How will the next financial crisis erupt? (Or perhaps we should describe it as a further chapter of the ongoing financial crisis.) It’s like figuring out which piece of tinder will ignite after a sizzling heat wave. We know it’s bad out there, but just where will the next spark hit? What follows is one of many- potential financial crisis scenarios that Canada could face.

For argument’s sake, let’s start with the United States — since their tenuous position has all sorts of ramifications for the rest of the world. Given the rise of the Tea Party in the U.S., American politicians are loathe to implement the sorts of government spending (aka fiscal policy) needed to support a very fragile American economy. So the U.S. must rely on monetary policy to strengthen U.S. economic growth.

Monetary policy is always tricky. Even if the U.S. Federal Reserve can lower long-term interest rates, will this increase investment? Firms won’t borrow money to increase production if they are worried that glum economic conditions kill demand for their output. (Fiscal policy is more focused: when the government spends money, there is some chain of accountability to ensure that it gets spent on its intended purpose.)

The Fed has been trying simulative monetary policy, but it has already exhausted its traditional monetary policy toolkit. Now they are again dabbling in what Ben Bernanke calls “a relatively unfamiliar tool of monetary policy.” That is one way to put it. The German finance minster calls it “clueless.” This new form of monetary policy is often called quantitative easing, and it will allow the Federal Reserve to buy $600 billion in financial assets in an attempt to force down longer term interest rates.

The jury is still out on whether the Fed’s move ends up doing much to promote economic growth. But we do know one thing: financial markets loved the Federal Reserve’s decision to pursue quantitative easing. You see, if the Federal Reserve buys $600 billion in financial assets, prices in financial asset markets as a whole enjoy a boost.

Instead of promoting real sector investment quantitative easing may just channel a pile of cash into financial markets, where it is raw material for speculative bubbles. As Paul Vaillancourt, chief investment officer for Canadian Wealth Management confirms, there is little doubt that the Fed is re-inflating an asset bubble in stocks and commodities.

Wait, did he say “commodities”? You mean those natural resources that the Canadian economy is so famous for? Yep, and commodity bubbles are a very scary thing here in Canada.

This new round of quantitative easing has coincided with a blossoming financial crisis in Europe, as various countries are being punished — often (as in Ireland’s case) for the public debt left behind when its banks got caught up in speculative excesses a few years back. So it’s a double header folks: monetary policy that is conducive to speculation while international financial capital is busy rushing around trying to respond to (and potentially even to profit from) the financial difficulties in Europe.

Speculative Bubbles 101

How do speculative bubbles work, anyhow? The developing world’s experience of speculative bubbles provides an important example — they have been suffering under the devastation of financial crises for a good long while. And they are no stranger to speculation in commodities.

Typically, money floods into the developing country, pushing up that country’s currency and snapping up all sorts of real and financial assets. Meanwhile, that country’s manufacturing exporters get hammered because they cannot compete when their currency has such an artificially high value. So if the capital inflow is massive and lengthy enough, it may wipe out big chucks of the domestic industrial base.

So the tinder is ready, where is the spark? Any number of things can cause foreign money to rush out again. Maybe policy reversals by central banks or governments (or any other event) suddenly erode the relative attractiveness of parking money abroad. Almost anything — real or perceived — that causes speculators to lose confidence will send them running for the exits. Sometimes a financial crisis will be provoked by an event that is entirely unrelated to the poor country that gets hammered by a capital outflow. (Nervous financial investors who fled Russia during the 1998 financial crisis decided to take their money out of Brazil as well, even though it had nothing much to do with the original Russian problems.)

But whatever spark ignites the fire, it is a bad scene once those flames spread. The domestic financial markets plunge, the currency gets hammered, and the economy may teeter close to collapse. Then the IMF folks may fly in to explain just how regular citizens are going to pay for the financial meltdown. And you better believe that the tab for a burst bubble often stretches out for years to come.

It’s no wonder that the recent G20 meetings were hijacked by fears that quantitative easing would provoke trade wars and competitive currency devaluations. In these precarious conditions, the specter of more international liquidity, disengaged from its supposed purpose of promoting real sector investment and spooked by events in Ireland and beyond, threatens to become a roving tsunami of hot money flows.

Many countries — especially developing world countries — are quickly initiating or strengthening capital controls to protect themselves from speculative financial flows. Capital controls are a speed bump to deter international “hot” money from rushing from country to country, creating havoc in its wake. If financial market participants face some sort of restrictions — or pay a penalty — for excessive movements of funds in and out of countries, they are less likely to stampede around the globe to fuel speculative bubbles.

What should Canada do?

Of course no one knows if the next chapter of the financial crisis will play out in these particular ways. (Hey — I’ve got plenty of other scenarios.) But these vulnerabilities must be addressed so that Canada is in a better position to weather future financial turbulence.

We need to start taking a page from the developing world in their efforts to defend themselves from hot money flows. The Canadian government should join with other countries and get capital controls on the books. Even if they are implemented gently at first, the fact that they are ready for use will enable Canada to react quickly if threatened in the future.

Canada must also look long and hard at its commitment to fiscal policy. Judicious fiscal policy could help to ensure that the domestic economy is more resilient in the face of international financial crises, including speculative booms and busts in commodities markets. In fact, if we implemented the right sort of capital controls, a tax on hot money might go a long way to funding those sorts of investments in Canada.

Ellen Russell is a senior economist for the Canadian Centre for Policy Alternatives.

Cathryn Atkinson

Cathryn Atkinson is the former News and Features Editor for Her career spans more than 25 years in Canada and Britain, where she lived from 1988 to 2003. Cathryn has won five awards...