An American Sneeze; A Chinese Cough
By Mo Fakhro
How can we prepare for the next global economic crisis? Where will it come from? How will we emerge from it? The financial crisis of 2008, was a lesson for the world about the risks of providing too much liquidity to the system, and the risks of too much deregulation. It also showed us how effective intervention by the Federal Reserve and Federal Government in the United States, helped to prevent a second great depression. While the coronavirus pandemic has shown us again how effective action by the Federal Reserve can lessen the impact of a major global crisis, it is important to also be aware of the risks that the current additional liquidity poses to the system, and to make sure an environment is not created that is similar to the one created during the years preceding the global financial crisis.
It is important for the global economy to not repeat the mistakes of the past. One of the initial triggers of the financial crisis was the increases in liquidity during the years leading up to the crisis (2). This was driven by the need to maintain economic growth, and by the US government’s need to offer housing to a larger portion of the population. However, it led inadvertently to an asset bubble in the housing sector and to speculation. The additional liquidity created by providing additional resources to Freddy Mac and Fannie Mae to buy mortgage-backed securities, led, perhaps inadvertently, to a rush to give mortgages to, in effect, anyone who would be interested to take them. This led to a loosening of controls on who could get a loan. The low principal payments, and the delays in the payment of initial installments, also created a speculative situation where people would purchase a property through a bank loan, not to use that property or rent it, but just to hold on to it for a few months before selling it. Greed ultimately got the better of the system. Individuals and financial institutions realized too late that they had overextended themselves, and the crash that followed led to a great deal of hardship around the world.
While deregulation of the financial system had many benefits, one of its drawbacks is that it led to the creation of very large financial institutions that became too big to fail. When the McFadden Act was repealed beginning in 1994, it set off a chain reaction that led to a wave of mergers and acquisitions in the financial services sector. The benefits of mergers from a business standpoint due to economies of scale and loan diversification, led to the size of banks growing and the number of banks reducing. This led to a situation around the financial crisis where a number of financial institutions had become too big to fail. They were thus emboldened to take on excessive risks, and their creditors became comfortable with excessive risks, due to the implicit assumption that if things did not work out, the government would have no choice but to bail them out.
Deregulation in the form of the effective repeal of the Glass-Steagall Act in 1999, also removed the rigid lines that separated retail banking from investment banking. The benefits of economies of scope thus began to take hold, and led to the creation of financial institutions that accepted deposits but also operated hedge fund divisions. The same financial institution that was entrusted with people’s savings, was also allowed to provide insurance against the default of mortgage-backed securities. This added to the sense of uncertainty during the financial crisis, because it was not clear what the impact of the crisis was having on the megabanks of the time, and it was not clear which of them would need a bail out or would even get a bail out.
The financial institutions that had offered insurance against the default of mortgage-backed securities found themselves in a particularly difficult position. These instruments, named credit default swaps, became a serious issue when the market crashed. Many large financial institutions, including AIG, found themselves holding huge liabilities because they had provided other firms with insurance against default of their mortgage-backed securities. These firms ultimately could not survive on their own. Some had to close down while others needed to be merged, acquired, or bailed out (5).
The overall end result of the financial crisis was that US Government debt increased from approximately 8.5 Trillion US Dollars in 2006, before the financial crisis, to 19.5 Trillion US Dollars by 2016, just ten years later (3). Furthermore, a 2011 report by the United Nations found that the number of unemployed people around the world by 2009 was 27 million more than it was in 2007 (4). As bad as the result of the crisis was though, it would have been significantly worse if governments and central banks around the world had not acted quickly to resolve the turmoil that ensued as financial institutions began to default on their obligations.
One of the consequences of the financial crisis has been that it has harmed to reputation of Wall Street banks, and led to a mistrust of the financial system by the general public. The percentage of people who generally distrust banks increased from 13% in 2007 to over 30% by 2011 (6). Wall Street financial institutions have come to be seen in a more negative light as a result of the financial crisis. The high salaries of bankers, and the high value of the bail outs that will ultimately be paid by tax payers, has left a bitter taste in the mouths of people.
The speculative bubble in real estate before the financial crisis, has similarities to the current situation in the US stock market. The wild speculation in the price of stocks like GameStop, a US games retailer with questionable business prospects, indicate that the market may be driven increasingly by speculators. The speculators increasingly appear to be buying shares not because they believe in the underlying value of the assets that they are buying, but because they simply are interested in day trading. Robinhood, a trading app that is popular with millennials, has seen rapid growth in volumes recently (7). The increased liquidity to the real estate sector before the financial crisis was well intentioned, but it inadvertently led to a crash. The increased liquidity to the banking sector currently is similarly well intentioned. It is important to make sure that it does not lead to a similarly calamitous outcome in the future if the market turns.
The similarities between the years preceding the financial crisis and the current situation of excess liquidity in the financial system, do not end there. As financial institutions aimed to increase their return on assets and return on equity, many increased their leverage. When the crash came, those that were exposed had to take write offs on the value of the real estate loans that they had given out or on the value of the real estate on their books, or the value of the mortgage-backed securities on their books. While the Federal Reserve acted very well to prevent a serious economic crisis during the coronavirus pandemic, some have argued that it may now be providing too much liquidity to financial institutions (1), and thus leading to the same increases in leverage that exposed financial institutions during the years preceding the financial crisis. When banks receive too much in deposits, this puts pressure on them to lend those funds out. With a constant equity base, this would have the effect of increasing the debt-to-equity ratios of banks and thus increasing their leverage.
As we move into a post pandemic world, it is important to recognize the vulnerability of the global economy, and the critical role of the Federal Reserve. While it is clear that the Fed played a key role in providing stability by adding liquidity to the system when the pandemic first hit, it is now a cause for concern amongst many that there is too much liquidity in the financial system. A recent article in the Economist (1) highlighted this added liquidity as a cause for concern. It mentioned that banks have so much liquidity that they are now driven to turn away depositors. The Federal Reserve has been buying approximately 150 Billion US Dollars in new bonds every month. As these dollars get deposited by the sellers of the bonds into banks, the money multiplier begins to take effect. The banks that receive the funds then lend most of them out to people or companies who deposit them in other banks, and so on.
The implications of this could be that there is an excess in liquidity in the system. Excess liquidity could have harmful effects on an economy. It may lead to an inflation in asset values. With most manufacturing done in low-cost areas around the world, it could be that the impact of excess liquidity of consumer prices will not be felt. For example, an excess in liquidity that drives rents higher in the US, will not necessarily raise the prices of consumer goods because the factory in China pays employees’ salaries who do not get impacted by the higher rentals in the US, and hence do not ask for raises. Another factor that may be preventing an increase in consumer prices is that retail has been impacted by the shift online, and so commercial rentals would tend to decline in such an environment, thereby preventing a rise in costs to retailers, and preventing the need to correspondingly increase prices. While consumer price inflation seems to be under control, that does not seem to be the case with asset prices. The increase in liquidity has been one of the factors that has driven up the price of stocks and bonds. This has led to an asset bubble that may ultimately burst in a way similar to what happened to real estate prices during the financial crisis.
It used to be said that when America sneezes, the world catches a cold. This became a common phrase after the Cold War left the United States as the dominant economy of the world. It greatly simplified the management of the global economy, because it implied that to avoid getting sick, the world had to just prevent America from getting sick, and to prevent America from getting sick, the Federal Reserve needed to simply act prudently and effectively to respond to economic turmoil. With the emergence of the European Union as an economic block and, in particular, of China and India as significant global economies, it sometimes feels as though we are moving from a unipolar global economy dominated by the United States to a multipolar global economy with no clearly dominant force. However, as the coronavirus has shown us, our globe is more interconnected than ever. A crisis somewhere could easily spread to a crisis everywhere. While we are no longer burdened by global borders, we are also no longer protected by them. During the global financial crisis, America sneezed and the world caught a cold. With the coronavirus crisis, a cough in China led to the death of millions of people, and to a shutdown of the global economy. Earlier this week, a single ship clogged an artery at the heart of global trade in the Suez, bringing the exchange of goods across large parts of the globe to a standstill. Where will the next crisis come from? How will we prepare for it? How will we respond to it? It will increasingly require the coordination of global institutions and cooperation between the governments of the world. The maintenance of open and cordial communication between governments is critical to achieving this, not only for global peace, but increasingly too for global prosperity.