How central banks have sown the seeds for the next financial crisis

The notion that governments have somehow got on top of the forces of financial instability is for the birds

Here’s a somewhat scary statistic for those meant to know about these things. After a six-year bull market, the typical stock in America’s S&P 500 shares index is valued on a multiple of more than 18 times estimated forward earnings. This is not just expensive by historic standards, but super-expensive. In fact, according to analysis by Goldman Sachs, it ranks as in the top 98th percentile of historic valuations since 1976, or in other words one of the highest in nearly 40 years. It scarcely needs saying that these peaks tend to signal the top of the cycle, with some kind of bear market or crash just around the corner.

But hold on a moment, you might say; we’ve barely recovered from the last downturn. It surely cannot already be time for another? Regrettably it can. Most business cycles last little more than seven years, and if anything they tend to be getting even shorter. The US economy contracted in the first quarter and has shown few signs of significant recovery since.

As for the Eurozone, spring has brought a rare burst of growth, but few believe it will last, let alone be strong enough to undo the damage caused by the crisis. Meanwhile, the prospect of Greek default continues to hover over everything like a permanent sword of Damocles, threatening at any moment to plunge much of the advanced world back into financial and economic turmoil.

This in turn is creating new sources of financial instability to replace the old incubators of it in the banking system. History rarely repeats itself exactly, and if looking for clues on what might trigger the next crisis, there is absolutely no point in looking for them in the last one. Banks are no longer a threat to the financial system or the economy. To the contrary, they have become so shrunken by credit loss and neutered by regulation that they have gone the other way, and if called on to help counter renewed turbulence elsewhere in financial markets would no longer be up to the job.

Now add to these markets the wholly price insensitive buying power of the central bank printing press, and all the conditions are again in place for a major train crash. Normally an investor judges value on the basis of perceived prospects for the asset involved – credit worthiness, market position, the outlook for growth, inflation, interest rates and so on.

Nobody can tell you when the next crisis will come, but the notion that governments have somehow got on top of the forces of financial instability – that just as Gordon Brown thought he had abolished boom and bust, they have now tamed the credit cycle – is for the birds. Credit expansion obeys the water bed principle; push it down in one area, and it merely rises up somewhere else. Central bank money printing undoubtedly helped stem the last crisis, but if it has also sown the seeds for the next one, you have to wonder about its long term consequences?

Full article: How central banks have sown the seeds for the next financial crisis (The Telegraph)

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