Quantitative Destruction: Are we headed for next financial crisis?

Quantitative Destruction describes the paradox that occurs when excessive easing creates unserviceable debt burdens for central banks and by extension governments which when attempting to relieve these burdens induces failures among the institutions (namely banks) for which the easing was originally incepted.

This paradox aptly describes the financial climate which we’ve created for ourselves since the global financial crisis in 2008. For over a decade our economies have been running on artificially cheap capital which central banks cascaded through our economies via open market operations. Each attempt to unwind these excessive rounds of Quantitative Easing since the post GFC liquidity crisis has resulted in very limited Quantitative Tightening and shortly thereafter prompted further excessive easing. In other words, a negative-sum game.

As we observed in 2007-2008, several financial institutions failed in a lead up to the October 2008 meltdown which induced a global deleveraging event. Bear Sterns, Lehman Brother, Meryl Lynch, and Northern Rock. These were early warning signals which we’re potentially seeing today with the failures of SVG, Credit Suisse and stress experienced by Deutsche Bank.

This state of perpetually diminishing returns has cultivated a climate welcome to seigniorage driven business models in the financial sphere enabled by digital disruption and the proliferation of FinTech. The latter being a portmanteau for ‘Financial Technology.’ Although mainstream banks have been slow in the uptake of this paradigm, significant strides have been made in adopting digital channels development. Other practices, however, have weakened the integrity of core banking which have adapted to dovish interest rates and an abundance of virtually free capital. Ostensibly, the COVID-19 pandemic exacerbated this predicament and amplified the effects of both digitally led deflation and quantitative destruction simultaneously.

In ideal circumstances policy makers would be capable of managing financial stability while regulating inflation, however, in practice efforts to curb inflation (still at ~6% in the US) risk inducing a banking crisis. Banks and financial firms have incurred unrealised losses in some cases and realised losses in others on their bond holdings that will only deepen with greater interest-rate rises via contractionary monetary policy. This is not an abnormal risk to manage, however, when liquidity is in short supply may temper confidence.

Those advocating for a hiatus in rate hikes note that financial instability itself acts akin to a rate hike as businesses attempt to preserve capital positions. Essentially, banks lend less while investors simultaneously pull back.

So, how do we escape this ‘Quantitative Destruction’ paradox?

Central Banks are faced with a dilemma, either resume Quantitative Easing in which case inflation persists beyond control or continue engaging in Quantitative Tightening and risk inducing a liquidity crisis. This paradox is discussed in my book, Bad Money.

Weak signals as to the difficulty experienced by the Fed is evident, in that banks borrowed the substantial sum of $152.85b from the Fed’s discount window in the week to the 15th March. Further adding another round of credit support will effectively wipe out approximately fifty-percent of the balance sheet relief the Fed has realised through Quantitative Tightening since June 2022. Ultimately, these emergency relief measures may be construed as further Quantitative Easing at a juncture where the Fed needs to be doing the opposite to stave off inflation.

So, are we headed for the next financial crisis?

I’d be interested in your thoughts as to how we may be able to escape this paradox.

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