- Has enough been done to prevent the next crisis?
As the dust settled on the global financial crisis of 2008, just after many of the world’s largest banks and financial institutions narrowly avoided collapse thanks to taxpayer-funded bailouts, many commentators believed the global financial system was going to be totally rethought.
Speaking in October 2008, Nobel Prize-winning economist Joseph Stiglitz said “the fall of Wall Street is for market fundamentalism what the fall of the Berlin Wall was for communism — it tells the world that this way of economic organization turns out to be unsustainable”.
Among reformers and campaigners, optimism was in the air. Ideas for change included the total rewiring the global financial system, reforming the incentives in the finance sector to ensure they drove greater personal responsibility, breaking up “too big to fail” banks and prosecuting high level bankers who had committed fraud. Sadly, however, policymakers were so focused on shoring up the existing system, none of this materialised. In the process, they arguably entrenched bad habits.
Kevin Dowd, professor of finance and economics at Durham University, believes the financial reforms brought in since 2009 are inadequate, untested or counterproductive. He said the Basel III capital regime, which requires banks to maintain capital equivalent to at least 8 per cent of their risk-weighted assets, as well as the central banks’ “stress tests” of banks, fall into the counterproductive category.
He added that ringfencing, which will force UK-based banks to split their retail banking activities from their investment banking activities from next year, fails to address the underlying causes of the crisis. He is also highly critical of the macroprudential approach to systemic issues adopted by the UK’s Prudential Regulation Authority, part of the Bank of England, from April 2013. He said this “unwisely presumes that policymakers have the incentive and the ability to time the economic cycle”.
Dowd added: “Many of these responses create new hidden systemic risks. They fail to address the root causes of excessive risk taking which requires a combination of much tougher personal liability on the part of senior bankers and much higher capital standards.” The result is that British banks are even more vulnerable to collapse than they were in 2007-8, says Dowd.
The failure to tackle the opacity of banks’ balance sheets has also stored up danger. As the Financial Times City editor Jonathan Ford recently made clear, post-crisis tweaks to accounting rules have done little to bring bank balance sheets and capital ratios into line with reality, ensuring that behind the confident façades presented by bank directors, auditors and regulators, the banking sector remains an impenetrable black box.
“Accounting is supposed to paint a picture that allows investors to assess the current valuation of a company,” says Ford. “But in the topsy-turvy world of banks, it can conceal more than it reveals about economic reality”.
Ann Pettifor, economist and author of The Coming First World Debt Crisis, warns that post-crisis reforms have only scratched the surface. “A few positive changes have been made, but the international financial architecture – the framework in which the banking system and financial institutions operate – has remained largely untouched.
“That includes the mobility of capital, the dollar’s status as global reserve currency, and the power of the U.S. Federal Reserve. It is this systemic architecture which that produces, with increasing regularity, financial crises, and it desperately needs to be transformed.”
Pettifor laments the fact banks have continued to funnel about 80 per cent of their lending into the property sector (which she dubs “existing assets”), inflating asset price bubbles, whilst lending very little to productive industries and innovative businesses which might boost productivity (“the creation of new assets”). “And, to make matters worse, the banks have been allowed to remain too big to fail. Virtually everything they do is guaranteed by the state, by taxpayers.”
Pettifor accepts that the Bank of England’s quantitative easing (QE) programme – by which the central bank created some £435 billion of new digital money to buys assets such as government bonds or corporate bonds off banks and other financial institutions in the hope they would use the additional funds to boost lending to households and businesses – was necessary.
But she said it was “wrong that banks and financial institutions have had access to that massive taxpayer-backed resource without any conditionality.”
For Stephany Griffith-Jones, financial markets director at the Initiative for Policy Dialogue at Columbia University, New York, the main problem is that policymakers and regulators have ignored shadow banking, which includes the provision of credit by entities other than banks.
“They’ve been relatively tough on the banks, but way far too soft on shadow banking. If it quacks like a duck, it is a duck. If it creates credit, it needs to be regulated,” says Griffith-Jones.
Russell Napier, market analyst and historian, author of the Sold Ground newsletter, and a non-executive director of the Scottish Investment Trust, sees regulators’ reluctance to rein in shadow banking as a major failure, and one that is likely to drive the next crisis.
“Banks are only a small part of the problem”. One reason that the shadow banking sector – which includes players such as hedge funds, investment banks and asset managers – has escaped scrutiny is because its senior players are so connected politically and do not stint on their political donations and lobbying.
That may be why policymakers and regulators are turning a blind eye as US-based hedge funds including Fortress Investment Group quietly revive the junk bond CDO – a collateralised debt obligation packed with junk bonds acquired with borrowed cash that yields in the region 20 per cent. CDOs are opaque financial instruments which enabled Wall Street to dupe investors about the quality of large bundles of subprime US mortgages, and were at the heart of the 2007-8 crisis.
Griffith-Jones believes the post-crisis austerity policies adopted by UK and European governments after 2010 did nothing to improve the stability of the system. “The austerity imposed by George Osborne as chancellor was particularly misguided, foolish and counterproductive: it stifled growth at a time when the UK could have borrowed more at relatively low interest rates, particularly for investment. In the US the economy recovered more quickly partly because they continued the fiscal stimulus for longer.”
Steve Keen, professor of economics at Kingston University London, warns that the post-2008 reforms are bound to fail because the policymakers, regulators and economists who drew them up “fundamentally misunderstand the role of credit in an economy”.
He believes they still erroneously equate credit with the “lubricating oil inside an engine” and regarded the crisis as “the engine seizing up because it ran out of lubricant”. In fact, says Keen, they should be viewing credit as fuel, in which case they would recognise sudden increases or decreases in supply prove disastrous. That is a fundamental misunderstanding that has driven deeply flawed remedies, says Keen.
- What will cause the next crisis?
Durham University Business School’s Professor Kevin Dowd believes the flawed policy responses to the 2008 global financial crisis – responses that were far too focused on rescue, and not enough on transformation – mean that another crisis is likely within the next 12 months. “They may have held the system together in the short term, but that came at the expense of aggravating the underlying problems. I’m fairly confident the coming crisis will be worse than the last one: banks are weaker, debt levels are higher, there is more hidden risk in the system and policymakers have less room for manoeuvre.”
In terms of debt levels, the International Monetary Fund recently pointed out that the median government debt-to-GDP ratio today stands at 52 per cent, up massively from 36 per cent at the time of the last crisis.
The balance sheets of central banks, particularly in advanced economies, are several times larger than they were ahead of the 2008 crisis; and emerging market and developing economies now account for 60 per cent of global GDP, up from 44 per cent in the decade prior to the crisis.
Against this backdrop of increased indebtedness, rising US interest rates and the unwinding of QE, and a concomitant rising dollar, are widely seen as the sparks that could ignite a global financial conflagration.
Pettifor warns that the global economy is in a very similar position to where it was in 2006. “It will be the same trigger as the last financial crisis – the current Fed chairman Jerome Powell is doing exactly what Alan Greenspan did: systematically raising interest rates, whilst failing to place any restraint on the creation of private debt.
“And he’s doing it at a time when there’s clear volatility, when there are very high levels of debt relative to income both at the global and national levels.” Pettifor added the fact the US Federal Reserve has been “locked into a process” of steady hikes in interest rates because it cannot be seen to acquiesce to President Donald Trump’s strident calls for rate cuts “seems to presage a crisis”.
She points out that many large corporations have been bingeing on debt, taking advantage of the tax advantages and lower interest rates to borrow enormous sums to fund share buybacks and humungous M&A deals. Many companies have borrowed so much, often on a so called “covenant-lite” basis that they have driven their own leverage ratios up to levels that are more commonly seen among ‘junk’-rated borrowers.
Keen believes that if US rates were to rise to 4 per cent it “will cause a recession but not a crisis”. “A four per cent Fed rate means at least a 6 per cent rate for commercial borrowing, which given current debt levels means that something of the order of 10 per cent of GDP would have to go on debt servicing. That’s unsustainable, so private sector entities will start reducing debt or going bankrupt, which will cause a recession.”
Napier is more concerned about an emerging market default. He says countries which borrow in foreign currencies to fund domestic investment are particularly vulnerable – listing Chile, Columbia, Czech Republic, Hungary, Latvia, Peru, Poland, Romania, Turkey, Ukraine and Uruguay as having foreign currency debt-to-GDP ratios of more than 30 per cent. According to the economists Carmen Reinhard and Kenneth Rogoff, these countries are in the danger zone. Napier said: “The crucial one is Turkey, which is already effectively in default”.
According to a different indebtedness metric favoured by the Bank for International Settlements, Canada, China, Hong Kong, Switzerland, Russia, Turkey, Korea, Norway and Thailand have a two-in-three chance of having a banking crisis within the next three years. “Turkey is flashing red on both measures,” said Napier. “And China it is off the scale on the BIS measure.”
Napier warns that, in the event of a domestic credit crisis, China would “start printing money like crazy”. That would in turn, he says, provoke an exchange-rate crisis for the world, as the value of Chinese currency the Yuan would plummet. “That would intensify the problem for anyone who’s borrowed lots of dollars. I’ve been predicting this for three years now – I believe it could happen any time.”
Stephany Griffith-Jones also believes the next crisis will be triggered by China, though for different reasons. She thinks that the People’s Republic could lose patience with Donald Trump, firing a deadly salvo in retaliation to his trade war.
“China holds nearly $1.2 trillion of US Treasuries,” said Griffith-Jones. “They could start buying fewer of these – or even start to dump their holdings.”
Such a move by China would trigger a wider rout in U.S. government debt, cause the dollar to plunge and make it harder for the US to finance its massive $20 trillion debt pile. There could easily lead to a worldwide economic shock. Another view on the risk from China comes from the Bloomberg columnist Nisha Gopalan, who recently warned that, since Beijing started clamping down on certain sources of credit, including peer-to-peer lending, many of China’s private sector firms are being revealed as effectively broke. “Without access to credit, the average private Chinese business won’t survive.”
President Trump is widely seen as the joker in the pack, and there are fears he could do something particularly stupid that would spark a global crisis. The author Michael Lewis, whose 2010 bestseller ‘The Big Short’ chronicled the absurdities of the subprime mortgage market in the US, says Trump may be foolish enough to default on America’s sovereign debt – just as he has frequently walked away from his own real estate development and casino companies’ debts throughout his business career.
“All of his instincts are to default on debt. To walk away,” Lewis told The Times. “He could precipitate a financial crisis that would make the 2008 crisis seem trivial. And a run on the dollar and all the rest. We take it for granted, and we shouldn’t, that the dollar is the world’s reserve currency. We have $20 trillion in debt and he’s jacking up the deficit in ways that we haven’t seen in a long time and he has no compunction about stiffing creditors.”
Other potential shocks that could trigger a global meltdown include bond investors losing faith in the maverick right-wing and populist government in Italy, which must service €2.3 trillion of government debt, and a no-deal Brexit bringing chaos to European business, trade, supply chains and transport.
- What are the most resilient investments?
In the event of another global crisis, there are unlikely to be many safe havens as so many assets and geographies are correlated nowadays. Another problem is that given how much more politically fragmented and fractious the international community is than it was a decade ago, a coordinated approach to international rescue and restimulus of the economy, along the lines of what prime minister Gordon Brown pulled off during the G20 London Summit in April 2009, has become improbable.
For Stephany Griffith-Jones, investors’ best bet will be AAA-rated government bonds, with those issued by Germany and the Netherlands being among her favoured ones. Ann Pettifor sees economies with their own central banks, their own currencies and the soundest institutions as likely to be the most resilient, “especially countries with current account surpluses such as Japan, Germany and China.” But she warned that countries with high levels of foreign liabilities, like the UK, will prove more vulnerable.
Keen does not believe any asset class will prove safe in the event a full-blown crisis, “as the all become correlated”, even though he does think gold could briefly rise in value. He sees the currencies of countries that avoided the fallout of the 2008 crisis through continued private sector borrowing as among the most vulnerable. “That means Canada and Australia, maybe South Korea, and France (but of course it uses the euro, so no deal).”
Keen suggests one solution for private investors will be to sell out of equities ahead of the downturn, stay in cash for a period, then reinvest once central banks embark on a fresh round of QE . “I think central banks will return to quantitative easing as the fragility of the stock market becomes obvious. So being in cash while they work this out, and being ready to buy back in when they restart it, makes sense.”
Napier predicts that it is the economies with low debt-to-GDP ratios that will to be the most prove resilient, adding these are mainly found in Asia, excluding China – so places like Indonesia, Malaysia, Singapore, South Korea, Taiwan, Thailand and Vietnam.
“These countries don’t have high debt-to-GDP ratios, they have not made huge promises to their people in the form of pensions and healthcare, and won’t need to take extreme measures to bail out their financial sectors.” However he warned that the risk facing such counties is that “they are in the front line of the new cold war that’s breaking out between China and America”.
- What are the most resilient career paths?
Are there any specific career paths which will enable people to ride out the likely economic storm? The most vulnerable areas are likely to be financial services and professional services focused on financial engineering – many careers in such areas are already under threat from machine-learning and artificial intelligence, and could be subject to mass layoffs in the event of he next crisis.
Jobs and salaries are more likely to hold up in areas such as engineering, medicine and science. “And as long as they focus on good accounting and not creative accounting and financial engineering, accountants should be alright,” said Griffith Jones.
Napier, however, was less optimistic about the future for accountants, next crisis or no. He said: “Accountancy isn’t safe. Blockchain could make huge inroads into accountancy.”
Pettifor, however, believes that one area where there is sure to be persistent demand for expertise is climate change related work. “There will be plenty of well-paid employment among climate scientists and people to manage floods, managing energy efficiency, new green technologies and all of those other environmental issues. That is going to be where there is going to be work would head in that direction long term because that’s where the jobs are going to be. And also the financing of that process.”
- Conclusion
If the crisis of 2008 had been better handled, a lot of things would have been different now. However, because the remedies introduced at the time were, for the most part, superficial and ill-conceived – a Band-Aid on a gaping artery rather than the open heart surgery that was required – we have already seen some grotesque consequences including surging global indebtedness and the rise of populism.
Given the perfect storm of rising interest rates, quantitative tightening, Trump in the White House, a more fractured international community, and clear pressure points in emerging markets, another crisis now seems inevitable. As the Rolling Stone journalist Matt Taibbi puts it: “Debt was the crack cocaine of the early 21st century. And we bailed out the dealers”.
This article as published in CA Magazine in January 2019
https://www.camagazine.co.uk/