The Next Financial Crisis

The Making of a 2020 Recession

“Remove the crutches that have supported global growth for a decade, throw in a trade war between the world’s two largest economies, add a dash of wage inflation and a side dish of Brexit and you have a recipe that may prove rather unpalatable to global markets in 2019.”
— Bonham Carter Vice Chairman Jupiter Fund Management PLC

he 2008 financial crisis dealt the biggest blow to the world economy since the Great Depression. It followed on a series of crises experienced around the world, including the East Asia crisis, the Mexican crisis, the Russian crisis, and the Latin American crisis. However, the world started recovering and although growth, over the years, has returned and the job market has tightened, the reverberations of the crisis continue to affect us in ways both obvious and indirectly connected. But, now the storm clouds of the next global financial crisis are gathering despite the world financial system being unprepared for another downturn. This is what David Lipton, the first deputy managing director of the IMF, pointed out when he said, “As we have put it, ‘fix the roof while the sun shines’. … I see storm clouds building and fear the work on crisis prevention is incomplete.”

Although the global economy has been undergoing a sustained period of synchronized growth, it will inevitably lose steam as unsustainable fiscal policies in the US start to phase out. Come 2020, the stage will be set for another downturn and, unlike in 2008, governments will lack the policy tools to manage it. But, no one is pointing to the erratic approach to ensuring a smoothly working global economic system that actually made this crisis inevitable.

What drives a financial crisis?

Primarily, there are three factors that can be held responsible for recession.

1. Demand-side policies

Demand-side policies that lead investors and citizens to believe that ‘there is no risk’, are the most prominent factor. Complacency and excess risk-taking cannot happen without the existence of a widespread belief that there is some safety net, a government or central bank cushion that will support risky assets. Terms like ‘search for yield’ and ‘financial repression’ come precisely from artificial demand signals created from monetary and political forces.

2. Excessive risk-taking

Excessive risk-taking in assets that are perceived as risk-free or bullet-proof is the second on this list. It is impossible to build a bubble on an asset where investors and companies see an extraordinary risk. It must happen under the belief that there is no risk attached to rising valuations because “this time is different,” “fundamentals have changed” or “there’s a new paradigm.”

3. Poor anticipation

The realization that this time is not different is another of the most crucial factors that cause financial crisis. Bubbles do not burst because of one catalyst. The 2007-08 crisis did not start because of Lehman Brothers; it was just a symptom of a much wider problem that had started to burst in small doses months before.

Reasons for the next crisis

There are, basically, 5 reasons for that:

1. Financial markets are falling

2018 has been a challenging year in financial markets, with stock exchange falls in emerging economies spreading across the world. Commentators, of late, were worrying about an oil price of $90, but today it’s now hovering around $60. On top of this, new statistics from the Bank for International Settlements (BIS: the central bank for central banks) suggest global house prices are on the slide.

2. Debt is rising

The 2008 crash showed what can happen when debt levels get out of control. And debt is now more out of control than ever.

In its November report, the OECD sounded the alarm on this with a warning that “vulnerabilities […] persist in many economies from elevated asset prices and high debt levels”.

3. The real economy is weakening

The OECD is clear that economic growth has peaked. Of the emerging economies Argentina and South Africa are in decline, Turkey is expected to follow. GDP in both Germany and Japan fell in 2018 Q3. And global confidence is deteriorating fast. The best the OECD can offer is a global economy that “looks set for a soft landing”. But “downside risks abound”.

4. Policy choices are making things worse

Over the past year, central bankers have called time on supporting the economy, and have reverted to the usual preoccupation with inflation and so higher interest rates and ‘quantitative tightening’.

There are two big problems with this strategy. First, there’s no sign that inflation is rising. For example, OECD wage growth over the latest quarter may be at a post-crisis peak, but at 3 percent this still falls far short of what should normally be expected (and vastly short of what is needed to make up lost ground). Overall, real wages are up only 1.7 percent since the crash – and they’re weakening. And inflation itself is still extremely low. Headline figures may have picked up a little following earlier rises in oil prices, but the underlying core rate is below 2 percent.

Second, interest rate rises are contributing to the world’s debt problems.

Higher US interest rates mean the dollar – the world’s main currency – is more expensive.

This is making it harder for companies and governments to pay any dollar debts, triggering “sudden changes in market sentiment” toward emerging-market economies and capital outflows, according to the OECD.

And as financial markets stop taking risks, the same thing will happen to companies and households with high debts in advanced economies.

The bottom line is a wider failure of policy since the financial crisis.

5. Lessons from 2008 still haven’t been learnt

Workers are all too familiar with the disastrous impact that years of austerity have had on growth and wages. But this has not stopped footloose investors from ploughing capital into emerging economies and trendy global tech and property ventures.

Now, as capital retreats and asset values fall, firms are facing a new round of severe financial pressures that will bear down on costs and ultimately on workers’ pay, conditions and jobs. There are also concerns that pensions are in the firing line, as funds have become seriously exposed to risk.

It all amounts to very little change ten years on from the financial crisis.

The OECD (and even two ex-BoE deputies) has already called for internationally-coordinated government spending in the event of a crisis. And we’re clear that a halt on rate rises is no less urgent. Recently, the ECB confirmed ‘quantitative tightening’ in spite of recognising increasing risks and conversely the Fed made backtracking noises.

But, above all, global action is needed to address the cause of growing debt, not just the symptoms.

The rise of nationalism has led many countries to turn inwards, blaming trade or migration for problems that are actually rooted in global financial excess.

The Great Depression eventually led to the Bretton Woods conference, when the world agreed to build a system that would contain these excesses.

There is a desperate need to renew this global debate before the next financial crisis arrives and workers are forced yet again to pay a price they simply cannot afford.

Nature of the next crisis

Needless to say, the particular nature and form of the next financial shock will be unanticipated. Investors, speculators and financial institutions are generally hedged against the foreseeable shocks, but there will always be other contingencies that have been missed. For example, the death blow to the global economy in 2008-09 came not from the collapse of the mid-2000s housing bubble, but from the concentration of ownership of mortgage-backed securities.

Likewise, the stubbornly long downturn of the early 1990s was not directly due to the deflation of the late-1980s commercial real-estate bubble. Rather, it was the result of failed regulatory oversight, which allowed insolvent savings and loan associations to continue speculating in financial markets. Similarly, it was not the deflation of the dot-com bubble, but rather the magnitude of overstated earnings in the tech and communications sector that triggered the recession in the early 2000s.

Is the world prepared?

In the starkest warning yet about the upcoming global recession, the IMF has warned that the leaders of the world’s largest countries are “dangerously unprepared” for the consequences of a serious global slowdown. The IMF’s chief concern: much of the ammunition to fight a slowdown has been exhausted, and governments will find it hard to use fiscal or monetary measures to offset the next recession, while the system of cross-border support mechanisms – such as central bank swap lines – has been undermined, warned David Lipton, first deputy managing director of the IMF.

“The next recession is somewhere over the horizon, and we are less prepared to deal with that than we should be . . . [and] less prepared than in the last [crisis in 2008],” Lipton says. “China is clearly slowing down — we think China’s growth has to slow, but keeping it from slowing in a dangerous way is an important objective,” he added, noting that a downshift would be “material very broadly, not just in Asia.”

Policy challenges

Perhaps the biggest challenge for many advanced economies centres on the slow growth of workers’ incomes, perceptions of lower social mobility, and, in some countries, inadequate policy responses to structural economic change. Not only has the trend in long-term advanced economy growth been downward; in many countries, the more meagre gains have gone primarily to the relatively well-off. In the United States, for example, median real household income was about the same in 2016 as in 1999. This pattern clearly predates the global financial crisis. But the crises themselves, along with aspects of the policy response, further soured the public mood. Such discontent, in turn, helped give rise to current tensions over trade policy as well as a broader scepticism toward centrist policies and leaders, who have traditionally supported global cooperation as the proper response to shared challenges.

Policymakers must take a long-term perspective to address this malaise. Inclusive fiscal policies, educational investments, and ensuring access to adequate health care can reduce inequality and are key priorities. So too are more secure social safety nets that can help workers adjust to a range of structural shocks, whether from globalization, technological change, or (in some countries) climate change. Policies to promote labour force participation and the economic inclusion of women and youth are especially important. Structural reform priorities differ by country, but in general, addressing them will raise output and growth over the medium term. That said, due consideration must be given to those who are already disadvantaged but might lose out further. Support for research and development and basic and applied scientific research offers the promise of raising growth rates, as many studies have shown.

Most countries also need to build fiscal buffers to make room for policy responses to the next recession when it comes and to reduce the long-term tax costs of servicing high public debts. Several emerging market and developing economies must undertake fiscal reforms to ensure the sustainability of public finances and improve market sentiment. Global and national actions have buttressed financial stability since the crisis, but the work remains incomplete in several respects, including, for example, safeguarding the nonbank financial sector and resolution in insolvency, especially for systemically important international banks, where a cooperative global framework is urgently needed. Some financial oversight measures that grew out of the crisis could be simplified, but a wholesale rollback would risk future instability. Even piecemeal deregulation must be cautious and carefully considered, because a sequence of smaller actions could eventually weaken the system enough to leave it fragile. Indeed, precisely because monetary policy will need to remain accommodative where inflation is below target levels and will need to proceed cautiously elsewhere, effective macro- and micro-prudential levers must remain available.

The growing weight of emerging market and developing economies in the global economy means that advanced economies internalize fewer of the global gains from their own support of multilateral cooperation. They perceive the leakage of benefits to other countries to be relatively larger now than in the past, compared with their own benefits. This change may tempt some to retreat into an imagined self-sufficiency. But economic interdependence is greater than ever – through trade, finance, knowledge spillovers, migration and environmental impacts, to name a few channels – and that makes cooperation in areas of common concern more important than ever too, including for advanced economies.

Multilateralism must evolve so that every country views it to be in its self-interest, even in a multipolar world. But that will require domestic political support for an internationally collaborative approach. Inclusive policies that ensure a broad sharing of the gains from economic growth are not only desirable in their own right; they can also help convince citizens that international cooperation works for them.

Asian Fragilities

This is supposed to be ‘the Asian century’. The spectacular rise of China and overall dynamism of the Asian region created the widespread perception that Western capitalism is stagnant and moribund, unlike Asian capitalism which will show rapid growth and create a new geo-economic balance. Developments in the wake of the global financial crisis appeared to confirm this: while growth rates in Asia (and in the largest economies of China and India) dipped in 2009, just as they did in most of the world, the recovery was rapid, and subsequent rates of growth remained higher than elsewhere.

But the optimistic view of the newly emerging growth pole in the East missed the evidence that the greater dynamism of Asia was mostly due to a tiny set of countries: first, Japan and South Korea until the late 1980s; subsequently, China in the current century. And Chinese exceptionalism has been just that exceptional, based on an astute use of unorthodox economic policies by a heavily centralized and controlling state. More to the point, since the global crisis, the recovery and expansion in almost all the major economies of Asia has been heavily based on debt. Even in China, debt-to-GDP ratios have more than doubled since before the crisis, and in many other Asian economies certain forms of debt – especially in housing and personal finance – have reached alarming proportions. In Asia – perhaps even more than in the Global North – the strategy of inducing recovery through lending private money has increased fragilities that could generate another crisis in the future. This is already evident in India, where bad corporate loans are creating debt so large that companies can’t take on additional debt to finance future projects – a phenomenon called ‘debt overhang’. This has become a drag on bank lending and on private investment, leading to absolute reductions in investment over the past few years.

Meanwhile, Asian economies are even more beholden to the unpredictable movements of global stock markets. In the run-up to the global crisis, the flow of liquidity primed both advanced economies and, mainly Asian, emerging markets. And once the ‘easy money’ response to the financial crisis was put in place, markets across the world turned buoyant once again. Several emerging markets in Asia became the targets of betting on currency values, as speculative investors moved in, backed with cheap capital. As a result, markets in South Korea, India and Thailand have been febrile and volatile, vulnerable to violent swings.

The legacy of these ‘bull runs’ – when everyone expects prices to rise – is large accumulation of foreign investments in both stock and bond markets. In such conditions, the slightest piece of negative news can lead to investors quickly taking their money out of these markets, triggering steep currency depreciation and internal financial problems. In other words, the flutter of a butterfly’s wings in a distant part of the world can create a financial storm in Asia.