The Real LIBOR Scandal—–6 Years Of ZIRP—-Will Cause A Terrifying Crisis

by Jesse Colombo, Contra Corner


The Euro, Japanese yen, British pound, and Swiss franc Libor rates for all maturities have also been at record lows for a record length of time (click on links to see charts). Low interest rate environments create economic bubbles that burst when interest rates eventually normalize. The reason why low interest rate environments inevitably lead to the inflation of bubbles is because low borrowing costs encourage credit booms and discourage saving by reducing the rate of return on savings accounts and fixed income investments.

Prior Libor rate troughs have resulted in bubbles that ended in crises when the rate rose again:

LIBOR2Chart source:

Here are the bubbles and crises of the past three decades that low Libor rates have contributed to:

1) Japan’s economic bubble and the U.S. savings & loans crisis (late-1980s)

2) The 1994 Mexican financial crisis and the Asian financial crisis (mid-1990s)

3) The Dot-com bubble (late-1990s)

4) The U.S. housing bubble and European housing bubbles (mid-2000s)

5) Post-2009 economic bubbles that have not yet popped (to be discussed in the next section)

To reiterate, the current Libor rate trough that started in 2009 has created another global bubble that is far more extreme than the bubbles created by prior Libor troughs simply due to the fact that rates have never been this low for such a long period of time. Libor rates have been at such unusually low levels because most Libor rate-setting banks are based in the U.K. and U.S., which have both experienced severe credit busts and balance sheet recessions during the financial crisis as a result of their large debt and asset bubble overhangs. Economies that experience credit busts are at risk of experiencing deflationary depressions, which central banks try to combat by cutting interest rates as low as possible.

While the U.S., U.K., Japan, and peripheral European nations have suffered with balance sheet recessions and now weak credit growth and recoveries, most other nations escaped from the financial crisis largely unscathed and have been growing at a steady rate. In a normal world, borrowing costs in these faster-growing economies would be in the 4 to 7 percent range, but instead borrowers in these countries are taking advantage of the record-low sub-1 percent Libor rates that are geared for truly sick economies. Today’s Libor rates are simply too low for non-crisis economies, so this cheap credit bonanza is helping to fuel borrowing binges and asset bubbles almost everywhere that is not the U.S., U.K., Japan, and peripheral Europe.

As the world’s most important benchmark interest rate, approximately $10 trillionworth of loans and $350 trillion worth of derivatives use the Libor as a reference rate. Libor-based corporate loans are very prevalent in emerging economies, which is helping to inflate the emerging markets bubble that I am warning about. In Asia, for example, Libor is used as the reference rate for nearly two-thirds of all large-scale corporate borrowings. Considering this fact, it is no surprise that credit and asset bubbles are ballooning throughout Asia, as my report on Southeast Asia’s bubble has shown.

English: The cranes of the (and behind, the Ma...

Record low Libor rates are helping to drive credit, asset, and construction bubbles in Asia, including Singapore, which is shown above.  (Photo credit: Wikipedia)

The post-2009 global bubble is hardly confined to emerging markets, as it is also inflating in China, Australia, Canada, New Zealand, and Nordic countries as well. In addition, record-low Libor rates are contributing to bubbles in some areas within the U.S. economy such as higher education, auto loans, and certain segments of the housing market. Most private student loans, 45 percent of adjustable-rate prime mortgages and 80 percent of adjustable-rate subprime mortgages, and many auto loans and credit cards use the Libor as a reference rate.

The bubbles that I have listed are just a few of the bubbles that are inflating around the world thanks in large part to record-low Libor rates. There are likely countless smaller bubbles, massive systemic malinvestment, and other distortions that will only be identified in hindsight after the post-2009 global bubble economy ends. As Warren Buffett once said, “only when the tide goes out do you discover who’s been swimming naked.”

How The “Libor Bubble” Will Pop 

The Libor and similar benchmark interest rates simply cannot stay this low for such a long time without causing serious consequences. These low rates are driving what mainstream economists call the global economic “recovery”, but there is no such thing as a free lunch because this recovery is actually another credit and asset bubble. The global bubble will pop when the current low interest rate environment ends, no matter how long it takes for interest rates to eventually rise again. While interest rates are likely to stay at very low levels for another few more years because of the tepid pace of growth in the U.S. and U.K., this simply means that the global credit bubble will grow far larger and even more threatening than it is now, particularly in the non-crisis countries that were previously discussed.

There are several different scenarios that I foresee leading to higher interest rates and the concomitant popping of the “Libor Bubble”:

Scenario 1: Growth and employment in the U.S. and U.K. continues to improve over the next few years, causing central banks to raise their benchmark interest rates, which will cause the Libor to rise in tandem.

Scenario 2: Even if growth and employment in the U.S. and U.K. grow at an anemic pace, central banks may be forced to raise their interest rates to curb dangerous asset bubbles in the equity and housing markets. A similar and related scenario is one in which inflation or stagflation eventually rears its ugly head, forcing central banks to hike rates.

Scenario 3: Even if the Libor rates themselves do not increase for many years due to a lack of a full recovery in the U.S. and U.K., ballooning credit and asset bubbles in non-crisis countries cause banks to charge increasingly larger spreads over the Libor reference rate to compensate for the higher risk of lending in these economies. This scenario would have a similar net effect as if the Libor rates themselves increased, i.e., the ending of abnormally cheap credit conditions.

The popping of the “Libor Bubble” may not even require Libor rates to rise because the bubbles may endogenously collapse under their own weight after growing even larger in the next few years. Though the popping of the global bubble is likely several years away, the time to worry about this situation is now because the damage (the debt buildup and asset price inflation) is occurring at this very moment.

I will be publishing many more reports about dangerous bubbles that are currently developing around the entire world – most of which you probably never even knew existed. Please follow me on TwitterGoogle+ and Facebook to stay informed about the most important bubble news and my related commentary.

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