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Bank of Canada is seen on March 10, 2020 in Ottawa.

Dave Chan/The Globe and Mail

Central banks, at least the ones that could, have moved with unprecedented speed to slash interest rates in the past two weeks as countrywide shutdowns related to the coronavirus pandemic drive the global economy to the brink of recession.

Yet, by holding interest rates at historically low levels since the previous financial crisis, these same central banks also created the conditions that could make the coming downturn more painful than it might have been had monetary policy been returned to normal over the past decade.

Instead, central banks, including the Bank of Canada, were extremely hesitant to remove the monetary stimulus that was introduced as a temporary patch to get their economies through the worst of the 2008-2009 downturn. The U.S. Federal Reserve Board under former chairwoman Janet Yellen, and her successor, Jerome Powell, took only baby steps to raise rates and end the quantitative easing program that pumped trillions of U.S. dollars into financial markets. They erred on the side of caution to avoid spooking investors.

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The consequences of that strategy are now revealing themselves daily. A decade of low borrowing costs has led to record levels of corporate debt, much of it of dubious quality. In search of higher yields, investors loaded up on bonds issued by “zombie” companies. Stock and real estate prices soared as trillions in borrowed cash chased after too few assets.

Complacency set in. Even normally cautious practitioners of the dismal science encouraged governments to take advantage of low rates to borrow, without regard for the consequences. They forgot that debt is almost always dangerous; that investors don’t think like them.

The air has now come out of the stock market bubble in a manner reminiscent of the worst crashes in history. Everyone is suddenly feeling a lot poorer. And the negative “wealth effect” resulting from a 30-per-cent and counting decline in the value of stock portfolios and pension savings will sap consumer and investor confidence for months, if not years, to come.

Many more shoes could drop with a deafening thud as corporations default on debt that they never would have been able to issue in a normal interest-rate environment. “The longer the coronavirus continues to spread, the more likely it is that the zombies begin to die, further depressing the markets – and increasing the risk of wider financial contagion,” Morgan Stanley Investment chief global strategist Ruchir Sharma warned this week in a New York Times op-ed.

Even scarier, most global economies are entering what threatens to be a deep recession before their central banks had replenished the arsenal of policy tools they deployed during the last crisis. In the past two weeks, the Bank of Canada, the Fed and the Bank of England have mostly depleted whatever room they had to cut interest rates before the outbreak of the coronavirus pandemic, while the European Central Bank (ECB), which had no room left at all, stood pat.

“I don’t think that anybody should expect any central bank to be the line of first response,” ECB president Christine Lagarde said last week, in a veiled admission of the bank’s predicament. Her words fell like a brick on the psyche of already rattled investors. But they were a wake-up call.

European governments will need to pick up the slack as best they can, although it may not be long before markets shut out the most heavily indebted sovereign borrowers, starting with Italy. The idea that fiscal stimulus can do most of the heavy lifting may be wishful thinking.

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In Canada, the federal deficit could easily soar past $100-billion in the 2020-2021 fiscal year, as stimulus measures combined with plunging tax revenues leave Ottawa with a record budget shortfall. Tack on provincial deficits that could also be set to soar to new heights, and this country’s overall government-debt profile could begin to rattle investors.

Central banks do have a virtually unlimited ability to print money. And they may not be shy about using it, as the Fed’s Mr. Powell hinted on Sunday after the U.S. central bank announced a US$700-billion bond-buying program that will pump cash into the financial system. “We think we have plenty of policy space left, plenty of power left in our tools,” Mr. Powell said.

The coming weeks will determine if he is right. But there is no doubt that this is not where anyone had hoped that central banks would find themselves on the eve of what could be a deep downturn. It could make the coming crisis far worse than the last one.

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