A Buttonwood piece in the Economist (30th September 2017) looked at how central banks can trigger the next financial crisis. Deutsche Bank have looked into long-term asset returns in developed markets and suggest that crises have become much more common. They define a crisis when a country suffered one of the following:
- a 15% annual decline in equities;
- a 10% fall in its currency or its government bonds;
- a default on its national debt; or
- a period of double-digit inflation.
Pre the Bretton Woods system of fixed exchange rates and a central bank’s limited ability to create credit, very few countries suffered a shock in a single year. But since 1980 there have been numerous financial crisis of some kind. Under the Bretton Woods system a country that expanded its money supply too quickly would encourage an increased demand for imports which would ultimately lead to a trade deficit and pressure on its exchange rate; the government would react by slamming on the monetary brakes. The result was that it was harder for financial bubbles to inflate.
But with a floating exchange rate a country has more flexibility to deal with economic crisis as they don not have to maintain a currency that is pegged to another. A weaker currency makes exports more competitive and imports more expensive. But it has also created a trend towards greater trade imbalances, which no longer constrain policymakers—the currency is often allowed to take the strain. See flow chart below.
As well as companies and consumers taking on debt, government debt has also been rising as a proportion of GDP since the mid-1970’s:
- Japan – a deficit every year since 1966
- France – a deficit every year since 1993
- Italy – only one year of surplus since 1950
This has resulted in significant credit expansion and collapse – by allowing consumers to borrow more money the cost of assets (esp. houses) is pushed higher. However when lenders lose confidence in borrowers ability to repay they stop lending and mortgage sales follow. This is then reflected in the credit rating of borrowers. In order to try and rectify the problem the central banks intervene and reduce interest rates or buy assets directly. This may bring the crisis to a temporary halt but results in more debt and higher asset prices.
Deutsche Bank suggest that could mean another financial crisis especially if there is the withdrawal of support from central banks who saved the global economy when the GFC started. Indicators suggest that this may be the case:
- US Fed – has pushed up interest rates and cut back on asset purchases
- ECB – likely to cut asset purchases next year
- Bank of England – has recently pushed up interest rates
However rates are still at a stimulatory level and developed economies have been growing for several years. According to Deutsche Bank any kind of return to “normal” asset prices from their high levels would constitute a crisis. This would then force central banks to once again lower interest rates again but they will not want to appear to be the ambulance at the bottom of the cliff every time this happens. Remember the bailouts of AIG and the investment banks. It seems that the investment banks are happy to privatize the reward but socialise the risk – when it all “turns to custard” they need to be bailed because they are too big to fail. The question that people are now asking is what is the vulnerable asset class? Mortgage-backed securities was the cause in 2008.
Below is another great video from PunkFT. Financial crises start with significant increases in asset prices followed by a severe correction and a collapse. But with more debt and more credit the market is unstable and although they have never been higher the yields have never been lower.
Thanks to more and more debt driving yet more and more credit, making everything more and more unstable. Today, for example, markets have never been higher. Yields have never been lower.
The early warning signs
These economic crises are easy to spot and they follow a familiar pattern. The warning signs are:
1. A bank grows very quickly and issues poor quality loans against nominal yields. It uses leverage to do this and fails to be aside reserves for possible future losses.
2. Normally the share price of these banks would plummet but in fact the opposite happens – the share price is driven up. As the bank takes more and more risk to generate more return, the market gets giddy, and they drive up the share price.
3. We don’t learn from our mistakes. The Global Financial Crisis suggests that the economy is following the contours of typical recession but that it is more severe. Subsequently forecasters who have tried to make resemblance to post-war US recessions are “barking up the wrong tree” and are of the belief that conventional tools like expansionary fiscal policy, quantitative easing and bailouts are way to go. The real problem is that the global economy is badly leveraged and there is no quick fix without a transfer of wealth from creditors to debtors. Ken Rogoff (co-author of ‘This Time is Different’) suggests that the ‘Second Great Contraction’ is a more realistic description of the current crisis in the global economy. The “First Great Contraction” was the Great Depression of 1929 but the contraction applies not only to output and employment, as in a normal recession, but to debt and credit, and the deleveraging that typically takes many years to complete.
If everybody else is doing it and getting rich, why, the CEO asked himself, shouldn’t I? The real cause of banking failures and systemic collapse lies with ethics at the top. And human nature tells us that bad ethics drive out good ethics.
Black Monday refers to Monday, October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. In New Zealand and Australia it is sometimes referred to Black Tuesday because of the different time zone. By the end of October stock markets around the world fell significantly:
- Canada – 22.5%
- USA – 22.68%
- UK – 26.45%
- Spain – 31%
- Australia – 41.8%
- Hong Kong – 45.5%
- New Zealand – 60%
Unlike other countries the effect of the crisis was compounded by the Reserve Bank of New Zealand’s inaction to lower interest rates and therefore reduce the value of the NZ dollar. This is in contrast to the USA, Germany and Japan whose banks loosened monetary policy to prevent a recession. Below is a video from the FT looking back at the events 30 years ago. Also a useful graph to put the crash in perspective – the two circled ares are the dot.com crash and the GFC.
An article in the Sydney Morning Herald last month looked the Reserve Bank of Australia (RBA) and the neutral interest rate. For almost a year the RBA has kept Australia’s official interest rate at 1.5% and uses this instrument to control the overnight cash rate to try to manage the economic activity of an economy. EG.
Expansionary = Lower interest rates = encourages borrowing and spending
Contractionary = Higher interest rates = slows the economy down with less spending
How do we know that 1.5% is either expansionary or contractionary? Central banks indicate what they believe is the neutral rate of interest – this is a rate which is defined as neither expansionary or contractionary. In Australia the neutral is estimated to have fallen from 5% to 3.5% since the GFC. RBA deputy governor, Dr Guy Debelle, explains that the neutral rate aligns the amount of nation’s saving with the amount of investment, but does so at a level consistent with full employment and stable inflation. In Australia this equates to 5% unemployment and 2-3% inflation.
The level of a country’s neutral interest rate will change with changes in the factors that influence saving and investment.
More saving will tend to lower interest rates
More investment will tend to increase interest rates
Debelle indicates that you can group these factors into 3 main categories:
1.The economy’s ‘potential’ growth rate – the fastest it can grow without impacting inflation.
2. The degree of ‘risk’ felt by households and firms. How confident do they feel about investing. Since the GFC people are more inclined to save.
3. International factors – with the free movement of capital worldwide global interest rates will influence domestic interest rates.
“We don’t have the independence to set the neutral rate, which is significantly influenced by global forces. But we do have independence as to where we set our policy rate relative to the neutral rate.” Dr Guy Debelle
Another very informative clip from the FT. Some of the salient points include:
- Since the global financial crisis the Bank of England, US Fed, Bank of Japan and European Central Bank have bought assets and printed US$12 trillion.
- Can interest rates return to what has been normal in the past – say 5% instead of close to 0%.
- US Fed plans to shrink its balance sheet later this year – monthly reduction US$6bn in its assets. But this is a very small amount when you consider that the Fed holds US$4.5 trillion
- But this is not happening elsewhere. Bank of Japan and European Central Bank are still printing money and buying assets. With Brexit the Bank of England faces huge uncertainties regarding their balance sheets.
- Interest rates will remain low partly due to: ageing population, low productivity growth and a savings glut. This has reduced the attractiveness of capital spending.
How important is it to have an economics background to run the Federal Reserve? The FT’s US economics editor Sam Fleming talks to several leading economists on whether being versed in the theory is a basic requirement for a Fed chair.
Current US Fed Chair Janet Yellen could be heading into the final six months of her first term at Fed Chair. If Donald Trump does not give her a second term it may usher in new thinking from the US Government. There is no requirement for Donald Trump to appoint someone who is from the academic world of economics. They mention the success of Paul Volcker as Fed Chair who didn’t have a PhD in Economics but had a Masters Degree and also experience in banking (Chase) and commercial sector. From the left you have – Janet Yellen, Paul Volcker, Alan Greenspan and Ben Bernanke.
Below is a recent documentary from Deutsche Welle (DW – Germany’s international broadcaster) on the impact of exploding real estate prices, zero interest rate (see graph below) and a rising stock market. The higher income groups are benefiting greatly from these conditions but how does it effect middle income earners especially those in retirement. The DW documentary addresses these issues and explains how money deals have become detached from the real economy. Worth a look.
For years, the world’s central banks have been pursuing a policy of cheap money. The first and foremost is the ECB (European Central Bank), which buys bad stocks and bonds to save banks, tries to fuel economic growth and props up states that are in debt. But what relieves state budgets to the tune of hundreds of billions annoys savers: interest rates are close to zero.
The fiscal policies of the central banks are causing an uncontrolled global deluge of money. Experts are warning of new bubbles. In real estate, for example: it’s not just in German cities that prices are shooting up. In London, a one-bed apartment can easily cost more than a million Euro. More and more money is moving away from the real economy and into the speculative field. Highly complex financial bets are taking place in the global casino – gambling without checks and balances. The winners are set from the start: in Germany and around the world, the rich just get richer. Professor Max Otte says: “This flood of money has caused a dangerous redistribution.
Those who have, get more.” But with low interest rates, any money in savings accounts just melts away. Those with debts can be happy. But big companies that want to swallow up others are also happy: they can borrow cheap money for their acquisitions. Coupled with the liberalization of the financial markets, money deals have become detached from the real economy. But it’s not just the banks that need a constant source of new, cheap money today. So do states. They need it to keep a grip on their mountains of debt. It’s a kind of snowball system. What happens to our money? Is a new crisis looming? The film ‘The Money Deluge’ casts a new and surprising light on our money in these times of zero interest rates.
Teaching ethics to my Yr 10 class I have used the sub-prime crisis as an example. As with behavioural economics the conventional view of finance assumes that markets are efficient and that the price of shares, bonds and other financial instruments are a reflection of the fundamental economic values that they represent. Behavioural finance is all about understanding why and how financial markets are inefficient. If there is a difference between the market price of a share or bond and its fundamental value then in conventional economics no one can make money in financial markets by exploiting the difference.
Global Financial Crisis
In July 2007 a loss of confidence by US investors in the value of sub-prime mortgages caused a liquidity crisis. Sub-prime mortgages were loans that were high risk and many mortgage holders unable to meet their repayments. The mortgages were pooled into what was know as a Collaterised Debt Obligation (CDO) which were sliced into tranches – safe – okay – risky. Investors tended to buy safe tranches as they were rated AAA by the rating agencies. However the rating agencies were very generous in their assessment of these investments as they were paid by the banks who created the CDOs. Banks also were able to take out insurance on the CDO even if they didn’t own them. This was called a Credit Default Swap (CDS).
The flow chart (above) and video (below) shows how Goldman Sachs sold a CDO called Timberwolf to investors and proceeded to bet against that investment by buying insurance from AIG so that when the CDO failed they got a pay out from them. As you maybe aware AIG sold a lot of CDS’s and ultimately had to be bailed out by the US government. However a significant portion of the bailout money went to the banks that had created the problem.
Below is another very good clip from the Big Short that explains how the mortgage market brought down the financial system. Good references to CDO’s in which celebrity chef Anthony Bourdain compares fish to finance?
Below is an image from National Australia Bank (NAB) with regards to the prospects for credit markets in 2017 looking at various scenarios – Bearish, Bullish and Base Case.