At the height of the Cold
War in the early 60’s, the
U.S. and the Soviet Union
were stockpiling nuclear
warheads in sufficient
quantities to destroy the
entire planet many times
over.
The nuclear arms race was fuelled in large part by a sense of paranoia between belligerents that were acting on imperfect information. The race soon turned into a “Nash- equilibrium” zero sum game1, as it became clear that no victor could possibly emerge in the event of an all-out nuclear war.
Fortunately the weapons were never deployed2 and although stockpiles have been cut drastically in the post Cold War era, it doesn’t change the fact that the world can still be destroyed many times over. The nuclear threat hasn’t extinguished wars altogether, conflicts still occur albeit at a far smaller scale.
An analogy can be drawn between the Cold War era nuclear deterrent and the various policies and actions central banks have taken over the last couple of years. Threats to financial markets have appeared in many guises, from damage inflicted by speculators to systemic disruptions, the list can be long. Central banks have countered these threats through a combination of words3 and deeds, and the recent past is abundant of examples.
When the global economic crisis started in 2007, the “weapon of choice” was the target rate, which was brought close to zero in a short time span. It soon became clear, however, that more was needed to turn the tides. The ensuing near credit crunch conditions in the fourth quarter of 2008 prompted the Fed and other central banks to use more potent firepower.
The decision to let Lehman fail was an attempt to stifle moral hazard4 risk, and although the message was loud and clear, it gave markets cold feet. The emerging threat of “credit crunch” paralysis prompted Central banks to purchase a record $2.5 trillion worth of government debt and troubled private assets from banks5.
This was the first wave of a highly potent intervention. It did a lot to stabilize the markets, averting a serious, great- depression like crisis. Soon it became clear, however, that most of the advanced economies were stuck in a protracted, weakened recovery state, necessitating further actions.
These actions occurred, to a large extent, through multiple rounds of quantitative easing (QE) in an attempt to maintain low yields across the maturity spectrum. Just as QE was kicking in and economies seemed poised for a more robust recovery, the European sovereign debt crisis happened in 2010, eroding most of the bullish sentiment that has been forming.
Fear and uncertainty gained traction, prompting speculators to go as far as challenging the existence of the Euro. Peripheral borrowing rates went through the roof, forcing the ECB chief to announce in July 2012 that they were prepared to “do whatever it takes to preserve the Euro. And believe me, it will be enough." This turned out to be a defining moment, the explicit threat combined with the setting up of generous borrowing facilities for struggling member states went a long way to normalizing the situation.
We’ve come a long way from the initial crisis, and new threats are continually appearing. The Eurozone economies and a few other countries are now facing a serious deflation conundrum. With traditional and less conventional tools largely exhausted6, authorities are having to find novel ways to counter the threats. More recently several countries have been experimenting with negative interest rates7.
The idea is that by charging negative rates on bank deposits, central banks could help spur greater lending in the economy. It should also contribute to further weakening the home currency by rendering it somewhat less attractive for both locals and foreigners. The strategy does not seem to be having much of an effect, but it is still early to draw conclusions.
It could be that borrowers don’t see many opportunities for capital spending. Also, financial institutions seem to be absorbing most of the costs probably due to the fierce competition. As the challenges change form, the deterrents and actions adapt, and the saga continues.
1 The Nash equilibrium is a solution concept of a non-cooperative game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his own strategy.
2 We came dangerously close though, in October 1962, in what became known as the Cuban Missile Crisis.
3 Words in particular can serve as a powerful deterrent to threats arising from speculators. The ECB’s announcement in July 2012, for example, that it is ready to do “whatever it takes to preserve the Euro” is widely credited for having caused a dramatic drop in Eurozone bond yields.
4 Letting Lehman fail was meant as a warning deterrent for large institutions, the message being that reckless risk taking could have serious consequences.
5 This was the largest liquidity injection into the credit market, and the largest monetary policy action in world history.
6 Although there may be no theoretical limit on central bank money printing, the bond purchasing activities of QE does spur an increase in government debt and, in some circumstances, can degrade balance sheet quality of the central bank.
7 The ECB in June of last year joined Denmark, Sweden and Switzerland in charging a negative interest on deposits.
The nuclear arms race was fuelled in large part by a sense of paranoia between belligerents that were acting on imperfect information. The race soon turned into a “Nash- equilibrium” zero sum game1, as it became clear that no victor could possibly emerge in the event of an all-out nuclear war.
Fortunately the weapons were never deployed2 and although stockpiles have been cut drastically in the post Cold War era, it doesn’t change the fact that the world can still be destroyed many times over. The nuclear threat hasn’t extinguished wars altogether, conflicts still occur albeit at a far smaller scale.
An analogy can be drawn between the Cold War era nuclear deterrent and the various policies and actions central banks have taken over the last couple of years. Threats to financial markets have appeared in many guises, from damage inflicted by speculators to systemic disruptions, the list can be long. Central banks have countered these threats through a combination of words3 and deeds, and the recent past is abundant of examples.
When the global economic crisis started in 2007, the “weapon of choice” was the target rate, which was brought close to zero in a short time span. It soon became clear, however, that more was needed to turn the tides. The ensuing near credit crunch conditions in the fourth quarter of 2008 prompted the Fed and other central banks to use more potent firepower.
The decision to let Lehman fail was an attempt to stifle moral hazard4 risk, and although the message was loud and clear, it gave markets cold feet. The emerging threat of “credit crunch” paralysis prompted Central banks to purchase a record $2.5 trillion worth of government debt and troubled private assets from banks5.
This was the first wave of a highly potent intervention. It did a lot to stabilize the markets, averting a serious, great- depression like crisis. Soon it became clear, however, that most of the advanced economies were stuck in a protracted, weakened recovery state, necessitating further actions.
These actions occurred, to a large extent, through multiple rounds of quantitative easing (QE) in an attempt to maintain low yields across the maturity spectrum. Just as QE was kicking in and economies seemed poised for a more robust recovery, the European sovereign debt crisis happened in 2010, eroding most of the bullish sentiment that has been forming.
Fear and uncertainty gained traction, prompting speculators to go as far as challenging the existence of the Euro. Peripheral borrowing rates went through the roof, forcing the ECB chief to announce in July 2012 that they were prepared to “do whatever it takes to preserve the Euro. And believe me, it will be enough." This turned out to be a defining moment, the explicit threat combined with the setting up of generous borrowing facilities for struggling member states went a long way to normalizing the situation.
We’ve come a long way from the initial crisis, and new threats are continually appearing. The Eurozone economies and a few other countries are now facing a serious deflation conundrum. With traditional and less conventional tools largely exhausted6, authorities are having to find novel ways to counter the threats. More recently several countries have been experimenting with negative interest rates7.
The idea is that by charging negative rates on bank deposits, central banks could help spur greater lending in the economy. It should also contribute to further weakening the home currency by rendering it somewhat less attractive for both locals and foreigners. The strategy does not seem to be having much of an effect, but it is still early to draw conclusions.
It could be that borrowers don’t see many opportunities for capital spending. Also, financial institutions seem to be absorbing most of the costs probably due to the fierce competition. As the challenges change form, the deterrents and actions adapt, and the saga continues.
1 The Nash equilibrium is a solution concept of a non-cooperative game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his own strategy.
2 We came dangerously close though, in October 1962, in what became known as the Cuban Missile Crisis.
3 Words in particular can serve as a powerful deterrent to threats arising from speculators. The ECB’s announcement in July 2012, for example, that it is ready to do “whatever it takes to preserve the Euro” is widely credited for having caused a dramatic drop in Eurozone bond yields.
4 Letting Lehman fail was meant as a warning deterrent for large institutions, the message being that reckless risk taking could have serious consequences.
5 This was the largest liquidity injection into the credit market, and the largest monetary policy action in world history.
6 Although there may be no theoretical limit on central bank money printing, the bond purchasing activities of QE does spur an increase in government debt and, in some circumstances, can degrade balance sheet quality of the central bank.
7 The ECB in June of last year joined Denmark, Sweden and Switzerland in charging a negative interest on deposits.
