The Bank for International Settlements studied the latent risk in a joint report with officials from central banks in 2018. They concluded that a “snapback” in interest rates was potentially dangerous. The global financial system, especially the non-bank shadow sector, had been lured into positions that could not be unwound with the flick of the fingers, and could not withstand a rate shock. A liquidity crisis was likely.
The report was so sensitive that publication was delayed. It was then released quietly and buried. One paragraph catches the eye. It warned of a collateral crisis in the “marked-to-market value of derivative contracts” leading to distress fire sales. That is what happened to the UK pensions industry in September. Regulators ignored the warning.
Philip Turner, one of the authors of the BIS report, says a decade of financial alchemy has left the global system overleveraged, opaque, and an accident waiting to happen. “UK pension funds are just the first bodies to float to the surface,” he said.
Let us be clear, QE was necessary to avert an implosion of the money supply and a second great depression after the Lehman crisis. The fundamental policy failure lies with governments. They imposed premature fiscal austerity in the US, UK, and Europe before economies had recovered, and at a time when banks were slashing credit to repair their balance sheets – made worse by ill-timed regulations forcing lenders to raise capital buffers too fast during the slump. Zero rates and QE were needed to offset the self-inflicted damage.
But by pushing the experiment too far, and by misrepresenting the trade-offs so dismissively, the central banks have tainted the whole apparatus of emergency money. The bar for a liquidity bail-out in the future is henceforth exorbitantly high, and we may well need one.
