We have been going through a paradoxical economic period for several months now. At first glance, the situation in many developed countries has never seemed so good, with historically low unemployment and stock markets close to their all-time highs. Yet, one can sense, by paying attention to the tone used by some media, that the ice sheet on which our economies are dancing is thinning day by day, and to use the image mentioned in the title, a sudden volcanic eruption could plunge them into the abyss. To illustrate my point, I would like to briefly consider two recent examples here.
First example, a bit abstract for the European reader, but very much alive on the other side of the Atlantic: bank failures due to sudden capital withdrawals, or bank runs. After Silicon Valley Bank and Signature Bank, First Republic Bank was hit a few weeks ago by rumors about its financial health, leading many savers to withdraw their money for fear of losing it (a total of 100 billion dollars just in the first quarter of 2023). Indeed, in the event of a bank failure, the deposit insurance agency (the Federal Deposit Insurance Corporation) only guarantees savers the first 250,000 dollars deposited in their account, with the balance potentially being lost. For many businesses, this level of guarantee represents only a fraction of their liquid assets. Unable to sell its assets at a high enough price to meet withdrawal demands (a topic already addressed in this blog), the bank had to file for bankruptcy at the beginning of the week. In summary, it was initially rumors of fragility that, when amplified, including by social media, led savers to withdraw their funds and ultimately allowed the rumor to come true: a perfect example of a self-fulfilling prophecy and deeply destabilizing for our financial systems.
Inflation can also be a vector of instability. Having disappeared in developed countries for several decades, it has made a big comeback in the last 18 months or so, reaching double-digit peaks in the United Kingdom and the Eurozone before receding, while remaining at a high level. Facing a high level of inflation is already dangerous in itself: indeed, the increase in consumer goods prices weighs on households, who demand wage increases in compensation, which increases the cost of labor, production costs, and further feeds inflation, until it becomes uncontrollable. This “price-wage” spiral can generate many social upheavals (just look at France to be convinced) and is therefore particularly feared by public authorities (to those interested in a historical perspective on how inflation can damage society, I encourage you to read We Need to Talk About Inflation by Stephen King).
To mitigate this risk, ensuring price stability is a mission entrusted in each country (or monetary zone) to a central bank, which acts as a regulator. Today, their ambition is to bring inflation back to an acceptable level (around 2% per year) without damaging the health of the economy. To do this, and without going into too much technical detail, central bankers have the power to fluctuate interest rates (the more expensive it is to borrow money, the less you will tend to spend, so demand decreases, prices increase less, and inflation decreases). Beyond the factual decision, economists analyze the speeches given by central bankers, who justify their choices by sharing their expectations about future price developments.
Of course, it is absolutely impossible for a central banker to admit that inflation is out of control: not only would they fail miserably in their task, but they would also encourage households, through an anticipation effect, to maximize their purchases for fear that prices will violently increase in the future, thus boosting demand and actually causing prices to skyrocket (another example of a self-fulfilling prophecy). In game theory, we would say that the strategy of the central bank to always minimize the risk of future inflation is a “dominant” strategy (see last week’s post for more explanations). Central banks find themselves trapped when inflation does not decrease as quickly as announced and confidence in central banks decreases. At the extreme, if the citizens of a country believe that their central bank has lost all credibility, they start to consume excessively as if inflation were about to become uncontrollable, effectively making it uncontrollable, even with the weapon of interest rates. This dystopian scenario is still only fiction, but could unfortunately become more real than ever if prices continue to increase dynamically, confirming the powerlessness of central bankers.
These two examples, among many others, clearly show that our economies rely on balances that are sometimes so unstable that a single grain of sand, taking, for example, the form of an unforeseen geopolitical event, can derail them.