard to think of candidates.

How long can Italian government bonds be supported by the low interest rates in the euro area and the European Central Bank’s bailout packages if you start big?

And what about Japan’s even higher debt burden, where the central bank is just beginning to exit decades of ultra-loose monetary policy?

Outside of the financial sector, much of the UK economy has yet to feel the full impact of last year’s interest rate hikes and tightening financing conditions.

For example many smaller companies just coming out of the covid support programs and could soon be paying much higher rates.

And closest to home, what about house prices? Rising mortgage costs and increasing economic uncertainty have already caused a sharp downturn in the housing market and construction, both in Europe and the US.

But this could be the tip of the iceberg as more homeowners need to shed their currently low fixes and refinance.

Analysis by the Bank of England has found that a sustained 1% rise in real interest rates could lower equilibrium house prices by up to 20%.

So the bigger picture is that we need to get back to normal interest rates, and that will be painful. Weaker companies and those with riskier business models may struggle the most, but they won’t be the only ones.

This presents central banks with two dilemmas.

First, how far should they be ready rescue failing institutions? If they do too little, the entire financial system could collapse.

If they offer too much support, they can simply encourage riskier behavior in the future (the classic moral hazard problem) or give the impression that the problems now run deeper than anticipated.

Second, on interest rates, how will central banks balance their responsibility for financial stability with their obligation for currency stability, ie bringing inflation back down?

This is not an impossible choice. Central banks could argue that avoiding a financial crash would prevent inflation from falling too far. Public authorities also have many different tools at their disposal to achieve their various objectives.

But that’s a difficult balancing act.

The European Central Bank (ECB) has already shown what its priorities are. On Thursday, despite the crisis in European banks, it pushed ahead with a further increase in key interest rates by half a point.

Admittedly, the hurdle for the ECB to pause (or raise just a quarter point) was higher than for other central banks as the ECB had already committed to another half point.

It would therefore be wrong to read too much into this step beforehand the Bank of England‘s own decision on UK interest rates next week. Our monetary policy committee takes each meeting as it comes (rightly so, in my view), giving it more flexibility to react to new events.

There have also been some pretty good reasons for a pause already, including signs that cost pressures in the pipeline are easing and wage inflation has peaked. So I would expect a maximum of a quarter point rise on Thursday and would personally vote for no change.

Still, it would be wrong to rely on central banks to fix problems caused by a prolonged period of very low interest rates by keeping interest rates low longer, let alone cutting them again quickly.

The chickens have come home to sleep. We need to go cold turkey and stop betting on free money.

Julian Jessop is an independent economist. He tweets @julianhjessop.

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