It is often stated that there is a major financial crisis every 10 years or so. Having said that, it’s been a little over a decade since the Lehman Brothers collapse sparked the last global financial crisis (GFC) and with global economic growth starting to show signs of petering out, some in the media and elsewhere in the public eye are forecasting another global financial crisis in the very near future.
There has been a variety of reports from prominent analysts lately with predictions as to when the next crisis will hit and what will spark it. Strategists at J.P. Morgan Chase recently made a splash with their announcement of a new predictive model that pencils in the next crisis to hit in 2020. Additionally, J.P. Morgan’s Global Head of Macro Quantitative and Derivatives Research, Marko Kolanovic, has highlighted a potential precipitous decline in stocks that could cause what has been termed “the Great Liquidity Crisis.” He identified the shift away from actively managed investing toward passive investing strategies such as exchange-traded funds, index funds and quantitative-based trading strategies, as well as computerized trading as the potential culprit, which could not only be the catalyst for the next crisis but could also exacerbate the fallout.
According to Joyce Chang and Jan Loeys of J.P. Morgan, “The shift from active to passive asset management, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns.” Passive investing strategies have removed a pool of buyers who can swoop in if valuations tumble, while many of these computerized trading programs are designed to sell automatically when weakness shows, which would only worsen the situation.
Others have cited the increase in fast-growing pockets of debt. Students in the U.S. are borrowing at record levels, companies are loading up on debt, and emerging markets also appear to be gorging themselves on cheap debt. Although these pockets of debt are nowhere near the levels of the U.S. housing bubble, according to a report by the New York Times, some are concerned that this accumulation of debt could potentially spur the next crisis, just like it did the last one.
“What we saw last time around is that things can creep up on you […] you can turn around and in three years’ time you can go from not much of a problem to a pretty big problem,” according to Wesley Phoa, a bond-fund manager at the Capital Group.
Still others have stated that deregulation could bring on the next financial crisis. Specifically, the rolling-back of Barack Obama-era regulations put in place in the wake of the 2008 crash, namely the Dodd-Frank Act. The Dodd-Frank Wall Street Reform and Protection Act was designed to put major regulation on the financial industry to curb the kind of excessive risk-taking that contributed to the GFC.
“I’m afraid because of the political situation in the U.S. today, we’re moving in the wrong direction of reducing regulation. We should’ve learned that more regulation is needed,” said Lawrence Ball, the Johns Hopkins University economics professor. “What we also should’ve learned is the last resort in a crisis is for the Federal Reserve to lend money. And that, unfortunately, is unpopular as well.”
Others have pointed to the China-U.S. trade war, the move toward protectionist trade policies in general around the world, and even the possibility of a cyber attack taking down the global financial system as possible causes of the next crisis.
With that said, we decided to ask 26 economic and financial market experts what they believe will be the catalyst for the next financial crisis and when they think it could happen.
This Fall marks ten years since the most acute months of the longest recession since the Great Depression. According to the National Bureau of Economic Research, the last economic downturn began in December 2007 and ended 18 months later, in June 2009. If the expansion lasts until June of next year, it will become the longest since records began.
As the duration of uninterrupted output growth increases, more people are asking when the next recession is “due”, and what the source of a future downturn might be.
Is another crisis imminent? There are indications that we may be nearing a cyclical peak: Unemployment is at a 50-year low and inflation has exceeded the Federal Reserve’s 2-percent target over the last 12 months – both signs that the U.S. economy is operating at capacity. Stock markets appear to have begun a period of downward correction from all-time highs. Continued trade tensions and further increases in the Fed’s interest rate target both make a decline in stock and bond prices more likely.
Yet, other indicators point to a longer-lived cycle than we might otherwise expect. The labor force participation rate, while recently ticking upward, remains three percentage points below pre-crisis levels. GDP growth in the second quarter was a robust (annualized) 4.2 percent, the consequence – depending on whom you ask – of productivity- and investment-enhancing tax cuts, or of deficit spending by the federal government. Consumer confidence rose to an 18-year high in August. Business sentiment is also at a post-crisis peak.
There are other reasons to expect the current bout of growth to last longer than its precedents. The post-2009 recovery was sluggish – the slowest, in fact, since at least 1948. U.S. GDP took three years to return to 2007 levels; employment took six years to recover, again a record. Given this slow start, it stands to reason that the economy will take longer to reach capacity.
The financial crisis and the regulators’ response to it also led to a retrenchment by financial institutions from mortgage lending, small business loans, and other credit markets. That retrenchment may partly explain the slow growth in production and wages after the crisis, and it may also help to delay the next recession by curbing the enthusiasm of businesses and investors. On the whole, however, the decline of banking activity post-2008 is regrettable.
What will cause the next recession, and when? Economists have as spotty a record of prediction as other forecasters. Yet, some have pointed to corporate borrowing – buoyed by record-low interest rates – as a potential point of failure. Others suggest that student loans, which have grown relentlessly since 2008 and have high default rates and uncertain payoffs, may pose a systemic risk.
Outstanding corporate lending to the most indebted firms, however, is a fraction of the pre-crisis U.S. mortgage credit market – and less than half the level of subprime lending at that time. Nor are business loans subject to the same government-mandated subsidies and interest-rate distortions as housing credit. Moreover, the correlation between risks faced by today’s most heavily indebted firms may be less than what we witnessed across American housing markets in the run-up to 2008.
Student loans, at $1.5 trillion outstanding, are also a concern. They enjoy taxpayer backing, which means they pose less of a systemic risk, as the burden of defaults will not be absorbed by private financial markets. That burden will instead fall on taxpayer shoulders, however, meaning that the U.S. national debt will grow by up to 7 percent of GDP. A bailout of student loans would therefore raise concerns about fairness, while running counter to the prudent management of the budget.
Indeed, the biggest risks may lie with public, not private, balance sheets. With the national debt held by the public at $16 trillion and set to grow by $779 billion this year, it is the public sector that is living beyond its means. Some dismiss warnings about the unsustainability of the present debt path with the argument that America issues its own currency, so can pay down its liabilities through money-printing. Yet such debt monetization would either cause high inflation, contradicting the Fed’s mission and undermining long-term confidence in the U.S. economy, or it would result in large-scale capital reallocation, with negative effects on growth.
The source and timing of the next crisis remain uncertain, but policymakers have their work cut out for them: They must rein in government spending.
Diego Zuluaga is a policy analyst at the Cato Institute’s Center for Monetary and Financial Alternatives, where he covers financial technology and consumer credit. He also wrtes for Alt-M, one of the FocusEconomics Top Economics and Finanace blogs. You can follow Diego on Twitter here.
The question is not whether there will be a crisis, but when. In the past fifty years, we have seen more than eight global crises and many more local ones, so the likelihood of another one is quite high. Not just because of the years passed since the 2007 crisis, but because the factors that drive a global crisis are all lining up.
What are the main factors that could trigger the next financial crisis?
- Sovereign Debt. The riskiest asset today is sovereign bonds at abnormally low yields, compressed by central bank policies. With $6.5 trillion in negative-yielding bonds, the nominal and real losses in pension funds will likely be added to the losses in other asset classes.
- Incorrect perception of liquidity and VaR. Years of high asset correlation and synchronised bubble led by sovereign debt have led investors to believe that there is always a massive amount of liquidity waiting to buy the dips to catch the rally. This is simply a myth. That “massive liquidity” is just leverage and when margin calls and losses start to appear in different areas -emerging markets, European equities, US tech stocks- the liquidity that most investors count on to continue to fuel the rally simply vanishes. Why? Because VaR (value at risk) is also incorrectly calculated. When assets reach an abnormal level of correlation and volatility is dampened due to massive central bank asset purchases, the analysis of risk and probable losses is simply ineffective, because when markets fall they fall in tandem, as we are seeing these days, and the historical analysis of losses is contaminated by the massive impact of monetary policy actions in those years. When the biggest driver of asset price inflation, central banks, starts to unwind or simply becomes part of the expected liquidity -like in Japan-, the placebo effect of monetary policy on risky assets vanishes. And losses pile up.
- The fallacy of synchronised growth triggered the beginning of what could lead to the next recession. A generalized belief that monetary policy had been very effective, growth was robust and generalized, and debt increases where just a collateral damage but not a global concern. And with the fallacy of synchronised growth came the excess complacency and the acceleration of imbalances. The 2007 crisis erupted because in 2005 and 2006 even the most prudent investors gave up and surrendered to the rising-market beta chase. In 2017 it was accelerated by the incorrect belief that emerging markets were fine because their stocks and bonds were soaring despite the Federal reserve normalization
What will the next crisis look like?
Nothing like the last one, in my opinion. Contagion is much more difficult because there have been some lessons learnt from the Lehman crisis. There are stronger mechanisms to avoid a widespread domino effect in the banking system.
When the biggest bubble is sovereign debt the crisis we face is not one of massive financial market losses and real economy contagion, but a slow fall in asset prices, as we are seeing, and global stagnation.
The next crisis is not likely to be another Lehman, but another Japan, a widespread zombification of global economies to avoid the pain of a large re-pricing of sovereign bonds, that leads to massive tax hikes to pay the rising interests, economic recession and unemployment.
The risks are obviously difficult to analyse because the world entered into the biggest monetary experiment in history with no understanding of the side effects and real risks attached. Governments and central banks saw rising markets above fundamental levels and record levels of debt as collateral damages, small but acceptable problems in the quest for a synchronised growth that was never going to happen.
The next crisis, like the 2007-08 one, will be blamed on a symptom (Lehman in that case), not the real cause (aggressive monetary policy incentivising risk-taking and penalising prudence). The next crisis, however, will find central banks with almost no real tools to disguise structural problems with liquidity, and no fiscal space in a world where most economies are running fiscal deficits for the tenth consecutive year and global debt is at all-time highs.
When will it happen? We do not know, but if the warning signs of 2018 are not taken seriously, it will likely occur earlier than expected. But the governments and central banks will not blame themselves, they will present themselves -again- as the solution.
Daniel Lacalle is Chief Economist at Tressis, professor of global economy and author of “Escape from the Central Bank Trap”.
It is my view that the next financial crisis is looming on the horizon resulting from the “tariff war”; the specific timeline will depend on how quickly tariffs (and retaliatory tariffs) are implemented as well as how quickly businesses and people react to them. Because higher tariffs may trigger inflation (and expectations thereof), higher interest rates may ensue.
Marie Mora, PhD, is a professor of economics at the University of Texas Rio Grande Valley and Director of the NSF-funded AEA Mentoring Program.
The Next Financial Crisis could be closer than we think. . .
While the global economy, and most certainly the U.S. economy, are enjoying a healthy and robust expansion, there are clouds on the horizon that spell trouble.
The first of these clouds is the trade war that the Trump Administration has started with China. Both nations rely heavily on each other and trade disruption will have a severe economic impact on both. The United States relies on the low-cost products imported from China which allows its consumer-based economy to thrive. China must sell products to its biggest customer, the United States, in order to be able to keep its economy growing at a healthy pace. Tariffs and trade protectionism will mean an economic slowdown for both countries and an eventual recession that neither can afford.
The other clouds come in the form of bubbles, that if a recession were to occur in the next 18 to 24 months will doom both the American and world economies. These bubbles include the:
- Credit card debt situation in which American consumers have charged over $1.03 trillion on their line of revolving credit. If a major recession were to hit soon, these consumers will either stop using their credit cards or not pay them back. The global markets will react negatively and many retailers, both brick-and-mortar and e-commerce, will probably close down their operations.
- Auto loans now total over $1 trillion and American consumers have gotten into deep debt on vehicles they can no longer afford. If consumers renege on their auto loans, banks, finance companies, and asset-backed securities will suffer tremendous losses that will rattle the financial markets. This will also cause a severe glut of new or nearly-new repossessed cars flooding the market and cause car prices to drop drastically.
- Student loans have exceeded $1 trillion and there does not seem to be any end in sight. As the cost of a college education increases every year, more American families are going deeper into debt to pay for their children’s education. If the child cannot pay back the loan because there are no jobs after graduation, or the parents are too deep in debt to repay the loan, this will cause difficulties for the American economy.
- The American stock market has seen new heights in the Dow Jones Industrial Average, the S&P 500, and the NASDAQ indices. But with the recent downward slides of these indices, the bubble may have finally burst and investors are worried. A bursting of the stock market bubble could mean that companies will rethink plans for expansion of their operations, hiring more workers, or improving their products or services. This will halt the flow of financial capital into the American economy and become the forerunner of an economic recession many fear is quite near.
Arthur Guarino MBA, MSSc, JD, is an assistant professor in the Finance and Economics Department at Rutgers University Business School teaching courses in financial institutions and markets, corporate finance, investments, and financial statement analysis.
I am not sure what is meant by a financial crisis in this context. Will there be some countries or sectors that face serious financial problems? The answer is sure. We can say that several developing countries, most notably Argentina and Turkey, are already in this boat. But if the claim is that there will be some financial crisis that rocks the world economy, this is just silly. Prior to the crisis caused by the collapse of the housing bubble, you would have to back more than 70 years to find a world shaking financial crisis. So the 10-year story clearly does not fit here. The 2008 crisis could shake the world economy because it was being driven by housing bubbles in the U.S. and Europe. That is not true today, although several countries do face a risk from housing bubbles, notable Australia, Canada, and the UK. If higher interest rates or other factors deflate these bubbles, their economies are likely to fall into a recession (with or without financial crises). I don’t see this a world-wide story however.
Dean Baker, PhD, is an American economist and the co-founder and senior economist at the Center for Economic and Policy Research (CEPR).
I would say 10 years is too frequent to attribute crises to finances, because it can take almost 10 years to get out of a financial crisis (one generated by financial imbalances as the last one is widely believed to have been generated). Japan certainly experienced a long period of stagnation after their financial crisis. Of course, in the US, the government is busy dismantling the safe guards that were put in place so it could happen here sooner, but personally, I don’t expect that in the next at least 2-3 years. If right on schedule it would have started in December 2017, which it did not. The current recovery is not as good as it looks for many actors, especially women, families headed by women alone, families in depressed communities, both urban and rural, and so on. So, we definitely have a ways to go, which is why I give the next crisis some time to emerge as well.
Heidi Hartmann, PhD, is the President and Founder of the Institue for Women’s Policy Research and is also a Distinguished Economist In-Residence for Gender and Economic Analysis at American Univeristy in Washington D.C.
The overall questions surrounding economic policy around the globe, and especially from the US, are a real source of concern for the outlook right now. The specific market I would focus on as a source of the next crisis right now are government bond markets. Many government fiscal policies are in untenable positions and there is little slack in the system to deal with future crises whether domestic, international, or global. The timing of such a crisis event depends greatly on perceptions of market participants, but without radical changes in policy I think a two year horizon until crisis seems likely.
David T. Flynn, PhD, is the Department Chair and Professor of Economics and Finance at the University of North Dakota.
It’s been about 10 years since the last financial crisis.
The short answer is yes. In the last 10 years not a single fundamental economic flaw has been fixed in the US, Europe, Japan, or China. The Fed was behind the curve for years contributing to the bubble. Massive rounds of QE in the US, EU, and Japan created extreme equity and junk bond bubbles. Trump’s tariffs are ill-founded as is Congressional spending wasted on war.
- Junk Bond Bubble Bursting
- Equity Bubble Bursting
Many will blame the Fed. The Fed is surely to blame, but it is prior bubble-blowing policy, not rate hikes now that are the problem.
It does not matter what the catalyst is actually. And there might not be any catalyst other than simple exhaustion: The pool of greater fools in stocks, bonds, and housing simply ran out.
Regardless, I expect all eight of the above discussion points to be in play when the crisis does hit.
Read the rest of Mish’s piece Eight Reasons a Financial Crisis is Coming for more of his thoughts on the matter.
Mike Shedlock a.k.a. Mish is a registered investment advisor representative for SitkaPacific Capital Management.
There are definitely real trouble spots in the world that could escalate into a global crisis. These include:
- No resolution of Brexit;
- The escalating trade war between China and the US;
- Antagonisms with Russia growing into threats to use nuclear weapons, and
- Some other unforeseen action precipitated by the US President.
The banks are clearly on a long enough leash so they could generate another crisis. And despite efforts by the Republicans to strip away safeguards put in place after the 2008 collapse, banks are now required to hold more capital than in 2008. So I don’t see them collapsing again in the foreseeable future.
I believe now most worrisome is the apparent lack of concern within the US government for the huge budget deficits and resulting debt the Federal government is generating. And Trump is now talking about a 10% middle income tax cut.
For many decades, the world has viewed the US dollar and other US debt as the safest investment available. The reckless disregard for in the US government any sort of fiscal balance could change all of this overnight. A global rush to liquidate US dollars, other US debt and other dollar assets could generate a severe financial crisis.
And I see it being only a matter of time before this happens.
Elliott Morss, PhD, is an economic consultant to developing countries on issues of trade, finance, and environmental preservation.
It is difficult to take a precise call about the next financial crisis will hit and what the catalyst(s) will be. The catalysts looks quite similar to the previous 2008 crisis: huge financial euphoria as seen in financial markets, rise in debt levels of governments and rebuild of hubris.
Amol Agrawal is an Assistant Professor at Amrut Mody School of Management, Ahmedabad University.
A characteristic feature of financial crises is that they arrive when least expected. However, there are plenty of reasons for concern in the current environment. At an aggregate global level, the biggest problem is that US interest rates have been held at low levels for a long period as a response to the Global Financial Crisis. This has promoted a re-emergence of what’s often called the carry trade: borrowing at low short term US rates to finance speculative investments of various kinds. This has extended to what Minsky, the leading theorist of financial crises, called Ponzi investments, most notably cryptocurrencies, but also the investment strategies of authoritarian governments like that of Turkey.
As the US Fed begins to raise interest rates, problems are already emerging, such as the economic crisis in Turkey and the sharp decline of cryptocurrency markets. However, provided that the process of returning interest rates to more normal levels is slow and gradual, it is likely that only Ponzi investors will be harmed, and that the financial system as a whole will emerge unscathed.
The big risk is that there will be a rapid increase in interest rates outside the control of monetary authorities such as the Fed. The most obvious possibility is that Chinese holdings of US Treasuries could be dumped, either as a move in the trade war or to secure liquidity in response to a slowdown in China. That could easily produce a systemic collapse. Hopefully, the Chinese authorities are aware of this fact and will move cautiously.
John Quiggin is an Australian laureate fellow in economics and professor at the University of Queensland, and a board member of the Climate Change Authority of the government of Australia.
The business cycle has become longer in recent decades. It follows no schedule. Many are itching to call a cycle top, but the actual evidence does not support that conclusion.
This is possibly the most important topic for investors, so I have sought those with the best expertise and records. I have learned three things. First, no one can do an accurate business cycle forecast more than a year in advance. Even a cursory review of past records will show that. Second, it is a popular topic for publicity-seekers, so many newly-minted “experts” are offering a viewpoint. Third, many of those who have the right tools use too many variables in their forecasts. There are not enough relevant past cases to apply a large number of independent variables. Using a lot of variables seems sophisticated, but it actually over-fits the model to past data.
What do I think? I am careful not to exaggerate what we can actually conclude. I don’t think we can forecast more than a year ahead, nor can anyone else. We can safely say that a recession has not already begun (despite some doomsayer claims) and that the odds against a recession starting in the next year are 3-1.
And the cause? No one knows that either, although it usually happens after a pop in the ten-year yield, a later move in short-term rates via the Fed, and a yield curve inversion. That process may play out again, but we are early in the story.
Jeff Miller is the President of New Arc Investments, Inc. and a former professor of advanced research methods at the University of Wisconsin.
Financial crises happen all the time. Currently, there are several underway, including in Argentina and Turkey. A financial crisis is generally limited in impact, unless the economy where it takes place is very large and very interwoven with the rest of the world.
The Financial Crisis in the US – when credit froze up in a credit-dependent economy – became the Global Financial Crisis because the US economy and banking system are so massive, and because US investment products, assets, and speculative bets are shuffled far and wide around the world.
If a financial crisis breaks loose in China, it will become a global crisis, but likely on a much smaller scale than the US Financial Crisis since Chinese bonds and other assets and bets are not nearly as globally distributed as those originating in the US.
A financial crisis in Japan would rattle the world too.
But a financial crisis in Italy will not become a global financial crisis. It will be tough on Italy and perhaps some other Eurozone member states, and it will ruffle some feathers globally. But that will be it.
Going forward, there will be many financial crises, and they will be mostly limited to the economy where they occur. But every now and then there will be a big one.
As with science fiction writers, economists play “if this goes on” in trying to predict problems. Often the crisis comes from somewhere entirely different. Equities, Russia, Southeast Asia, global yield chasing; each time is different but the same.
Given that, I’m going to predict a crisis from known causes; not just because I can but because we have seen this movie, too, ca. 1974. It’s time for the sequel, in three-part disharmony.
The first unforced error is Interest on Excess Reserves. This was a quaint, arguably academic, problem with Fed Funds running in the 0.25-0.50% range. With rates running at 2-3% and banks still paying depositors close to zero, anyone who is not liquidity-constrained will put their money elsewhere. (I’m talking my book here; I have more money in Treasury Direct accounts right now than in Savings.) As bank liabilities decline, balance sheet adjustment is an identity.
Increasing assets, though, would require greater lending. Unlike equity investors, banks do not “invest” based on forecast EBITDA, a.k.a. Earnings Before Management, once removed from reality. Recent years have seen the major publicly-traded corporations return to the practices of the Nineties and the Noughts: taking more money out of companies in buybacks and dividends than the year’s earnings. This has been sustained by corporate debt issuances, at rates and spreads that seem unlikely to be sustainable in a higher-rate environment, especially given an overall the lack of R&D investment post-Crisis.
Both above practices have been sitting out in public, sprawling on park benches and being politely ignored, the expectation of passersby that the worst case will be “a correction” in the equity market again. Taking the Dow back to around 21,000 and NASDAQ down to around 5,000 or so, with similar effects worldwide, would be disruptive, but it wouldn’t be a crisis, just as 1987 didn’t sustain a crisis.
For that, we need more complications. Two things happened in 1973. The first was floating exchange rates finished correcting from long-sustained imbalances. The second was that energy costs moved closer to their fair market values, also from an artificially-low level. Firms that expected to spend 10-15% of their costs on direct (PP&E) and indirect (transport to market) energy expenses saw those costs double and could not adjust quickly. When expected losses dwarf menu costs, you change the menu—raise prices, even as your customers are seeing the same issues on a micro scale. Finding an equilibrium takes time.
Additionally, they are complications in the Chinese economy, even ignoring a general slowdown in their growth, there are possible squalls on the horizon. The People’s Republic of China arose in 1949. As part of that, the land was nationalized and then leased out by the state—for 70 years. Those leases expire beginning in October of 2019—less than twelve months from now. If Chinese real estate and rental prices move closer to a fair market value, the consequences of that will have to be managed domestically, leaving China with limited options in the event of a global contraction. If the early 1970s taught us anything, it is that an exogenous shock can wither Aggregate Demand. If the rest of the world repeats its austerity gaffes and China cannot stimulate, whither Aggregate Demand?
Corporations continue not to invest, banks continue to not provide viable investment options, and demand continues to slow in the face of rising global interest rates. Throw in an overdue adjustment in Chinese real estate costs bringing headwinds to the most successful growth story of the past decade, and there is likely to be “disruption.” The aftershocks of those events will determine the size of the crisis; whether it will occur seems only a question of timing.
Ken Houghton is a principle in his own company and former economist for several major financial companies. He is a regular contributor to Angry Bear.
There are two different types of extreme financial events; one is a crisis, the other isn’t. In 2008, banks and other financial firms were so highly leveraged that a modest decline in housing prices across the country led to a wave of bankruptcies and fears of bankruptcy. By contrast, the dot-com crash at the beginning of the millennium led to a large decline in stock prices, but no domino effect beyond that. Because most stock-holding is done with wealth people actually have, rather than with borrowed money, people’s portfolios went down in value, they took the hit, and basically there the hit stayed. Leverage or no leverage made all the difference. Stock market crashes don’t crash the economy. Waves of bankruptcies in the financial sector—or even fears of them—can. The lesson is: Don’t allow much leverage in the financial sector!
Financial leverage means borrowing a lot. What does it mean to not allow much leverage? It means requiring banks and other financial firms to raise a large share (say 30%) of their funds either from their own earnings or from issuing common stock whose price goes up and down every day with people’s changing views of how profitable the bank is. When people buy common stock, they know they are taking on risk. By contrast, when banks borrow, whether in simple or fancy ways, those they borrow from may well think they don’t face much risk, and are liable to panic if there comes a time when they are disabused of the notion that the don’t face much risk. Common stock gives truth in advertising about the risk those who invest in banks face. One might question whether banks should be forced to issue stock to immediately get up to 30% of their funding coming from stock, but forcing banks to retain all of their earnings until and unless they reach that 30% threshold of being financed by stock has no real downside.
If banks and other financial firms are required to raise a large share of their funds from stock, the emphasis on stock finance
- Provides a strong shock absorber that not only turns defangs the worst of a crisis, and also
- Makes each bank enough safer that after a period of market adjustment, investors will treat this low-leverage bank stock (not coupled with massive borrowing) as much less risky, so the shift from debt-finance to equity finance will be more costly to banks and other financial firms only because of fewer subsidies from the government: less of an implicit too-big-to-fail subsidy, less of an implicit too-many-to-fail subsidy, and less of the tax subsidy to borrowing.
My view on this owes a lot to an important book by Anat Admati and Martin Hellwig: The Bankers’ New Clothes. This book has persuaded many economists.
Sometimes people point to aggregate demand effects as a reason not to reduce leverage with “capital” or “equity” requirements as described above. New tools in monetary policy should make this much less of an issue going forward. And in any case, raising capital requirements during times of low unemployment such as now is the right thing to do. Sometimes people think the economy as a whole will take on too little risk if banks are required to have low leverage. My view is that if the taxpayers are going to take on risk, they should do it explicitly through a sovereign wealth fund, where they get the upside as well as the downside. (See the links here.) The US government is one of the few entities financially strong enough to be able to borrow trillions of dollars to invest in risky assets. However controversial that is, providing an implicit guarantee to financial firms that get the upside while the taxpayers foots the bill for the bailouts should be more controversial. The way to avoid bailouts is to have very high capital requirements, so bailouts aren’t needed.
Miles Kimball is the Eugene D. Eaton Jr. Professor of Economics at the University of Colorado and also a columnist for Quartz.
A number of commentators have been surprised by the length of the current bull-market. I myself have worried on several occasions over the last few years.
Given that the main driver of the stock market has been interest rates, one should anticipate a rise in rates to drain the punch bowl. The recent weakness in emerging markets is a reaction to the steady tightening of financial conditions resulting from higher US rates.
The domestic US economy has remained largely immune. Tariff barriers and tax cuts have more than offset the monetary drain.
Historically the correlation between the US stock market and other equity markets is high. Recent decoupling is within the normal range.There are sound fundamental reasons for the decoupling to continue, but it is unwise to predict that, ‘this time it’s different.’
The danger signs are:
- An upside breakout in the USD index (U.S. officials are constantly talking the currency down).
- A slowdown in U.S. growth despite the prospect of further tax cuts.
- At present the USD is not excessively strong and economic growth remains robust.
The global economic recovery since 2008 has been exceptionally shallow. US fiscal policy has engineered a growth spurt by pump-priming. When the downturn arrives it will be protracted, but it may not be as catastrophic as it was in 2008. Lightening seldom strikes in the same way twice. A ‘melancholy long withdrawing breath,’ might be a more likely scenario. A decade of zombie companies propped up by another, much larger round of QE.
When will it happen? Probably not yet. The economic expansion (outside the tech and biotech sectors) has been engineered by central banks and governments. Animal spirits are mired in debt; this has muted the rate of economic growth for the past decade and will prolong the downturn in the same manner as it has constrained the upturn.
Markets behave in a suboptimal manner unless they are permitted to clear. The Austrian economist Joseph Schumpeter described this phase as the period of ‘creative destruction.’ It can clearly be postponed, but the cost is seen in the misallocation of resources and a structural decline in the trend rate of growth.
I remain uncomfortably long of US stocks. To misquote St Augustine, ‘Grant me a hedge Lord, but not yet.’
Colin Lloyd is a veteran of financial markets of more than 30 years.Visit his website In the Long Run.
Cyclically, the U.S. economy (as well as that of the EU) is overdue a recession. Consensus amongst macroeconomic analysts suggests the recession around late-2020. It is highly likely that, given current forward guidance, the recession will arrive somewhat earlier, some time around the end of 2019-start of 2020, triggering a large downward correction in financial markets. Unless, of course, a different shock, arising from the ongoing problems in the financial and real economies across the emerging markets and China, leads us into a global downturn ahead of the U.S. and European one. Timing is a precarious game of guesses and ambiguity-rich analytical forecasts. That said, the fundamentals are now ripe for a Global Financial Crisis 2.0. History tells us, it is likely to be more painful than the previous one.
Get the rest of Constantin’s in-depth analysis on the matter in his piece: The conditions are ripe for a Global Financial Crisis 2.0
Dr. Constantin Gurdgiev is Professor of Finance at Middlebury Institute of International Studies at Monterey and continues as adjunct assistant professor of finance at Trinity College, Dublin.
There is no obvious frequency for crisis (financial or not). It is true that in recent US cycles, recessions have happened every 6 to 10 years. But in earlier decades (pre-1980) recessions were more frequent. Some of these recessions have a banking or financial crisis component, others do not. Although all of them tend to be associated with large swings in stock market prices. If you go beyond the US then you see even more diverse patterns. Some countries (e.g. Australia) have not seen a crisis in more than 20 years.
Ignoring the actual frequency, we typically look for signs of crisis by using leading indicators or signals of imbalances. Unfortunately, some of these early indicators have limited forecasting power. And imbalances or hidden risks are only discovered ex-post when it is too late.
From the perspective of the US economy, the US is approaching a record number of months in an expansion phase but it is doing so without massive imbalances (at least that we can see). Yes, the current account is in deficit, (some) debt levels are high, stock and housing prices look expensive,… but many of these indicators are not too far from historical averages either. For example, the stock market risk premium is low but not far from an average of a normal year. In this search for risks that are high enough to cause a crisis, it is hard to find a single one.
So everything is fine? I do not think so. We have a combination of an economy that has reduced scope to grow because of the low level of unemployment rate. Maybe it is not full employment but we are close. A slowdown will come soon. And there is enough signals of a mature expansion that it would not be a surprise if, for example, we had a significant correction to asset prices. In addition we have a long list of risks. Domestic ones: effect of trade war, US politics, the mid-term elections,… And some global ones: China, Italy, Brexit, Middle East,… The chances none of these risks delivers a negative outcome when the economy is slowing down is really small.
So I think that a crisis in the next 2 years is very likely through a combination of an expansion phase that is reaching its end, a set of manageable but not small financial risks and the likely possibility that some of the political or global risks will deliver a large piece of bad news or, at a minimum, would raise uncertainty substantially over the next months.
Antonio Fatas is a professor at INSEAD Business School, a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).
In the US we have a flattening of the Treasury yield curve. That is an accurate indicator we are nearing a recession. This recession is expected to come in the form of a moderate slow down over a handful of fiscal quarters. We are already seeing this in certain segments and it’s nothing the US can’t overcome, but it does cause panic as to how long it will last since uncertainties over long term growth are strengthening. In Europe economies are still catching up from the last downturn and political fears persist over a potential breakdown in Italy – or a full blown trade war which would affect economies dependent on exports like Germany. Away from that we are seeing a slowdown of unknown proportions in China and the world hasn’t dealt with a major slowdown in China for a very long time. China has a number of factors at play that could cause a recession in the US or a G20 economy and kick off a domino effect, stifling long term global growth.Regardless, global political furor has everyone on edge and there are many risks in flux.
Chad Hagan is a financier, author and CEO and Chief Investment Officer of Hagan Capital Group.
As we reach the tenth anniversary of the 2008-09 Financial Crisis and Great Recession a key question is when will the next recession will begin? This is especially of interest given that the current expansion is now rather long in the tooth. However, we are already on the road towards the next downturn given that periods of prolonged interest rate hikes are often precursors to downturns and the U.S. Federal Reserve has now raised its benchmark rate eight times since 2015. It is noteworthy that the three years prior to the 2008-09 financial crisis were also marked by a period of rising rates. The triggers of the next major downturn are underway and involve the interaction between public debt, rising interest rates and a trade/tariff war induced economic slowdown. The recovery from the 2008-09 recession is incomplete given that fiscal stimulus and easy money have resulted in a greater global debt pile. Along with traditional culprits such as Italy, Japan and Greece which saw their general government gross debt to GDP ratios grow between 2008 to 2018 (Italy-102% to 130%; Japan-183% to 234%; Greece-109% to 191%) there are now growing US and Chinese debt piles. The US has seen its gross government debt to GDP ratio rise from 74% to 108% while China’s has grown from 27% to 48%. China’s number may well be an underestimate as some analysts have suggested it is well over 60 percent as a result of local government debts. Moreover, its infrastructure fueled economic growth rate is slowing. Governments will go into the next recession with fewer economic tools at their disposal as the already large public debt and deficit burden will limit fiscal policy. Moreover, while interest rates are rising and slowing growth they are not high enough to allow for substantial stimulatory reductions. Creative monetary policy will be further limited given that central bank balance sheets are already swollen from quantitative easing. Also, growing international discord will also make it difficult to coordinate policy action as the world economy slows in the wake of trade wars.
We know another crisis is coming, eventually–in the same way we know there will be another earthquake around the world, eventually. If I knew when the next crisis was going to hit, I would adjust my portfolio accordingly just as I would know where not to buy real estate if I knew where and when the next earthquake was going to hit. But I don’t really think periodic crises matter that much over the very long run as these convulsions tend to be followed by new highs in standards of living not just in rich countries, but increasingly around the world. The most important thing is to keep our ethical and our economic wits about us lest we panic and make unwise, growth-reducing policies based on the idea that it has been “the final crisis of capitalism” or something like that.
Art Carden is a Research Fellow at the Independent Institute in Oakland, California and an Associate Professor of Economics at Samford University’s Brock School of Business. He is a contributor to the book Future: Economic Peril or Prosperity?
A study from the San Francisco Fed shows that the length of time an economy has been expanding is not a good predictor of when the next crisis is coming. So we can’t say that a crisis is “due” just because it has been about a decade since the last one. Like many economists who came of age in the aftermath of the last crisis, I’m a little reluctant to make (public) forecasts of when and why the next will occur. A big lesson from history is that unknown unknowns will surprise us, and that should instill a sense of humility.
I have read compelling arguments that the next financial crisis could be sparked by geopolitical events, a crisis in China, a crisis in the leveraged loan market, or even something like a cyber attack that disrupts payment systems. About as far as I will go at this point is to speculate that the speed at which we go from some triggering event to a full-blown crisis could be much faster than before, for several reasons:
- First, it is less clear that massive international coordination and cooperation like we saw in the last crisis would be feasible, though markets are as interconnected as ever.
- Second, there is a lack of fiscal and monetary space to respond to a crisis. That generally makes crises more severe, and could also destroy confidence.
- Third, technological and financial innovations are all about complexity and speed– that is both a benefit and a risk.
- Fourth, when the last crisis was beginning, there was pretty widespread acceptance of the wisdom of strong independence for central banks. The last crisis put a really bright spotlight on central banks and to various extents among citizens and politicians eroded some support for this independence, or at least made it seem less sacred. So in the next crisis, central banks could feel constrained by the very real possibility that they will have their independence restricted.
Beliefs and expectations can change in an instant, and we see this in crisis after crisis. In the next major crisis, for all of the above reasons, beliefs about policy inefficacy will likely be self-fulfilling.
Carola Binder, PhD, is an Associate Professor of Economics at Haverford College.
Business expansions don’t die of old age. Actuarial tables tell me that as I get older, the probability that I will die tomorrow inexorably increases, but economic data do not have that pattern. There is little if any evidence that the probability of a recession starting in the next quarter increases as the length of an expansion grows longer. Even so, it would not be exactly surprising if a recession came along soon. Journalists often remind us that when June 2019 comes around, this expansion will be the longest in business cycle history. For some reason, they less often note that if we measure from peak to peak, the current cycle is already the longest in U.S. history – 130 months and counting, as of October 2018, compared with the previous record of 128 months.
The exact catalysts of the next recession are anyone’s guess. A Chinese slowdown? Turkish debt? Failure of a big financial corporation? An asteroid strike? It could be anything. What know more about are the factors that will make it harder to cope with a downturn when it does come. The biggest such factor, in my opinion, is the huge imbalance between fiscal and monetary policy in the United States. It is not normal for fiscal deficits to be approaching record highs, and still growing, when the economy is at or close to full employment. When the crash comes, it will be very hard to persuade Congress to embark on further fiscal stimulus. If it does not, the Fed will have to bear the burden of expansionary policy all by itself. Yet it has little room to maneuver. Interest rates are just now approaching a neutral level. If a financial crisis were to hit, interest rates would be back at zero bound in a blink. Then what?
Ed Dolan is an American economist who holds a PhD in economics from Yale University. He is a Senior Fellow at the Niskanen Center.
The next crisis has already begun, but we do not yet see the signs. The most likely sources of stress are opaque accounting and questionable governance at Chinese firms, Donald Trump’s fiscally irresponsible tax cuts for the rich and corporations, and the rise of various other populist leaders (besides Trump) who prefer mercantilist trade policies. Other factors of interest are over-compliant central banks that value economic growth over economic stability and the rising costs of climate disruption. In terms of a global recession, I think that corporate debt markets might be the first to run into trouble either due to fraud or regulatory interventions that reduce liquidity or the perceptions of risk. Although the international trading system is fairly robust relative to the situation in the 1930s, I could see a Trumpian-style war of all-against-all as a likely first casualty of any sizable macro disruption, in the same way that rising tariffs in the US (Smoot-Hawley) and elsewhere were erected in the years after 1929’s Black Friday. Although companies with large domestic revenues might appear as beneficiaries in an isolationist world, I think that their share prices will fall after a brief increase as they experience disruptions and other collateral damage from populist policies.
David Zetland, PhD, is an Assistant Professor at Leiden University College The Hague, where he teaches various classes on economics.
In a nutshell, I see crises as caused by a collapse in credit from a high level of private debt. Since the US & UK had that experience in 2008 and are still carrying high levels of private debt, their credit levels are low compared to past years, and a serious decline in credit-based demand as happened in 2007/9 (from +15% to -6% of GDP in the US’s case) is unlikely. However I think they’ll continue slipping from positive to negative credit over time, as Japan has done since its crisis in 1990. Many countries that avoided a crisis in 2007/8 did so by continuing to expand private debt: China, Canada, Korea, Australia and France are prominent there. I think they will have localised crises in the next 1-3 years.
Steve Keen is an Australian economist and a professor of economics at the University of Kingston in London.
The next crisis will not be as severe as the last crisis, because the banks are in good shape. As such, think of the crises that happened in 1987 or 2000-2, which were not systemic. Also, look at places where floating rate liabilities and other short liabilities are used to support long-term assets. All crises occur from short-term liabilities financing overvalued assets. As such, look at real estate in hot coastal markets (where ARM financing is high), corporate floating rate debt, and private student loans. Something will be triggered as a result of the Fed tightening rates. We already have the first taste of that with weak countries like Argentina, Turkey, South Africa, etc. The initial effects of monetary tightening have knocked down those countries because they relied on increasing liquidity. The next phase will come when decreasing liquidity makes something crack where a set of oversupplied assets can no longer service its debts. Again, this isn’t a repeat of 2008-9 (though we still haven’t fixed repo financing). This will be something where demand fails because stimulus cannot continually increase, and we are oversupplied in a number of areas – autos, homebuilders, etc. That what recessions are for – eliminating bad debts, and recycling the assets into better-financed holders at lower prices.
David J. Merkel, CFA, runs his own equity asset management shop, called Aleph Investments.