Since the latest the crisis in 2008/2009, central banks around the world have been doing their best to expel risks from financial markets. By lowering interest rates, fixing them at extremely low levels, or issuing more credit and money, monetary policymakers make sure that ailing borrowers are kept afloat. In fact, central banks have put a “safety net” under the economies and the financial markets in particular. As it seems, this measure has been working quite effectively over the last ten years or so.
Investors do no longer fear that big borrowers – be it big governments or big banks and big corporates – could default, as evidenced by the low credit spread environment. Liquidity in basically all important credit market segments is high, and borrowers experience no trouble rolling over their maturing debt. What is more, stock market valuations have continued to increase, significantly propped up by central banks’ easy monetary policy. For low interest rates help drive stock prices and their valuation levels up.
Artificially suppressed interest rates lead to higher present values of firms’ discounted future profits. Furthermore, the decline in credit costs tends to increase corporate profits, thereby also boosting stock prices and their valuations. By no means less important, the low interest rate regime has caused firms’ capital costs to go down, encouraging additional investment activity, which is stoking investor optimism and feeding a buoyant stock market.
Decline in risk perception, rising stock valuation
Financial market stress indicator and price-earnings ratio of US stock market1)
Source: Thomson Financial; graphic by Degussa.
As a measure of risk perception, figure 1 shows a “financial market stress indicator”, together with the price-earnings ratio of the US stock market. From eyeballing the series, one can easily see that, since around 2009, the PE ratio has been rising considerably, while risk perception, as measured by the financial market stress indicator, has gone down substantially and has been hovering at relatively low levels since around the middle of 2014. The message of the chart is, therefore: Risk down, stock valuations up.
Of course, there is nothing wrong with this development per se, were it not for the fact that the decline in risk perception does not come naturally, but has been orchestrated by central banks’ many interventions in the credit and financial system. In particular, by artificially lowering market interest rates, central banks have triggered a “boom”, which produces pretty-to-look-at official data (on GDP, investment, employment, and such), but which is, and unfortunately so, built on quicksand.
The boom will only continue if and when market interest rates remain at suppressed levels, or are lowered even further. For if interest rates were to rise, various investments would turn out to be unprofitable; loans would default; banks would run up losses and rein in their credit supply; unemployment would rise; and so on. In other words: Higher interest rates would turn the boom into bust, for they would actually collapse the production and employment structure that has been nurtured by a policy of extremely low interest rates.
This is why central banks are most likely to continue with their “crusade against risk.” That is, they will very likely keep their interest rates at current low levels for a very long time or will, where it is still possible, lower them even further. For how long can this go on? Presumably no one knows for sure. At least on a scientific basis it is impossible to forecast when the crisis will hit, when the current boom will turn into bust. It might be a bitter pill to swallow, but it goes well beyond the science of economics to make any such predictions.
In view of central banks having effectively taken full control of the credit market, however, the odds are now that the boom will go on longer than many observers presumably suspect. For if central banks succeed in keeping a lid on market interest rates, a very important correction mechanism that could potentially turn the boom into bust – and that is a return of market interest rates to ‘normal levels’ – is effectively switched off; central banks’ crusade against risk proves to be devilishly efficacious indeed.
To be sure: By putting to rest investor risk concerns – in the form of, say, credit default, liquidity, reinvestment and horizon risks – central banks exert enormously distorting effects – which come clearly on top of the distortions resulting from a lowering of central banks’ key interest rates. Not only financial assets get increasingly mis-priced. Capital goods and all kinds of commodity prices get also heavily distorted (as these goods are priced according to their discounted marginal value product).
If central banks get away with their current monetary policies, then the probably greatest economic and financial distortion the world has ever seen will be fabricated: malinvestment, price bubbles and over-leveraging on a truly epic scale, accompanied by a dwindling purchasing power of the currencies involved. A plausible near-term scenario: For major central banks around the globe have teamed up in an effort to keep the current boom going, and there should be little doubt that they will do whatever it takes to do just that.
The extreme downside scenario, if and when it kicks in, is no doubt very unpleasant. In the words of Ludwig von Mises (1881–1973), it is this: “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”1
Fortunately, man’s future is not foreordained, as Marxian dialectic materialism wants people make to believe. On the contrary. Mans’ ideas and actions shape his future; fatalism is logically incompatible with his nature. Having said that, we have good reason to take side with Hans F. Sennholz (1922–2007), who noted: “[W]e are ever hopeful that, in the end, reason and virtue will prevail over error and evil.”2 It is by no means an oversimplification to say here that the monetary problem in this world can be solved quite easily.
The key step would be opening up a free market for money: that is allowing for a system to emerge in which people can freely decide which kind of money they wish to use. People would then no longer be effectively forced to use central banks’ monopolized currencies, and central banks could no longer abuse the monopoly power for catering to the needs of, say, the deep state and big business, which of course comes at the expense of the majority of the people.
A free market in money would also have the potential to mitigate the severity of the economic, financial and social crisis the current monetary system holds in store for basically all of us.
Dr. Thorsten Polleit, Chief Economist of Degussa and macro-economic advisor to the P&R REAL VALUE fund. He is Honorary Professor at the University of Bayreuth.
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