Read more: The secret history of the banking crisis
Financial crises are an inexorable part of civilisational history and, since the Dutch “tulip mania” in the 17th century (yes, it really was about flowers), they have often been triggered by asset bubbles bursting. People (or firms) borrow to purchase the thing that’s surging in price, and there comes a certain point they can’t afford to service that debt. In the run-up to 2008, several debt-financed bubbles were in play—not tulips this time, but mortgage-backed securities and government bonds from southern European states. Eventually, as Adam Tooze explains, a vicious cycle set in—prices collapsed, and the credit markets which had financed the stampede of investments suddenly closed.
A decade on, the response to the 2007-8 crisis has created another bubble, and thus the conditions for another crash. In November 2008, the Federal Reserve began with Quantitative Easing (QE)—making up money, and pouring it into the system by purchasing assets. Now, thanks to QE, the Fed, the Bank of Japan, and the European Central Bank (ECB) collectively hold more than $13 trillion worth of assets, many of which are government bonds. This has created an unprecedented monetary order. You’d normally expect high levels of debt to make borrowing more expensive. But world debt has grown to more than 325 per cent of world GDP, while interest rates remain on the floor. Earlier this year even Argentina, a state that defaulted as recently as 2014, was able to sell 100-year bonds with a yield of only 8 per cent.
The logical corollary of extremely cheap money is extremely high bond prices. QE ensures a voracious demand for government bonds, and so drove prices up—so long as the authorities were buying on a mass scale, investors knew that if they piled into bonds, they’d be able to sell them on at rising prices. Thanks to all the easy money from QE, this could be done on virtually free credit. Now, however, the central banks want to draw back. They fear that if their extremely loose policies are not ended before the next recession hits, then even more extraordinary medicine could be required, with who knows what side-effects. The Fed terminated its QE purchases in 2014 and has since raised interest rates to 1.25 per cent; the ECB has said it will be done with QE by the end of this year. Some rate-setters at the Bank of England have been talking about tightening policy too.
So there is no longer the certainty of open-ended support for the bond markets. The government bond bubble, and parallel bubbles in shares and other things, thus look at risk of bursting. If they do, governments and the rest of us are in for a sharp rise in borrowing costs. That will knock growth. The effects could ricochet worldwide, as they did in December 2015, when the Fed raised rates for the first time in nine years, and caused capital flight from China and carnage in emerging markets, as investors were lured by higher returns in the United States.
The very vulnerability of the bond bubble, and the grave consequences of a bust, could keep it going for a time yet. When in 2013 the Fed first tried to taper its Treasury bond purchases, investors pushed up yields dramatically, and a hasty retreat had to be beat. That could happen again.
History tells us bubbles always eventually burst. But it doesn’t tell us when. And it certainly doesn’t tell us what happens when central banks created the bubble—to escape from the last crisis, which they are not at all sure is over yet.
Financial crises are an inexorable part of civilisational history and, since the Dutch “tulip mania” in the 17th century (yes, it really was about flowers), they have often been triggered by asset bubbles bursting. People (or firms) borrow to purchase the thing that’s surging in price, and there comes a certain point they can’t afford to service that debt. In the run-up to 2008, several debt-financed bubbles were in play—not tulips this time, but mortgage-backed securities and government bonds from southern European states. Eventually, as Adam Tooze explains, a vicious cycle set in—prices collapsed, and the credit markets which had financed the stampede of investments suddenly closed.
A decade on, the response to the 2007-8 crisis has created another bubble, and thus the conditions for another crash. In November 2008, the Federal Reserve began with Quantitative Easing (QE)—making up money, and pouring it into the system by purchasing assets. Now, thanks to QE, the Fed, the Bank of Japan, and the European Central Bank (ECB) collectively hold more than $13 trillion worth of assets, many of which are government bonds. This has created an unprecedented monetary order. You’d normally expect high levels of debt to make borrowing more expensive. But world debt has grown to more than 325 per cent of world GDP, while interest rates remain on the floor. Earlier this year even Argentina, a state that defaulted as recently as 2014, was able to sell 100-year bonds with a yield of only 8 per cent.
The logical corollary of extremely cheap money is extremely high bond prices. QE ensures a voracious demand for government bonds, and so drove prices up—so long as the authorities were buying on a mass scale, investors knew that if they piled into bonds, they’d be able to sell them on at rising prices. Thanks to all the easy money from QE, this could be done on virtually free credit. Now, however, the central banks want to draw back. They fear that if their extremely loose policies are not ended before the next recession hits, then even more extraordinary medicine could be required, with who knows what side-effects. The Fed terminated its QE purchases in 2014 and has since raised interest rates to 1.25 per cent; the ECB has said it will be done with QE by the end of this year. Some rate-setters at the Bank of England have been talking about tightening policy too.
So there is no longer the certainty of open-ended support for the bond markets. The government bond bubble, and parallel bubbles in shares and other things, thus look at risk of bursting. If they do, governments and the rest of us are in for a sharp rise in borrowing costs. That will knock growth. The effects could ricochet worldwide, as they did in December 2015, when the Fed raised rates for the first time in nine years, and caused capital flight from China and carnage in emerging markets, as investors were lured by higher returns in the United States.
The very vulnerability of the bond bubble, and the grave consequences of a bust, could keep it going for a time yet. When in 2013 the Fed first tried to taper its Treasury bond purchases, investors pushed up yields dramatically, and a hasty retreat had to be beat. That could happen again.
History tells us bubbles always eventually burst. But it doesn’t tell us when. And it certainly doesn’t tell us what happens when central banks created the bubble—to escape from the last crisis, which they are not at all sure is over yet.
