The New Paradigm: Major Central Banks Don’t Fail

Warren Buffet has called the Federal Reserve, the US central bank, “The Greatest Hedge Fund In History”.  That is because the Fed as it is commonly known has persisted in printing money and buying $85 billion in bonds each month in order to artificially support the US and by extension the global financial markets.

This is quite possibly the recipe for another financial disaster.

The Fed’s balance sheet now stands at a colossal $3 trillion and every time there is the suggestion that the Fed has gone too far in printing money and inflating asset prices, including bonds, stocks and houses, the markets cry foul and the Fed continues on its merry way.

This large scale printing of money for assets purchases by the Fed and also by the way the Bank of England is known as Quantitative Easing or QE. Their actions would appear to be based on a simple new paradigm: major central banks don’t fail.

However, history informs us that new paradigms especially when coupled with cheap money are particularly and spectacularly prone to destruction. It is a combination that has proved to be the deadly breeding ground for financial crises.

In the 2000s, the financial markets operated on the assumption that by holding highly diversified portfolios of debt, irrespective of individual creditor quality, they could somehow make themselves immune from large credit losses. This belief was further reinforced by the use of credit derivatives that were designed to provide insurance against credit losses.

A new paradigm thus emerged; destructive credit failures were a thing of the past. This new paradigm was underpinned by ample flows of cheap money because the Fed kept interest rates artificially low even as asset prices were rising rapidly, thus allowing the paradigm to be thoroughly tested. Unfortunately, it was tested to destruction as we experienced what became known as the subprime financial crisis when banks and investors suffered massive credit losses and the global economy descended into a tailspin.

In the 1990s there was the internet craze where the idea took hold that if a company created a business model around a website, then it was most certainly on its way to establishing an unassailable economic and competitive advantage. Securing a dotcom was the passport to untold wealth and that became the new paradigm. Money poured into this “new economy” but ultimately dotcoms became dot bombs and banks and investors lost billions.

The new paradigm of the early 1980s was one which maintained that lending vast amounts of money to developing countries was not a problem as countries didn’t fail. In this case the cheap money was provided by petro dollar deposits from Gulf Arab states. That paradigm only remained true until Mexico defaulted on its debts in 1982, inevitably followed by the default of a host of other countries. This resulted in the LDC (lesser developed countries) debt crisis.

We could keep examining financial crises all the way back to the stock market crash of the 1920s and the Tulipmania of 17th century Holland and we would find the same set of circumstances. Each and every time we would find too much money chasing after some new paradigm; an absolute belief in an object of financial desire that, at least in theory, would never go bad.

As such, the markets will continue to press the Fed to prolong its QE operations and continue to delay the day of reckoning in the belief that the Fed can do no wrong and that it will never fail.

In theory of course the Fed can always print money. However, the longer the delay the more likely it is that it will all end in grief. Everything has its breaking point and that includes even major central banks such as the Fed.

Jonathan Ledwidge is the author of the book Clearing The Bull, The Financial Crisis And Why Banks Need A Human Transformation (iUniverse).

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