Central banks go for bust

The previous one followed the tsunami two years ago. But what is remarkable about the fall in the Nikkei is not its size but the fact that it has been so long in coming.

For a year, financial markets have been in bullish mood even though Europe is in a prolonged double-dip recession, the United States recovery has been poor and China is losing momentum.

After relentlessly turning a blind eye to bad data, markets responded badly that night to rising Japanese bond yields, a weak business survey from China and mixed messages from Washington about the future of quantitative easing.

The reason markets have been rising has, of course, nothing to do with real economic conditions and everything to do with the willingness of central banks to print money. Investors have been able to play in the casino with chips liberally provided by the Federal Reserve, the Bank of England and, more recently, the Bank of Japan. They have been having a fine old time of it. After such a strong rise, a correction has always been inevitable. The question is whether this is a pause for breath, or the start of something more serious.

Almost certainly, it will be a temporary pause, a blip. Central banks may well be inflating the biggest financial bubble the world has ever seen, the popping of which would trigger a second global slump, but they are convinced they know what they are doing.

Extra liquidity, they believe, will feed through into higher business and consumer confidence, and this will put the global economy on a stronger path. They prefer to have the problem of asset prices going through the roof than the problem of deflation. If they are wrong and the bubble bursts before the recovery arrives, it will be the mother of all credit busts.

The central banks are now in a very tricky position. Financial ­markets are so hooked on the electronic money created through quantitative easing that they cannot cope without it. The Fed chairperson, Ben Bernanke, made it clear on Wednesday last week that he wanted the quantitative easing to continue at its current rate.

In the short term, a commitment to keeping the money taps running full on will do the trick. Market corrections will be followed by soothing words and policy easing by central banks, and this will prompt further buying of assets. In the end, of course, this increases the chances of an almighty bust. That indeed looks likely. But not yet. — © Guardian News & Media 2013

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