The largest economic bubble in history is finally popping. COVID-19 served as the needle; the perfect catalyst. But it is by no means the root cause of the crisis.
Though the direct impact of the virus would likely have been negligible by itself, the aggressive containment methods implemented by governments around the world have already begun to cripple global supply chains. The longer travel restrictions and quarantines remain in place the more severe these disruptions will be. However the secondary consequences which have been set into motion by these measures are all but unstoppable at this point. The stock market crash of 2020 is just the beginning. Globalization is in the early stages of a total collapse. The world as we know it will never be the same. To understand why — and to prepare for what comes next — we must examine the underlying vulnerabilities in the current system.
Central Bankers Are Out of Ammunition
It is widely assumed that in the event of a serious financial crisis central bankers will always step in to save the day. However this time around they simply don’t have the means.
In response to the 2009 financial crisis, central bankers engaged in an monetary experiment labeled “quantitative easing” (aka QE). During Quantitative Easing central banks created new money which was used to purchase trillions of dollars in bonds and distressed assets. This was the digital equivalent of running printing presses nonstop for years.
Between 2009 and 2014 the Federal Reserve was spending 40 billion a month on on these assets. By the time all was said and done the Fed alone had added 4.4 trillion dollars to its balance sheet, while the ECB and the Bank of Japan added 5.6 trillion and 5 trillion respectively (for a total of 15 trillion).
In parallel, central banks brought interest rates down to zero following the housing crisis, and held them at this level for almost a decade, fueling a massive credit expansion. This set off a secondary wave of money creation through a mechanism referred to as “fractional reserve banking”. Fractional reserve banking is a fancy way of saying that banks are allowed to loan out money they don’t have. In most countries banks can legally loan out 10 times more than they hold in reserves. As this new money entered into circulation consumer spending increased, businesses expanded, and the economy grew.
This influx of new money flowed mostly into stocks, real estate and other investments inflating the largest asset bubble in history. A short glance at the relationship between the S&P 500 and the Fed balance sheet makes the correlation crystal clear.
It should be obvious that if low interest rates and mass bond purchases stopped the previous crisis and sent the stock market through the roof, then the reversal of these policies must have an inverse effect.
The Federal Reserve began raising interest rates in 2015, and began selling bonds in 2017, thus tightening monetary and credit conditions simultaneously. By October of 2018 the Fed was unloading 50 billion in bonds bonds every month. Money was being sucked out of the economy even faster than it had been added.
This reduction in liquidity led to a sharp downturn in equities, prompting central banks to reverse course and start pumping money into the system again. Asset prices rebounded immediately. It’s worth noting that this latest round of money printing was already underway long before the corona virus reared its head.
As stock markets tanked in February 2020 in response to COVID-19 many began to talk about another central bank intervention. Though such an intervention is all but guaranteed at this point, the outcome is likely to catch many by surprise. With the Fed Funds Rate sitting at 1.75%, even if they cut to zero this won’t move the needle significantly. Nor will another round of money printing. In fact the lack of effect is likely to spark a deeper panic as markets come to terms with the fact that central bankers have completely lost control.