Ten years after the Lehman Brothers’ bankruptcy, policymakers give themselves high marks for rescuing the global financial system.
But with any extraordinary policy response comes unintended consequences, some of which could be sowing the seeds for the next crisis.
Since Lehman, central bankers have collectively continued asset purchases coupled with exceptionally low rates which is only now coming to an end.
Instability resides with those assets that overly depend on cheap money.
Prolonged easy money has increased vulnerability in the form of dependence on deficit financing, excessive debt build-up and pockets of asset bubbles that eventually will need to deflate as rates rise. As central bankers wind down their asset purchase programs and financial conditions increasingly tighten, we see several key risks.
Rising debt levels
Emerging markets (EM) currently appear at the epicentre of rising risks, but vulnerabilities are more idiosyncratic than structural.
The risk of contagion is still limited, simply because most of EM has saved more and reformed past the external vulnerabilities of Turkey and Argentina – particularly in Asia where savings rates are high and ongoing reforms are paving the way for more balanced growth.
More worryingly, cheap money has led to a broad build-up in global debt, mainly among corporates and also developed market sovereigns that have more than offset the benefits of consumer deleveraging since 2008. US corporates have participated in the binge as well as corporates in EM, most notably in China.
The US more than doubled its sovereign debt load over the last 10 years, yet interest costs declined with falling rates and new supply limited by US Federal Reserve asset purchases – essentially, painless deficit spending.
Today, supply is increasing both for widening fiscal deficits and balance sheet reduction. Coupled with higher interest rates, this is beginning to crimp demand for risk assets. Similar dynamics will be at play as the European Central Bank (ECB) and potentially the Bank of Japan (BOJ) are ending their own asset purchasing programs.
Against this backdrop of higher debt levels with rising rates, there is an elevated risk of a policy mistake.
Just as asset purchases over the last decade were unprecedented and largely experimental, so will be the experience of winding down these programs.
Risk impact in an asymmetric risk environment
While elevated policy risk suggests unanchored inflation expectations or a possible hard landing, the more likely outcome is a grinding reversal of quantitative easing (QE) induced flows, requiring deleveraging and debt restructuring that policymakers have seemingly long sought to avoid.
For the first time since 2008, aggregate central bank balance sheets – the Fed, ECB, BOJ and the People's Bank of China – are beginning to contract.
Net liquidity withdrawal adds to volatility and likely the speed of crisis development as witnessed in the fast evolving currency crises in Turkey and Argentina.