Yves here. In the “great minds work alike” category, former derivatives trader Satyajit Das sent the post below, on the high odds of bad outcomes in financial markets the same day we were writing The Inevitable Financial Crisis and Nouriel Roubini argued in his usual detailed manner in Project Syndicate that the crisis was already here, as shown by tight and increasingly illiquid markets for new borrowing, particularly for risky credits.
Michael Pettis is voicing similar worries:
This is an important point. Banks are famously subject to bank runs because their role is to mismatch maturities – specifically by borrowing short and lending long – and this makes them vulnerable to a sudden shift in the relative liquidity of each side of the balance sheet.
— Michael Pettis (@michaelxpettis) October 5, 2022
The real problem is when certain features of the economy (e.g. central bank policy) encourage a very large number of “banks” to mismatch their assets and liabilities in exactly the same way. When that happens the economy suffers from systemic risk.
— Michael Pettis (@michaelxpettis) October 5, 2022
And from reader Li: “Ray Dalio quit Bridgewater just before the market implodes.”
Mind you, the point is not so much that credible analysts are coming to broadly similar conclusions. It’s that when you look at the state of the financial markets and the global economy, there is almost nothing to like, yet asset prices don’t reflect that.
The spectre of financial crisis now looms alongside pestilence (Covid19), war (Ukraine and unreported hidden Middle East and Africa conflicts) and famine (real in emerging nations, high food and energy prices elsewhere). Frantically cutting growth forecasts, the IMF entitled its latest economic forecast ‘Gloomy and More Uncertain’.
Noise – day-to-day gyrations and speculation- masks the fact that a major re-set, the largest since 2007, may be underway.
End of Magical Economics
The first driver is that magical economic thinking and era of ultra-cheap money is coming to a close.
The 2008 financial crisis, the great recession that followed, and the more recent pandemic led to unprecedented government spending, low interest rates and liquidity injections by central banks. This underpinned a large proportion of activity. But these factors contributed to excess demand which combined with supply shortfalls due to Covid19 disruptions, the Ukraine conflict, especially poorly thought through sanctions, resource scarcity, and extreme weather caused sharp price increases.
Debates about recessions notwithstanding, a slowdown is evident. One factor is states embarking on varying degrees of budget repair. Another is central banks increasing interest rates to counteract inflationary pressures, although how this will resolve supply side issues, the pandemic, climate change or wars is unclear. Over-zealous rate rises risk exacerbating the downturn undermining employment which remains strong in developed economies.
Significantly, China, a major engine of global growth, faces difficulties from its disruptive zero-Covid policy, the unwinding of a large debt fuelled real estate bubble and Western restrictions on technology and market access. As the world’s factory, China matters, remaining pivotal to supply chains. It also is an important source of demand, especially for raw materials and commodities.
There are significant long-term headwinds. Adverse demographics in many countries will create unsustainable dependency ratios with shrinking numbers of workers expected to support a growing aged population which is living longer.
There is the accelerating costs of climate change, with growing parts of the planet becoming increasingly uninhabitable. Scarcity of food, energy, water and other resources is emerging. Geo-political tensions are at their highest level in decades. The mega-rich are already planning their escape, colonising outer space.
Future growth -modern civilisation’s panacea for all problems- will be patchy and volatile.
The second factor is the brutal destruction of ludicrous financial fantasies. Everything and everywhere asset price bubbles, fuelled by decades of debt financed consumption and investments and low cost of funds, now face their most rigorous examination.
High flying new enterprises prospered in an unhealthy cycle where investors backed those with strong sales growth, which then used the cash to attract more unprofitable customers to boost revenues to attract further capital etc. That game is over.
Even established technology firms, some heavily dependent on advertising revenues and facing regulatory scrutiny, may struggle. Lacking radical new products and satiated consumers, at least in advanced countries, many industries now face more challenging times.
Cutting through the quantum opacification, all values depend on future cash flows. An annual payment of $1 discounted back at 4 percent rather than 0 percent results in a reduction in present value of 19 percent over 10 years and 32 percent over 20 years. That is before you consider that many businesses are not profitable or cash flow positive as well as other deteriorating fundamentals. Equity valuations based on finding a greater fool to pay you more than you did were never sustainable.
Borrowings are high. Individuals, businesses and governments have, in the words of Bruce Springsteen, debts that no honest man can pay.
Slower economic growth and lower asset values may result in rising bad debts. While better capitalised than before, banks are still highly leveraged and vulnerable to financial shocks. This is compounded by the still large shadow banking system to which is connected by financial dealings. Ultimately, any problem will work its way through the hyper-linked global financial system.
Already weakened by the pandemic, many emerging market borrowers may need to restructure debt. The unresolved European debt crisis is remerging. The European Central Bank acted as buyer of last resort for almost-bankrupt members to cover up the problem. Rising rates will pressure highly indebted countries; France (government debt at 113 percent of GDP), Greece (193 percent), Italy (151 percent), Portugal (127 percent) and Spain (118 percent).
Fault lines between inflation-phobic creditor and debtor nations will increase. The indebted eurozone-member’s lack of independent monetary policy, fiscal capacity, currency flexibility and ability to monetise away debt will again become problematic.
Currency instability is a visible manifestation of the rising dysfunction. The Euro, the Yen, Pound and many emerging market currencies have fallen sharply against the US dollar. The sharp moves affect domestic inflation and trade competitiveness as well as foreign capital flows. Desperate chatter about a new Plaza accord highlights the problems.
The reckoning may not be immediate. The Great depression, 2000/ 2001 tech bubble and 2008 mortgage problems took years to develop. As economist Rudiger Dornbusch noted: “the crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.“
Authorities will resort to the old rule book to stretch the game out for a little longer. But the narrowing path out of the problems means it will be difficult to contain the ultimate dislocation.
Governments have high debt levels, central bank balance sheets are bloated and real (inflation adjusted) interest rates already negative. While inflation will ease over time, rates are unlikely to retrace as central banks will be cautious about elevated absolute prices and wary of reigniting inflationary expectations.
The much vaunted pivot (front end loaded rate rises followed by cuts in 2023) may only occur if the economy and financial markets crashes. The ‘bad-news-is-good news’ meme (poor economic data boosts asset prices through greater central bank support) may be a case of wishful thinking.
The paucity of policy tools is evidenced by the European Central Bank’s Transmission Protection Instrument to prevent financial fragmentation. Designed to lower the borrowing costs of vulnerable members (whose rates are rising relative to Germany), it contradicts increases in official Euro interest rates. In a similar vein, the Bank of England’s rapid turnaround – injecting liquidity to avoid imminent collapse rather than reducing accommodation to fight inflation- highlights the dilemma.
Social and political matters are increasingly likely to dominate.
Populations exhausted by the sequential problems are unlikely to remain quiescent. Globally, resentment of governments, unable to deliver on promises, and elites, emblematic of wealth inequality, underlies social unrest. In China, in an unusual sign of disharmony, a growing number of home buyers stopped paying mortgages on incomplete and stalled projects, forcing the government to act.
But few are, for the most part, unwilling to acknowledge conflicting priorities. Additional investment in public services and cost of living assistance is incompatible with lower taxes and sound public finances. Deregulation and interventionism on pet issues are inconsistent. Sacrifices and lower living standards are firmly rejected.
These interlocking crises risk the impoverishment of large sections of the population, creating conditions for social and political upheaval. French political scientist Alexis de Tocqueville held that such events occur when a period of objective economic and social development is followed by a sharp reversal. People’s mood and attitude shifts when they fear that the gains acquired with great effort may be lost. He wrote: “Evils which are patiently endured when they seem inevitable become intolerable once the idea of escape from them is suggested.”
Despite going on for more than a decade, parties, as Prince sang, were never meant to last!
© 2022 Satyajit Das All Rights Reserved
An earlier version was published in the New Indian Express.