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Teetering on the financial brink

  • 08 June 2021
An often overlooked fact about the financial system is that it entirely depends on trust. When trust starts to evaporate, especially between the big players such as banks and insurance companies, the whole artifice is put into peril. Trust in the system is now at an extreme low and that points to extreme danger.

Consider some recent examples of what happens when trust fails. In the lead up to the global financial crisis of 2007-8 the players in the repo (repurchase) market, a place where banks raise short term cash, stopped trusting each other. It led to a panic that eventually spilt over into distrust in the interbank lending market, which keeps money moving around the globe. Interbank lending froze, effectively cutting off the blood supply of the whole system and almost destroying money itself. 

The problems exposed in 2008 were never solved and in September 2019 there was another crisis in the repo market. This time, though, the markets were engulfed by an even bigger problem: the COVID-19 crisis. Western central banks frantically printed money, either by issuing government debt or simply plucking it out of thin air by using a process called quantitative easing, which involves buying back government or corporate debt. That flooded the market with liquidity and covered up what was looming as a repeat of 2008.

It brought a temporary reprieve but the system continues to worsen. It is a point repeatedly made by analysts who criticise fiat money, which is backed by government regulation rather than a physical substance like gold.

At one level, these criticisms are reasonable. Governments cannot print money indefinitely without eventually causing a collapse. But it can be argued that the real issue is not too much control from governments, but a lack of it. After financial deregulation in the 1980s, central banks lost oversight over the quantity of money (in Australia, the government could once instigate a credit squeeze to restrict the amount of money but that mechanism is no longer available). Now they only have one tool left: the cost of money, or interest rates. With rates near zero in most developed economies, that tool has largely gone, too. There is no ammunition left.

The system is teetering. Most Western economies, including Australia, are mired in unsustainable debt that is only kept from collapse by interest rates close to zero (in Australia it is household debt that is most perilous). If inflation starts to rise, and central banks raise interest rates in