Central bankers face some very difficult choices

Six years ago this month the sub-prime crisis in the US finally erupted and unleashed the greatest shock that the global economic and financial system had seen since the 1930s.

Global policy makers are still struggling to come to terms with the impact, as evidenced by a prolonged period of zero interest rates in the US and interest rate levels in the eurozone that the inflation hawks in the ECB would never have deemed possible.

Central bankers have been forced to pursue and continue to pursue very unorthodox policies, such as bond buying and quantitative easing of money, and some governments have been trying to inject fiscal stimulus, while others have been trying to do the very opposite to arrest burgeoning public deficits.

It has been a total mess. Despite all of the valiant efforts of policy makers, the eurozone is still in recession, the UK economy is growing at a very modest pace, and even in the US, where the recession technically ended four years ago, growth is not exactly stellar. Unemployment levels almost everywhere are frighteningly high, with Europe a particular black spot. The growth in China has prevented a much worse outcome for the global economy, but even there certain stresses are now becoming evident.

For Ireland, this external backdrop has been truly horrendous and has dramatically exposed the well documented and painful imbalances that had been allowed build up in the economy. Many domestic mistakes were obviously made, but no country could remain immune to the global shock that has been unleashed, and particularly one like Ireland that had allowed its banking system run totally riot.

Unfortunately, until some semblance of global normality returns, there is little prospect of normality here.

In the US one gets very conflicting views on what is happening in the real economy. US equity markets have been doing very well since the spring of 2009, but there is a nervous sense of unease underlying market sentiment here. Corporate profits are still doing well, but there is a distinct lack of conviction about the extent to which the real economy can continue to support the market, but more particularly markets are very worried about the impact that the inevitable withdrawal of monetary stimulus will have.

In May, Federal Reserve chairman Ben Bernanke suggested that it might slow down its massive purchasing of long-term government bonds and other securities that have kept long-term interest rates down and injected liquidity into the financial system and the real economy. The market response was pretty difficult with long-term interest rates spiking up and equity markets had a few very difficult days. A few weeks later he was forced to suggest that monetary policy would remain easy for the foreseeable future.

The problems and risks. for equity market investors are quite clear. Markets have been buoyed up since 2009 by very artificial market conditions. Normally it is not the role of central banks to buy up the bonds issued by governments, but that is exactly what has been happening for four years.

Because there has been little investor interest in buying bonds of highly indebted countries, and because of the need to inject more money into the system to stimulate bank lending and general economic activity, central banks have been very active. In normal times the market system facilitates bond market functioning and the supply of credit, and central banks should not be getting involved in any meaningful way.

The big quandary now is how central banks will be able to withdraw from their abnormal activities without creating chaos in bond and equity markets and in the real economy. One suspects that equity investors will have much to worry about over the coming months.