Shades of Neville Chamberlain In Yellen's Crisis Prediction
In September 1938, on the eve of the Second World War, on returning from Munich Prime Minister Neville Chamberlain assured the British public that there was to be “peace for our time”. This week, some eighty years later, speaking in London Federal Reserve Chair Janet Yellen assured us that in our lifetime we will not experience another financial crisis like the one we experienced in 2008. Ironically, she did so on the very day that the Bank for International Settlements (BIS) issued a stark warning about the dangers of an excessive buildup of debt around the globe.
One has to hope for our sake that Mrs. Yellen’s bold prediction does not come back to haunt her through the annals of time as did the hapless Mr. Chamberlain’s statement come to haunt his memory. However, judging by what the Fed has wrought over the past eight years through its highly unorthodox monetary policy, I would not advise betting the ranch on Mrs. Yellen’s bold statement being proved to be correct.
One reason to fear that Mrs. Yellen will come to regret her bold statement is the frequency with which major global financial crises now seem to be occurring. The 1998 Asian financial crisis, which shook the global financial system to its core, was supposed to be a once in a lifetime event. Yet some ten years later, in large measure due to the way in which the world’s central banks reacted to the 1998 crisis, the world experienced an even worse financial crisis, the Lehman crisis in 2008. That crisis in turn produced the worst global economic recession in the post-war period.
A more basic reason for fearing the recurrence of another major financial crisis within the next year or two is the way in which world’s central banks have reacted to the 2008-2009 Great Economic Recession. Not only have those central banks kept interest rates at unprecedentedly low levels for a prolonged period of time, forcing investors to stretch for yield and making markets overly complacent. They have also engaged in massive bond buying programs which have caused their balance sheets to balloon. Since 2008, it is estimated that the Fed’s balance sheet has increased by around US$3 ½ trillion while combined the world’s major central banks’ balance sheet has increased by a staggering US$10 trillion.
One has to worry that Mrs. Yellen is seeming to turn a blind eye to the distortions in the global financial system caused by years of very easy monetary policy. As the BIS recently pointed out, the global debt to GDP ratio today is some 50 percentage points higher than it was in 2007 on the eve of the last global financial crisis. One also has be concerned that she is choosing to ignore the gross mis-pricing of risk and the great degree of market complacency to which years of very low interest rates has given rise.
It is not simply the fact that global equity and housing prices are at lofty levels and that these markets seem to be unfazed by any bad news. Rather, it is that credit spreads across global debt markets now seem to be not offering investors with nearly sufficiently high returns to compensate them for the likely risk of debt default.
One important example of credit spreads being too tight is that in the US high-yield debt market where interest rate spreads today are at the very tight sort of levels that characterized this market on the eve of the 2008 economic crisis. Other examples can be found in the emerging market debt market as well as in the European sovereign debt market.
The toxic combination of too much debt and the gross mis-pricing of that debt are all too reminiscent of the state of the world economy on the eve of the 2008-2009 Great Economic Recession. Compounding matters is the fact that there are no shortage of potential triggers that could focus the market’s attention on today’s gross mis-pricing of debt, which in turn could reveal fragility in the world financial system.
One potential set of such triggers could be the unwinding of years of ultra-easy monetary policy by the world’s major central banks. Another might be a setback in any of the numerous systemically important economies like Brazil, China, and Italy where major fault-lines are all too apparent. All of which has to make one less confident than Mrs. Yellen seems to be that we will not experience another major financial crisis in our lifetime.