The Western world is trapped. A perfectly foreseeable disaster is unfolding as years of irresponsible and unsustainable policies catch up with our institutions of government.
Since the Global Financial Crisis, continuous government deficits have been financed by central banks who have engaged in Quantitative Easing (QE) where new government debt was exchanged for freshly printed money (technically bank reserves) and simply added to the central bank balance sheets. As long as rates were kept low by the central banks, governments could borrow freely without having to worry about the cost or finding buyers for their debt. Some warned that the policy of QE would turn out to be inflationary but the warnings were ignored and QE seemed to be the magic money tree which allowed fiscal restraint to be a thing of the past. Of course we now know that those warnings should have been listened to. Now, with central banks having to apply the brakes to avoid inflation spiralling out of control, interest rates are soaring and QE will have to be replaced by Quantitative Tightening (QT), the reverse process of central banks selling bonds or at least not reinvesting interest payments and notional redemptions. This switch from artificial demand to increased supply of government debt will of course accelerate the increase in interest rates as bond prices fall. Government will face increased borrowing costs and just as the world enters recession more and more of falling tax revenues will have to be spent on servicing the massive debt burdens carried by governments the world over. We are seeing this play out across the Western world.
It was all avoidable, but there was no willingness to accept that government, like everyone else, must live within its means and that recession is the inevitable consequence of a boom caused by artificial expansion of the money supply. No-one in the institutions of power wanted to listen to those of us who called the policies out as unsustainable, irresponsible and dangerous and suggested that recession should be allowed to run its course to correct for years of capital misallocation. Now it’s too late. The dice have been cast.
How could this now play out? One scenario is economic Armageddon. At some point central banks will throw in the towel and perform their pivot, reversing policies by cutting rates and engaging in new QE programmes to combat recession and bail out bankrupt governments. But this will add fuel to the inflation fire and put pressure on bond markets, making the dichotomy between central bank attempts to keep rates low and market pressures to send rates higher unsustainable. Something will have to give. Central banks will become the buyers of last resort, hoovering up increasing amounts of government debt as other buyers evaporate. It will become clear that because there is no willingness to accept a deep recession, the policy of QE is irreversible. What was meant to be a temporary measure will finally emerge from its disguise to reveal itself as what it inevitably would become: the monetisation of government deficits. The legitimacy of our institutions of government will be strained and, with it, the trust in fiat currency regimes the world over. The consequences could include sovereign debt and currency crisis and state bankruptcies like we know from emerging markets, may become reality in the West.
Is this inevitable? Maybe not, if central banks have the gumption to stay the course, allowing interest rates to normalise at much higher levels and halt any further QE which will eventually reduce inflation and allow interest rates to fall again. But this will inevitably induce major recessions in highly leveraged Western economies, including house price collapse and likely a financial crisis, as bank balance sheets are decimated by delinquencies and defaults. That is the choice. Accept a devastating recession or break the trust in our monetary system. Not a pretty choice. But one we set ourselves up for.