The Next Financial Crisis Won't be Like the Last One

September 15, 2015

It seems increasingly likely the next Global Financial Meltdown will arise in the FX/currency markets.

Central banks are like generals: they tend to fight the last war. The Great Financial meltdown of 2008 was centered in too big to fail, too big to jail transnational banks and other financial entities with enormous exposure to collateral risk (such as subprime mortgages), highly leveraged bets and counterparty risk (the guys who were supposed to pay off your portfolio insurance vanish in a puff of digital smoke, leaving you to absorb the loss).

In response, the central banks and treasuries of the major economies "did whatever it took" to save the private banking sector from insolvency and collapse. In effect, central banks launched a multi-pronged bailout of banks and other financial heavyweights (such as AIG) and hastily constructed a clumsy and costly Maginot Line to protect the now-indispensable private banks from a similar meltdown.

The problem with preparing to fight the last war is that crises arise not from what is visible to all but from what is largely invisible to the mainstream.

The other factor is what's within the power of central banks to fix and what's beyond their power to fix. Correspondent Mark G. and I refer to this as the set of problems that can be solved by printing a trillion dollars. It's widely assumed that virtually any problem can be fixed by printing a trillion dollars (or multiple trillions) and throwing it at the problem.

Yes, the looming student-loan debacle can be fixed by printing a trillion dollars and paying down a majority of the existing student debt.

But lots of other problems are not fixed by printing a trillion dollars. Printing $1 trillion can pay for a lot of make-work jobs, but that's not the same as boosting employment in a sustainable, organic fashion.

The ocean's fisheries will not magically come back from being stripmined if a central bank prints $1 trillion. If the $1 trillion is spent wisely, perhaps in a decade or two fisheries can recover. But neither employment or ecosystems can be "saved" by printing money and throwing it at the usual vested interests.

So what else is beyond the easy fix of a quick $1 trillion printing/bailout? How about the foreign exchange (FX) market? Many a government and central bank has attempted to fix the foreign exchange market, but they fail for the simple reason that the FX market is too large to control for long.

$1 trillion just isn't that much in a market that trades $3 or $4 trillion per day.

It's not that difficult to predict that the next global financial crisis will arise not in the banking sector but in a market that's beyond the reach of central banks. That is, printing $1 trillion and promising to "do whatever it takes" won't fix what's broken.

One reason I have been focusing on the potential of the U.S. dollar (USD) to strengthen for the past four years is the potential for this dynamic to fatally disrupt the central bank-managed global "recovery."

Could the U.S. Dollar Rise 50%? (January 12, 2011)

We can already see the consequences of a strengthening USD: since the USD started strengthening against other currencies late last summer, capital flows have reversed globally, fleeing China and the emerging markets. Commodities and global trade have crashed as a result of this drain of capital out of emerging markets into USD-denominated assets.

The other reason crises arise is policies designed to solve one problem end up triggering another even more uncontrollable problem. Trying to control FX markets is intrinsically loaded with paradoxes and unresolvable conflicts, as whatever a central bank or treasury does to effect global FX markets has another set of consequences within the domestic economy that issues the currency.

Conversely, if the central bank/treasury set policies to control a crisis in their domestic economy, those policies have uncontrollable consequences in global FX markets.

For example: if a central bank raises interest rates to defend its currency, those higher rates strangle the domestic economy. In effect, the central bank has only bad options: either accept a domestic recession to defend the currency, or let the currency devalue and watch the domestic economy implode as import costs soar and capital flees the devaluing currency.

Add all this up and it seems increasingly likely the next Global Financial Meltdown will arise in the FX/currency markets. The core paradox--that central banks can't control both domestic and global FX markets with the same set of policies--cannot be resolved by printing $1 trillion, or even $5 trillion.

Printing money to fix one problem leads to another set of problems that are only made worse by additional money-printing.

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