Are we on the verge of another financial crisis?
It is a question well worth asking as the prices of stocks and property have been sky high by central bankers flooding the markets with cheap money.
What should risk professionals do?
The first question for risk managers, internal auditors and finance professionals is; how much of the cheap and plentiful liquidity provided by Quantitative Easing, or QE as it is known, has gone into inflating asset prices—stocks, bonds and housing?
The second question is: how far will asset prices fall when the Fed and the Bank of England start to “taper” or reduce their QE and how will that impact my institution?
Finally, what is my firm doing in order to manage the inevitable fall in asset prices—a drop in stocks, a bear market in bonds, a burst of the recent housing bubble and a downward adjustment in emerging market assets and currencies?
It is not a question of if the Fed will taper but merely a matter of when. Yet, the market is urging continuity and no change in Fed policy by calling for Ben Bernanke’s deputy, Janet Yellen, to be appointed at the end of his term in order to continue more of the same. It appears that part of the reason Larry Summers fell out of favour for the job was that he would most likely have changed course.
The markets should be very careful what they wish for—especially since their record on lobbying regulators to give them more latitude in terms of both liquidity and regulation produced such a nasty shock the last time round.
Yet, it also appears that the markets have not learned from history.
It was cheap money from the Arab petro states which eventually found its way into the debt of the Lesser Developed Countries (LDCs) and later precipitated a crisis in the early 1980s. Cheap money also fuelled Japan’s inflationary expansion in the mid to late 1980s. That particular binge saw a calamitous drop in property prices and a fall in the Dow from 40,000 down to less than 10,000 at one stage—followed by two decades of stagnation.
The subprime financial crisis erupted on the back of a long and sustained period of cheap and plentiful money orchestrated by the Fed and willingly followed by other central bankers around the world. During that time former Fed Reserve Chairman Alan Greenspan remained firm in his determination to maintain the policy of cheap money while doing absolutely nothing about asset price inflation.
Now that the Fed is presiding over another era of cheap money economists are now beginning to think that it is a very bad idea—none more so than Raghuram Rajan.
Mr. Rajan is the governor of the Reserve Bank of India (RBI) and an online article in Quartz (http://qz.com/) entitled; The economist who predicted the financial crisis just sounded another alarm—it would be wise to listen this time, lays out exactly why we should heed his words. Specifically, the article recalls how in 2005, when he was chief economist at the International Monetary Fund (IMF), Mr Rajan was firm in stating his contrary view on the Feds’ cheap money policy even while others were hailing Greenspan as probably the best central banker ever.
After years of economic and financial pain we all now know just how correct that contrary view was.
This time however, Mr Rajan has company as central bankers from such disparate parts of the globe as Norway and Australia are raising interest rates to combat asset price inflation—which by the way is exactly what Mr. Rajan is doing in India.
In the UK, the Bank of England is finally signalling that it will start to taper its quantitative easing even as the property price bubble continues apace—a bubble which bears no relationship to the actual state of the real economy.
The task for risk managers, internal auditors and financial controllers is clear. Find out precisely what actions your institution is taking to guard against the next major disruption in the markets and where appropriate ensure that a suitable process of deleveraging is in place as when the markets turn, any activity funded by cheap money will be automatically doomed when interest rates rise.
Jonathan Ledwidge is author of the book Clearing The Bull, The Financial Crisis And Why Banks Need A Human Transformation (iUniverse).