This week marks the fifth anniversary of the global financial crisis. Five years ago, the world of finance was shocked when BNP Paribas announced a freeze of three of its money market funds that were undergoing a deadly run of withdrawals. At that moment, a huge pyramid of complex financial assets—then sustained as collateral accepted by banks and the “shadow banking system”—hedge funds and money market funds—started to crumble.
What a party had ended for finance! An era in which asset values typically moved upwards, and one in which the realm of finance was taken as an accurate reflection of the underlying real side of the economy, was over. Not by chance “reading the financial tea leaves” had become a fashionable expression.
Fast-forward five years and one now sees the hands of governments and central banks all over the place in finance, sustaining markets with their maneuvers upon quantities and prices of assets available. Central banks’ balance sheets in the countries at the core of the crisis have expanded dramatically because of purchases of domestic assets to ease monetary conditions and avoid asset fire sales. Yield curves have flattened through several types of intervention in order to maintain long term yields close to their current historic low levels. Support to banks via bail-outs or broad liquidity facilities have avoided the collapse that funding costs imposed by private creditors would lead to. Regulatory requirements of liquidity have been tweaked, and in practice, have created a captive demand for government bonds, pushing down their yields. Currency markets have been subject to systematic interventions by heretofore hands-off governments, no longer comfortable with free floating under current conditions.
This is not the first time in history that public money extends itself in order to occupy the vacuum left by the destruction of the “private money” created during a previous phase of euphoria. And things would have been worse in the absence of such a provision, as investors rushing to swap private money for public funds would have otherwise provoked a liquidation of private assets, markets and institutions even more dramatic than the one that took place. The real sector would of course have been dragged deeper down—as happened during the Great Depression of the 1930s.
An open “politicization” of finance came out as a consequence of governments and central banks stepping in, in the sense that the dynamics of financial asset prices is now determined directly in the political sphere. Think of the Eurozone. Policy makers in those member countries under financial stress, currently implementing national programs of fiscal austerity and structural reforms, hold the view that the chances of success would rise if they had the support of supplementary creation of public money by the European Central Bank (ECB). On the other hand, the ECB’s actions are constrained by the political view predominant in other Eurozone countries according to which such a support would undermine the political willingness to reform. Financial markets now move on a daily basis between the poles of collapse and stability in accordance with signals of where the balance of those political views tilts.
Think of the US. The fiscal retrenchment—the so-called “fiscal cliff”—poised to be reached next year has not been created by private investors requiring sky-rocketing yields, but rather as an outcome of the battle between political views in Congress. As monetary easing by the Federal Reserve can be effective only to some extent without a concurrent fiscal stimulus, a precocious fiscal adjustment may well harm the prospects of economic and financial recovery.
During the apogee of the belief on the prescience of financial markets, armies of engineers, physicists and mathematicians were hired by financial institutions to develop quantitative models to decipher what the “financial tea leaves” were saying at each moment in time. One may wonder whether now the search is being taken over by political wonks.
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