Opinion | For the cause of the next financial crisis, look to central banks’ overextended balance sheets

Assets of the US Federal Reserve, European Central Banks and Bank of Japan stand at 3.5 times their pre-crisis level

Protectionism, populism and political dysfunction could provide the trigger that tips vulnerable global markets into crisis

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Traders work at the New York Stock Exchange as a screen shows US Federal Reserve chairman Jerome Powell’s press conference after the central bank announced it would cut interest rates for the third time this year, on October 30. Photo: Reuters

Published: 1:00am, 26 Dec 2019Updated: 2:53am, 26 Dec 2019

Predicting the next crisis – financial or economic – is a fool’s game. Yes, every crisis has its hero who correctly warned of what was about to come. And, by definition, the hero was ignored (hence the crisis). But the record of modern forecasting contains a note of caution: those who correctly predict a crisis rarely get it right again.

The best that economists can do is to assess vulnerability. Looking at imbalances in the real economy or financial markets gives a sense of the potential consequences of a major shock. It doesn’t take much to spark corrections in vulnerable economies and markets. But a garden-variety correction is far different from a crisis. The severity of the shock and the degree of vulnerability matter: big shocks to highly vulnerable systems are a recipe for crisis.

In this vein, the source of vulnerability that I worry about the most is the overextended state of central bank balance sheets. My concern stems from three reasons.

First, central banks’ balance sheets are undeniably stretched. Assets of major central banks – the US Federal Reserve, the European Central Bank and the Bank of Japan – collectively stood at US$14.5 trillion in November 2019, which is down only slightly from the peak of around US$15 trillion in early 2018 and more than 3.5 times the pre-crisis level of US$4 trillion.

A similar conclusion comes from scaling assets by the size of their respective economies: Japan leads the way at 102 per cent of nominal gross domestic product, followed by the ECB at 39 per cent and the Fed at a mere 17 per cent.

Bank of Japan governor Haruhiko Kuroda (left), then US Federal Reserve chair Janet Yellen and former European Central Bank president Mario Draghi meet in August 2017, in Jackson Hole, Wyoming, at a global central bankers’ symposium. Central bank balance sheets have ballooned in the post-crisis era. Photo: Kyodo