This is not 2008, when a solvency crisis (a system-wide lack of equity) spawned interlinked and self-reinforcing liquidity shocks (a funding drain combined with a lack of sellable liquid assets at stressed institutions).
Solvency crises cannot be resolved by monetary policy and lender-of-last-resort support; and they entail deep economic contractions, as the impaired credit system reinforces the negative feedback loops of all recessions.
The dynamics are critically different today. In the GFC, idiosyncratic stresses worsened the collapse of confidence in the big banks at the heart of the system. A generalised run from all leveraged financial institutions was contained only when the state deployed its balance sheet as a back-stop.
By contrast, in March, the G-SIBs have been net beneficiaries of liquidity stress elsewhere in the financial system. No doubt the system’s overall preference for liquidity (over risky assets) has increased – the central dynamic in risk-off phases. But, to date, this has been primarily about where investors want to hold their liquid assets – the very definition of a liquidity shock.
In this cycle, the causation is set to work in reverse: idiosyncratic liquidity stress, via its impact on broad financial conditions and economic activity, will threaten a solvency crisis.
The core banking system has more than enough capital and liquidity to function through a normal cyclical downturn. Crucially, if central bankers are willing (backed by the political and intellectual elite) and able (their price stability mandate is not threatened) to flood the system with liquidity, it will only ever remain a threat. The key judgement is how quickly, and how far, the major central banks will go to forestall a series of liquidity shocks morphing into a deep recession that undermines the core banking system.
The Fed will not countenance widespread financial distress that turns a run-of-the-mill recession into something far ghastlier.
The Fed is perfectly willing to be blamed for a shallow recession that prevents a repeat of the 1970s. In the long run, it would surely enhance the institution’s credibility, much as Paul Volcker is now lionised for his actions in the early 1980s. But the Fed will not countenance widespread financial distress that turns a run-of-the-mill recession into something far ghastlier. That is the route to irreconcilable political breakdown in Washington, a permanent fracture of the Republication Party and an existential threat to the Fed.
For three decades, there has been no trade-off in periods of financial distress: demand stimulus and liquidity provision could be justified to minimise the threat of deflation (falling consumer prices) and limit contagion across the financial system (falling asset prices). Today, a trade-off does exist: a potentially significant downturn is needed to curtail inflationary momentum, but the only route to a downturn is a Fed-induced squeeze on the financial system that could rapidly get out of hand.
This will not be a multi-year crisis born of excessive balance sheet leverage, as in 1929-1933 and 2008-2013. Instead, the system’s fundamental weakness is asset illiquidity. Policymakers have the artillery that worked in previous crises at their disposal, they can and probably will use it. But to do so would be in an act of short-term expediency which comes with a long-term cost.