As markets step up the pressure on Ben Bernanke to pump even more money into the financial system, many are concerned that activist strain of central banking that’s swept through the developed world is stoking the fires for an even larger financial bonfire.
In his latest note, John Taylor, chief investment officer of FX Concepts, the world’s largest currency hedge fund, points out that the trend had its beginning in 1979 with the Chrysler bailout. At that stage, the US Treasury guaranteed a $1.5 billion loan to the car manufacturer, but in return the US government demanded, and received, $2 billion in concessions from unions, the company, and other stakeholders.
But, Taylor notes, central bank activism took a big step forward when Alan Greenspan took over as the boss of the US central bank. Greenspan reversed the 1987 stockmarket collapse, he rescued Mexico in 1995, South East Asia in 1997 and then went on to save the global banking system which was at risk after the collapse of the speculative hedge fund Long Term Capital in 1998.
Greenspan, of course, had some failures, notably the Russian default in 1998. But overall, Taylor argues, the perceived Greenspan "put” – the idea that the US central bank would slash interest rates and boost liquidity whenever a crisis arose – made investors extremely complacent. "Buy risk, you were safe, was the only way to go”.
But Taylor points out that Greenspan’s efforts to rescue the global banking system after the LTCM collapse now look like child’s play. "The central banks have to pay a lot more for optimism today. Loans aren’t enough; now they must give the money away. Printing presses are running flat out... and the developed world monetary base is almost three times higher than it was at the start of 2008.”
According to Taylor, "all this money sloshing around is nothing but kindling. This is enough to start one hell of a large inflationary fire, but probably not until we have a deflationary panic first – which will add even more kindling to the pile.”
Taylor argues that the progression from the first $1.5 billion Chrysler rescue to today’s multi-trillion dollar efforts by central banks in the US, the United Kingdom, Europe and Japan to support financial markets is similar to efforts to suppress forest fires.
Although fire-fighters are able to limit small fires, they now know that the longer they suppress them, the greater the chances of a highly disastrous, totally uncontrollable, conflagration.
When that catastrophe will occur is unpredictable but "by suppressing small fires, the forests approach an unstable state where the dead wood, resulting from the natural cycle of birth and death in the wild, is piled high, ready to explode into flames if the conditions are right.”
Taylor argues that central banks in the developed world are following exactly the same approach. "The central banks and other governmental authorities have piled the money so high that bubbles are popping up everywhere.”
Inflation may not have hit food prices yet, but Taylor argues that it is certainly hitting other asset prices, which is impoverishing those who do not own these inflating assets.
He also points out that this strategy of inflating asset prices is highly risky. "As those assets are in a bubble, a sharp reversal in price could appear at any time, just like the fire might begin in the forest. With so many bubbles and so much kindling, volatility in price is a sure thing.”
It’s impossible to accurately predict the timing of these dramatic breakdowns – whether it’s a forest fire, an earthquake or a market crash. It’s also extremely difficult to contain the damage they wreak.
Taylor notes that fire fighters have now worked out that the best way to control conflagrations is before they start. But, he pleads, "please tell Bernanke!”