Even before the Covid-19 crisis had slashed stock prices nearly in half since it erupted in January, financial markets were in an inherently unstable condition. Years of quantitative easing had loaded so much money into stock and bond prices that stock price/earnings multiples and bond prices were far too high by any normal and reasonable historical standards. Risk premiums have disappeared, with only a few basis points separating U.S. Treasury bills and corporate bonds.
The Fed’s Quantitative Easing since 2008 plus large companies using their earnings for stock buybacks drove the prices of financial assets into a realm of unreality. The result was that markets already were teetering on the brink of fragility. Any rise of normal interest to more normal conditions, or any external shock, was bound to crash the artificial values at which financial markets were priced. The Fed’s policy was to perpetuate this situation for as long as possible by pumping in yet more credit. But at near-zero interest rates, there was little that could be done.
A close parallel to this situation was the state of Third World debt in the mid-1980s. Mexico’s announcement that it could not meet its foreign debt service was the shock that brought ugly financial reality into conflict with the assumption that somehow any government debt could be paid – even debts denominated in a foreign currency. (Mexico and other countries had denominated their bonds in dollars in order to obtain lower interest rates than bonds denominated in their own currencies would have to pay. The assumption was that export earnings would provide hard currencies with which to redeem the bonds.)
The international financial system was rescued by the issue of Brady bonds – “good” new bonds for old “bad” ones. The capital value of these bonds was still far below the original debt, but they had the virtue of setting realistic levels by bringing the debt balance more in line with the actual ability of debtor countries to earn the dollars or other hard currencies needed to service bonds denominated in foreign currencies, mainly the US dollar.
The current crisis requires a similar write-down and recognition that fictitious price levels must give way to reality at some point. In fact, we have reached the end of an illusion – the illusion that bond (and stock) prices could be sustained indefinitely simply by financial engineering,