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Monday, November 14, 2016

There Are No Free Lunches, Not Even for Central Banks

A disaster looms for global financial markets. Protectionism can only make it worse.


Milton Friedman never tired of reminding us that there is no such thing as a free lunch.

All indications are that we may soon find out how true Friedman’s dictum will prove to have been with respect to the unprecedented balance sheet expansion of the world’s major central banks.

It took the Fed only six years, from 2008 to 2014, to more than quintuple its balance sheet.

While that balance sheet expansion might have helped the world economy recover from the depths of the 2008-2009 Great Recession, it did so by setting up the stage for the next major global economic downturn.

As an indication of how aggressively unorthodox global monetary policy has been, it is well to start with the Federal Reserve.

Toward the end of 2008, once U.S. interest rates had reached their zero lower bound, the Fed embarked on three separate rounds of aggressive government and mortgage bond buying — also known as quantitative easing — in an effort to stimulate the US economy. As a result of that bond buying, whereas it took the Fed some 100 years to increase the size of its balance sheet to $800 billion, it took the Fed only six years, from 2008 to 2014, to more than quintuple its balance sheet to its present level of around $4.5 trillion.
The very scale of the Fed’s balance sheet expansion alone would have had a major influence on global interest rates and on global liquidity conditions.

However, the Fed was far from alone in printing money on a massive scale. Rather, over the past eight years, similar — and in some cases even more aggressive — forms of balance sheet expansion have been pursued by the Bank of England, the European Central Bank, the Bank of Japan and the People’s Bank of China.


A TV screen showing U.S. President-elect Donald Trump is pictured in front of the German share price index, DAX board, at the stock exchange in Frankfurt, Germany, November 9, 2016. REUTERS/Kai Pfaffenbach

There are a number of reasons to think that the extraordinarily unorthodox policies of the world’s major central banks has likely created the conditions for a perfect international economic storm in the years immediately ahead. Among the more important of these is that those policies have given rise to a substantial increase in the overall global debt level.

A key ingredient of most global financial market crises is the mispricing of risk across major financial markets.

According to a recent International Monetary Fund (IMF) study, far from declining, over the past eight years the global debt level has risen to its current all-time high of 225 percent of gross domestic product (GDP).

While the high level of global debt is troubling, the very rapid increase in debt levels in key parts of the global economy have to be of particular concern. One has to be concerned that since 2008, Chinese credit to its state enterprise and non-financial corporate sector has increased by a staggering 90 percent of GDP. Such a rate of credit expansion considerably exceeded that which preceded the U.S. housing bust in 2007 or Japan’s lost decade in the 1990s.

One also has to be concerned that public debt levels keep rising in the eurozone’s economic periphery and that dollar denominated debt contracted by emerging market corporations has increased by $3.5 trillion over the last eight years.

A key ingredient of most global financial market crises is the mispricing of risk across major financial markets.

It is for this reason that one has to be concerned that the extraordinarily large scale of bond buying by the world’s major central banks have both spawned major bond market bubbles across the globe and have led to an undue compression of credit spreads in the high-yield debt market, the eurozone sovereign debt market and the emerging market bond market. Those latter credit spreads now do not nearly compensate investors for the default risk on those bonds.

Yet another reliable leading indicator of a future global financial crisis is pronounced weakness in systemically important banks. In this respect, one has to be concerned about the present weak state of the European banking system in general and those of Italy and Germany in particular. Two indications of how weak the European banks are may be assessed from their present very high levels of nonperforming loans and from their recent very poor share price performance.

The combination of very high debt levels, the gross mispricing of global credit risk, weak banks of systemic importance and fault lines in the global economy make it all too likely that the world is headed for a major global economic and financial crisis over the next year or two.

The question remains as to when such a crisis is likely to occur and what might trigger such a crisis.

Resorting to more protectionist policies is the last thing that a fragile global economy needs.

While such questions are always intrinsically difficult to answer in advance, there would seem to be reasons for thinking that we may not be that far off from such a crisis. Such a crisis could be triggered by a normalization of U.S. interest rates which could cause global liquidity to dry up. Alternately, it could be triggered by any one of the many fault lines in the global economy, be it in Italy, Brazil, China or Japan.

It is against this background that one must hope that, in formulating domestic economic policy, the new U.S. administration will focus on economic developments abroad and prepare for the contingency of a full-blown global economic and financial market crisis.

More immediately, one would hope that the Trump administration will find a way to back off from the anti-globalization rhetoric of the presidential election campaign, since resorting to more protectionist policies is the last thing that a fragile global economy now needs.

Republished from AEI.


  • Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.