More than a decade has passed since the financial crisis that nearly plunged the global economy into a prolonged depression. The investment bank Lehman Brothers – a casualty of the subprime mortgage meltdown – imploded in September 2008. Contagion spread to major financial institutions in America and Europe. As a result, banks abandoned lending money to each other. Costs of borrowing skyrocketed, business lending lost momentum and trade financing was choking. In the twelve months from April 2008, global trade, industrial output and the value of the stock market all fell faster than they had during the first year of the Great Depression of the 1930s.
Unlike the interventions after the Great Depression, in an internationally coordinated effort, governments cooperated and were able to stimulate their economies by increasing spending and reducing interest rates. The G20 pledged to provide fiscal and monetary stimulus and to refrain from protectionism. This assured each country that its policies would be reinforced, not weakened, by those of its counterparts. Governments monitored each other’s trade and investment restrictions through the World Trade Organization (WTO) and worked together to solve a shortfall in trade finance.
10 years later: What has changed, and can the next crisis be prevented?
Looking back at the crisis 10 years on, we can observe that while regulatory policies have been implemented, we are not able to entirely prevent a new crisis from happening again. For example, Basel III, a regulatory framework for banks has been widely incorporated. Banks must now fund themselves with more equity and less debt. Focus on bank governance and culture change has led to have them depend less on trading to make money and on short-term wholesale borrowing to finance their activities. Banks are subject to stress test and must have plans in place to end their operations orderly (chapter 11). Consumer protection and financial literacy shall be improved too.
The following two main risk factors to global financial stability prevail:
1) Ever rising debt levels
Today, we certainly have better policies in place. But we also have ever-growing government debt levels, particularly in the United States (US), where the federal government is running enormous deficits. This is very dangerous; the economy is running at full speed with an essentially full employment rate. At the same time, the US Congress voted to reduce tax significantly.
According to a recently released report by the International Monetary Fund (IMF), the near-term risks for global financial stability have even risen in the last six months, while medium-term risks remain elevated. In countries with “systematically important financial sectors”, total non-financial debt has risen to US$167 trillion, or about 250 per cent of their combined GDP, up from US$113 trillion or 210 per cent of GDP in 2008.
Its analysis sees a tail risk that emerging-market economies – excluding China – could face medium-term debt outflows, similar in magnitude to that during the global financial crisis in 2008.
Looking at Argentina and Turkey, we observe two economies with a wide current-account deficit, heavy foreign-currency debts, and high inflation. That have introduced different isolated measures to fight their currency crises without success. Turkey, in particular turned to Qatar for help, as reaching out to the US-influenced IMF was likely not seen as a good option considering the current political tensions between the two countries.
Italy is sitting on a pile of questionable debt, has weak banks, an erratic government, and a sizable economy able to inflict collateral damage across Italian borders. This could very well be the epicenter of the next financial crisis.
It is still likely that the next crisis might involve property again. Just as in the mid-2000s, governments from developed countries have never properly reconciled the desire for home ownership with the caution to avoid dangerous booms in household credit. In the US, taxpayers are still the guarantor of household debt.
Similar to the US housing crisis triggering the subprime mortgage meltdown in 2008, low interest rates made borrowing easier and encouraged a flood of financing for the young US fracking industry. Fracking boomed and made the US the leading producer of oil and gas by some estimates. However, the fracking industry is only sustainable if the oil price is high (not even taking the environmental costs into consideration). This makes it easy to believe that we are sitting on a time bomb about to explode. If the oil prices continue to decline, the frackers’ profits will go south and turn red very fast, causing investors to pull out. This will likely lead to another debt-fueled crisis in the US.
At the same time the US economy is running full steam, at full employment; what measures can the Fedtake to avoid another crisis on the verge of happening? Offering cheap money to create more jobs doesn’t seem to be working any longer. If government debt keeps increasing in good times, this means there will be an even steeper increase of deficits in bad times.
2) Waning multilateral relations and rising protectionism
The current US administration is spearheading the implementation of protectionist measures. This is fueling a trade war with China and doing everything to move relations with Canada and the European Union to an all-time low. Keep in mind that exactly those excellent multilateral relations – built up in the 2000s and earlier – are one of the main reasons that the financial crisis of 2008 could be brought under control.
The imposed tariffs on many of Americas trading partners, prompted retaliation from China, Canada, the European Union, and others. Negotiations to resolve differences might be faltering amid tensions over trade surpluses and deficits. The seemingly modest effects of the protectionist measures were barely noticed as global economic growth was still fairly strong. But costs might gradually start to add up for businesses and consumers. Investments might falter, and global supply chains might be choking soon.
As a result, in China, confidence in corporations’ abilities to service debt might fall, leading financial markets to tumble. When the renminbi loses value, Chinese products will be even cheaper, resulting the American government to place even higher quotas on many imports. Surplus goods from China might flood into other markets, where pressure to raise import barriers become irresistible. This could lead to a negative spiral and worsen the downturn, resulting in tens of millions job losses in the next years to come.
The risk of a new financial crisis with significant global ramifications is now even larger
High credit risk (subprime mortgages), weak policy measures and insufficient banking rules have caused bank insolvencies which were the base of the crisis of 2008. An internationally coordinated effort avoided a greater depression. The European Central Bank (ECB)served as the lender of last resort to the banking system in Europe, avoiding bank runs and a liquidity crisis for the banking system as a whole. The Fed acted as lender of last resort to the world, stimulating the economy by printing money (quantitative easing) to buy bonds and pumping cheap cash into the economy. New multilateral rules were set too (e.g. Basel III). Ultimately, this led to more jobs and a relatively fast global recovery.
But would it work again today?
In my opinion, it certainly depends on the scale of the next crisis, but overall, things do not look very promising. Passing on debt from one generation to the other is still the main problem. Debt accumulation is accelerating, and the tipping point will be reached soon. Passing on debt is equal to passing on risk. If we take into consideration that debt is growing exponentially, it becomes clear that one way or the other a correction is needed. For example, hyperinflationmight occur if the USD loses its trust and status as world currency. Quantitative easing would be less effective in such a scenario.
Furthermore, I believe that the persisting trade hostilities and dilution of values are seemingly making it impossible to believe that a common ground for a globally coordinated effort will be found. The rise of nationalism also obstructs Europe from solving the Euro’s structural problems. The future of the single currency is still in doubt and a chaotic collapse is still possible.
Globally, too many leaders dismiss international rules as unfair influence upon national sovereignty. Having said that, cross-border flows of capital, goods, services, and data have left us more interdependent than ever before. One country’s monetary, fiscal, and regulatory policies affect another’s growth extremely.
Unfortunately, there are similarities between the Great Depression of the 1930s and the current rising nationalist sentiments. As it becomes clear that without the so important global effort to fight the crisis of the future in a globally coordinated manner, there will be little hope of curtailing a future breakdown of the global economy.
I do also strongly believe that the financial risk caused by neglecting climate change is at its highest level. For example, the financial risk of real-estate developed on densely populated areas near sea level is extremely high. Consider Florida, where a total of USD 351 billion property valuation is at risk. Here it is all about passing on risks from land owners to property developers, from property developers to buyers, from buyers to insurers for the time the speculative buyers have found another buyer paying a higher price than they have paid before. This works as long as the insurers are insuring the environmental risks. But looking at the increasingly rising sea levels alongside floods and storms, it is a question of time until the last buyer (the last fool) will be sitting on an uninsured and worthless piece of land he will not be able to sell any longer. A moment like this could well be the trigger to a new financial crisis.
In my mind, the combination of ever rising debt levels, waning multilateral relations, rising protectionism and still insufficient regulation marks today an even higher risk of a new potential financial crisis as compared to the 2000s.
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The Fed (Federal Reserve System) is the central banking system of the United States of America.