Rising anxiety in financial markets

A higher default risk concentrated in financial markets catalyzes runs in a financial distress.

As in old days, a run is a reasonable behavior of self-protection. The rule is simple: who sells first loses less.

Investors buy riskier assets because they must store their wealth somewhere. The digital value store options are still exiguous. Digital assets such as crypto currencies do not provide a less risky alternative with high volatility.

Investors become more anxious against bad news as the default risk of portfolios soars.

Via quantitative easing, central banks have prevented credit defaults for more than a decade. Investors are well aware of the fact that zombie borrowing has surged in the financial system. Piling default risk in portfolios is leading to a more dramatic run in the next financial distress, coercing central banks to buy riskier assets. Central bank interventions exacerbates the situation, incentivizing the production of riskier assets.

Investors buy riskier assets because they must store their wealth somewhere. The digital value store options are still exiguous. Other digital assets such as crypto currencies do not provide a less risky alternative with high volatility. Physical store of value in cash or gold is the closest alternative as anxiety surges in the financial markets. If investors take their money out of the financial system, next time, the Fed will need to buy everything in the markets. This is certainly unsustainable.

A higher default risk concentrated in the financial markets induce runs in a financial distress. As in old days, a run is a reasonable behavior of self-protection. The rule is simple: who sells first loses less. As the default risk of financial products soars, investors become more anxious against bad news.

How could the anxiety in the financial system be attenuated? Doing the opposite of what is being done now. The default risk can be lowered via two ways, either by increasing the amount of safe assets or decreasing defaults. Quantitative easing has become a major factor which dampens the supply of safe assets available to investors. Shrinking the central bank balance sheets could be a nice step to attenuate future financial anxieties.

Alternatively, the need to safe assets could be alleviated via the digital currency. If risk-averse investors could deposit their money at the central bank, they would simply do it. Central bank would be the securest place, could an investor store wealth. Digital currency would also deactivate quantitative easing which pushes investors to risky assets.

The second step would be reducing zombie borrowing. The default risk in the financial system would fall when zombie borrowers are gradually liquidated in good times. The incentive of a run while a financial distress would alleviate when the probability of loss falls. While interest rates stay low, liquidation of zombie firms requires new macroprudential tools such as the debt service coverage (DSC) ratio.

Quantitative easing is on its limits. Central banks need new tools to interfere with financial and economic crises.