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Are central banks creating the next financial crisis?

Financial Crisis

By Rohit Mishra

“The seeds of the next financial meltdown are sowed at the end of the previous one”. While the world economy is still recovering from the after effects of the 2008 crisis, central banks of various countries are pushing reforms that haven’t delivered results so far, and are rather backfiring in some cases.

The banks blindly sold these securities without considering the consequences.

Going back in time, let us have a look at the key events that led to the 2008 financial crisis. The crisis occurred due to the high influence of the banking lobby over policy formation. In the year 2000, Phil Gramm, then Chairman of the Senate Banking Committee exempted derivatives from the scrutiny of the Securities and Exchange Commission (SEC). Further, the SEC relaxed the net capital rule, which in turn helped the investment banks to leverage their debt level substantially. Strategically executing these amendments cleared the way for high-risk Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO). The banks blindly sold these securities without considering the consequences. These risks ultimately snowballed into the recession of 2008.

Since then, the Federal Reserve has been trying to stimulate the economy by pumping money into the system. It has conducted this monetary easing in three phases: 2008, 2011 and 2013. Then, after almost a decade, it increased interest rates in 2015. Today, with unemployment levels just under 5%, growth rates at around 2% and inflation less than 1%, the US economy has managed to get back up on its feet. However, low productivity and wage growth paint a dim future.

European Hurdles

The European Central Bank undertook measures to tackle financial crisis in Eurozone economies

The European Central Bank undertook measures to tackle financial crisis in Eurozone economies | Photo Courtesy: Flickr

Head East and the situation shows no improvement. Mario Draghi, the governor of the ECB has kept interest rates negative and deposit rates at zero, without reducing quantitative easing. The ECB has announced an extension of its bond-buyout programme for at least another six months until March 2017. This was done to revitalise the Eurozone economy and tackle deflation. However, growth is minimal and inflation is still nearly zero. In addition, the recent Brexit vote along with the Greek crisis have further weakened prospects of growth in the Eurozone. With major discrepancies between monetary and fiscal policies, economic growth in Europe might be a distant dream.

Japanese Slowdown

Countries in Asia such as Japan, have their own central bank problems. The three tools for economic growth: monetary stimulus, financial “flexibility” and structural change have actually caused economic decline. The people of Japan have preferred to delay consumption through savings, which has led to a serious shortage of liquidity in the economy, thereby impeding growth. In order to discourage consumers from saving, the Bank of Japan initiated a negative interest rates regime. However, this has failed in achieving the 2% inflation target.

The growth story of the 20th century is now a perfect example of how unconventional monetary policy can backfire.

More Such Policies in the Pipeline?

Several other unconventional monetary policies are being considered despite the failure of various such measures.

More unconventional monetary policies are being considered despite the failure of various such measures. One such theory is that of ‘helicopter money’, a theory proposed by Nobel laureate Milton Friedman. It involves giving cash directly to consumers to boost spending and foster growth. The case for such a policy has gained ground, especially in the context of the Japanese crisis.

Despite efforts by central banks to boost growth, desired results are lacking. Any trigger of the same magnitude as witnessed during the bankruptcy of the Lehman Brothers could invite another financial crisis.


Featured Image Credits: Pixabay

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