Bernard Hickey surveys a financial landscape full of morally hazardous trades based on 0% interest rates forever and finds inflation is the key

By Bernard Hickey

This week's turmoil on global markets has reminded us all that we live in financially turbulent times. They are also morally hazardous times.

'Moral hazard' is the phrase used to describe the problem where investors take a risk knowing they cannot lose and that someone will always be there to bail them out.

Time and again since the Global Financial Crisis in 2008 it has seemed as if there was always some central bank or Government there to rescue investors from a true collapse in global financial markets and banking systems.

Firstly, interest rates were slashed to reduce the burden of high debts. Then banks were bailed out to stop the financial system from collapsing. Then when interest rates were cut to zero, central banks printed money money to buy bonds and other assets to push up their prices and drag long term interest rates down.

The US Federal Reserve cut its Official Cash Rate to almost 0% in 2008 and has left it there ever since. In addition, it has launched three rounds of so-called Quantitative Easing (QE) and has only just recently stopped this money printing to buy Government bonds.

The Bank of Japan has been printing for years and only recently ramped that up to try to lift its economy out of decades of perma-recession. The European Central Bank has cut its deposit rate all the way to minus 0.2% to try to force savers to invest and kick-start the Euro Zone's stalled economy. That means savers have to pay the bank to look after their money.

All this rate-cutting and money printing have made it very attractive to buy assets such as stocks, property and bonds that produce some sort of regular income greater than the near-zero interest rates. Stock and bond markets have rallied to record highs over the last six years despite the Global Economy enduring its longest recession since the 1930s and repeatedly failing to fire as forecast time and again.

Bizarrely, it seems, the global economy is mis-firing in many areas yet investors can be sure there will always be a regular interventions by central bank Governors and Finance Ministers to stop markets collapsing when the apocalypse beckons.

This time appears no different. China's Government has blown US$200 billion trying to prop up a stock market that has fallen at least 43% from its peak. It also intervened to firstly push the Chinese yuan lower and has since spent another US$200 billion to stop it from falling further. This week the People's Bank of China cut its main lending rate by 0.25% to 4.6% and loosened the lending rules for banks so they could lend out another US$101 billion.

There is now talk the US Federal Reserve will have to delay until next year the long-awaited, long-hoped-for and long-feared increase in its version of the Official Cash Rate by the shocking amount of 0.25% from the current nearly 0%. Some, including the former US Treasury Secretary and one of the world's biggest hedge fund managers, are even suggesting the Fed' restart money printing with a fourth iteration of Quantitative Easing known as 'QE 4'.

It seems these days that whenever markets start to fall, there's always a friendly central banker to soothe the fevered brows of investors and stop the markets from plunging. Stock markets recovered at various points this week in reaction to these morally hazardous interventions.

New Zealand investors are not immune. It's not often talked about these days, but our Reserve Bank lent the big banks here over NZ$7 billion at one point to tide them over during early 2009 when they couldn't borrow on frozen international markets. The Reserve Bank also cut the Official Cash Rate from 8.25% to 2.5% in less than a year to cushion the blow from the Global Financial Crisis. Property investors who geared up in 2007 and 2008 were essentially rescued by the Reserve Bank in 2009 and 2010, even though inflation spiked at various points to well over the Reserve Bank's targets.

Even this week Finance Minister Bill English and Prime Minister John Key were talking up the flexibility in New Zealand's economy that would allow the Reserve Bank to further cut the Official Cash Rate from the current 3% to closer to the 0% seen in other markets. English also talked about the potential for the Government to ditch its surplus targets and loosen the Government's purse strings to avoid recession if China's economy suffers a hard landing.

It seems investors can't lose. The mere suggestion of a slump and the grown-ups jump in to rescue them.

But just how long will Governments and central banks be able to use public balance sheets to turn the tides of markets? Can these rescues go on forever? There is technically no limit to the amount of money that central banks can print and Governments can borrow as much as they want while interest rates are 0%. They're technically defensible when Consumer Price inflation is dead.

The moment of truth will come when (or if) inflation starts to rise. Firstly, it would unleash the mother of market meltdowns in bond markets and quickly spread to stock markets supported by low interest rates.

But, curiously, all this money printing and 0% interest rates has yet to unleash the inflation dragon, at least for prices of goods and services. Asset prices are pumped up and juicy, but prices of goods manufactured in factories and services hosted in the cloud are firmly in deflationary mode.

Many investors will feel they are bullet proof while inflation is dead. They may even point to structural factors dragging on inflation such as massive factory over-capacity, globalisation of services and ageing populations reducing investment appetites.

But they should be careful. All bets are off on this morally hazardous series of trades if inflation takes off. Then central banks will have no choice but to put up interest rates and the leveraged bets will go bad.

The key to this puzzle is inflation. It has the potential to unlock this moral hazard.  

------

A version of this article first appeared in the Herald on Sunday. It is here with permission.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

We welcome your comments below. If you are not already registered, please register to comment or click on the "Register" link below a comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current Comment policy is here.

9 Comments

The idea that governments were free of fundamental financial constraints was always rubbish. Maybe they could kick the can down the road for longer than individuals - but it was always going to bite us in the end.

Not so much MH, more some elements of the ecosystem have/ are obtaining super (when risk adjusted) returns for particular activities.

Look more closely at exactly who is the beneficiary of the concept described. We are afraid its not the dear readers..

It is interesting. The banks can get their money for bugger all, close to 0%, but the people who actually put it to use don't. So again it is effectively a bail out of banks. Sure they can justify by handling fees, costs of making the money available to the user etc, but their margins are pretty big. Perhaps as has been previously discussed, the reserve banks could make sure that the ordinary person on the street can only be charged so much for the use of money. After all the banks have made record profits in NZ so far.

The Japan experience is barely mentioned and the probability of it occurring are flatly rejected.

good write up Bernard Hickey. Telling it like it is.

im always amazed when i chat to those tied up to property development, who when asked about borrowing, always have the same opinion. "borrow as much as possible, as property always goes up in value". And we dont worry as the government wont let the market collapse.

Thats the problem right there. one side of the equation is skewed.

perhaps the government and the reserve bank should let the whole thing tank.

Kane you obviously have not been a developer yourself. Four years ago I entered into a joint venture subdivision of some size with a pure developer. As a professional I thought we would put some cash in as a deposit. His response was hell no or words to that effect and further that we would borrow the whole purchase price of the land, the interest costs and the infrastructure costs. If it cannot stand on its own feet you do not do it. I had to trust his judgment and luckily we were successful. We chose the right bank and we were lucky with timing. We have since expanded our initial holdings and again have borrowed the total cost. The trick is to get a bank behind you and not a second or third level lender and to get the timing right. We are currently doing nothing as where we are land sales have slowed down a bit. We also did not strip the company of too much cash and have paid off the initial borrowings.

Oh dear, it looks like BH has read my comments :-) ... and dumped Krugman.

Next question is of course what can set off consumer price inflation? While noting that asset price inflation has wrecked a lot of lifes around the globe as is, together with mostly stagnant wages.

I would not bet on inflation being the only factor that could end the mass lunacy. Our paper money economy is built on trust. Trust that government and central planning bankers have in my view already shattered. What will happen when Joe Blow finally gets the plot?

lifting gross wage always lifts inflation