Are financial crises inevitable?
Ten years already. In summer 2017, we celebrated the sorry tenth anniversary of the last great financial crisis. We may well ask ourselves the question of what form the next one will take and most of all when it will happen (if it happens). We might also ask whether we have learned from our mistakes and from these crises. That is by no means certain. Finally, where might the next crisis come from, in a specific environment, such as the one we are currently in. These are the questions I would like to tackle, although with no confidence that my words will give any assurance.
"What remains of our love?” in the words of the Charles Trénet song
What does a crisis leave behind and what do we learn from a crisis? We always learn something, of course. Do we come out of a severe financial crisis bigger and stronger? Probably. However, the learning process seems to take longer than common sense would suggest. We have a short memory for adverse events. People and finance companies are too quick to forget. We certainly try to do better without always achieving the success we might reasonably expect. The causes of crises and the crises themselves come and go like fashions, in a sort of never-ending dance with minor variations. It is as if there were a cycle of crises, doomed to repeat one after the other. The real question is how to prevent them rather than how to deal with them once they have happened. Trying to achieve too much is always self-defeating, and when it comes to crises, trying to achieve too much can often be the cause of the crisis itself and of its scale. The domino or knock-on effect and the effect of correlation mean that today everything is intimately linked together and that sooner or later a crisis will end up impacting a whole series of things by chain reaction. This is the collateral damage. The good news since 2007 is that the budgetary virtue shown by the EU has, to some extent, benefited us all. In terms of regulation, it should also be noted that behaviour has been whiter than white at the European level. The State is once again trying to play a key role in oiling the cogs of the capitalist system, but also acting as watchdog and guardian of the temple.
The financial system looks more resilient
Although we may reasonably think that the financial system is more resilient than it was before the last crisis, the fact remains that the firefighters are still on hand to fight the fire, in case it should reignite. We would do well to remember the words of Janet Yellen who, in substance, said: "I hope – and I think – that there will be no further (major) financial crises in our lifetimes" (during a speech to the British Academy). She thinks that a crisis of such a scale, greater than the 1929 crisis, is no longer possible in her lifetime. Let us hope she lives a very long time, but I would not like to be the judge of her views. But we must hope that governments and supervisors have learnt from their mistakes. We cannot readily imagine the sudden onset of another crisis. However, we need to remain vigilant. The question to ask is whether there is any risk of implosion. There is, in fact, a speculative bubble on the bonds market (rather than on the equities market, even though it is very expensive). Long-term interest rates are too low. The sudden resurgence in them, when that happens, could have significant effects. An explosion will then no longer be beyond the bounds of possibility. The interest burden of companies will then surge spectacularly. What is more, the Bank for International Settlements (BIS) has warned of the "debt trap" risk. Businesses in the USA have not de-leveraged since 2008. There are many zombie companies whose interest expense exceeds profit before financial charges and taxes. No one disputes that stock prices and PEs are very high. The ratio of prices to earnings stands at over 30 according to Robert Shiller. This ratio was higher only before 1929 and before the dot-com bubble burst in 2000. There are therefore very good reasons for being worried. China is another risk. A landing of one sort or another is on the cards, and there is nothing to say it will be a soft landing. China is thought to be vulnerable while at the same time being capable of affecting the rest of the world. There is a great and worrying over-dependence on the country. Then comes "shadow banking", with little or no regulation, which includes hedge funds, private equity funds, investment funds, crowdfunding and others. The summer 2007 crisis started with liquidity problems in three money market funds. Today, the finger is being pointed at the extraordinary expansion of ETFs (Exchange Traded Funds), tracker funds that are quoted and traded all day long in real time. Many are used for speculative purposes, which is a source of huge risk. The next risk in line is what is known as "sub-prime" automobile loans – these Americans are certainly incorrigible. We are talking about a figure of around USD 1,200 billion, which is 50% higher than in 2007. These loans have obviously been "securitized" and resold to lenders. They are under surveillance. However, nobody wants to see a second "sub-prime" crisis, but who knows… A European crisis is still possible, which is the reason why safeguards have been put in place. Systemic banks are better supervised with strengthened equity. Will that be enough? "Bail-in" mechanisms have replaced the famous "bail-outs". Shareholders have to come to the rescue rather than governments, which have been bled dry. Italy is still a tinderbox that needs watching. Saving its banks has cost the Italian government dear. Happily, for what it's worth, states are less indebted in Europe as a whole thanks to negative interest rates. Against that, growth is still weak and the political situation fragile, even with Macron's arrival and Merkel's re-election. Geopolitical risk comes next on our list of points that need the greatest attention (e.g. recent Spanish crisis on Catalonia independence). North Korea is a worry, as are some South American countries and the powder keg of the Arab world. Real estate is always a splendid source of risk. The residential sector is dangerous in many European countries in which it is very high. Rising household debt is never good. The deregulation proposed by Donald Trump also looks catastrophic. Thinking that you can deregulate because things will go better is criminal in the view of experts and other economists. Cyber-attacks and the risk of other types of computer crime weigh heavily upon us. There are an increasing number of reports everywhere of hacking, ransom demands and other digital misdeeds. And finally there might be an unexpected and unforeseen event, the famous "Black Swan" event that could spark everything off. A combination or superimposition of some of the selection of risks that I have covered could cause the whole lot to flare up. The risk of another huge crisis has therefore not completely disappeared, I fear. Furthermore, human nature is such that we spend more time on fixing the last crisis than on preventing the next one.
Need we fear another crisis?
It is reasonable to think so, or at least to bear it in mind. One alert finance person is worth two, as the old saying goes after being tweaked a bit. In the Middle Ages, residents of a district grouped together to arrange a watchman for themselves, to be forewarned of threats. With the onset of globalisation, international bodies and other supervisors have taken over from these worthy watchman, with a certain measure of success. Arguments from the left and the right ask us to think that, as in 2006, some knowledgeable economists together with the IMF are asking us to believe that commercial banks are stronger and perhaps less vulnerable to shocks affecting lending or the economy. What a load of nonsense! The economy runs on trust and when it disappears suddenly, the whole lot turns into a house of cards. Current imbalances suggest that the risk of readjustment or rerating and a sharp correction cannot be discounted. All the ingredients are there, although that does not in any way mean there is a crisis. We must not talk about the end of the world like doom-mongers. There have been plenty of predictions, but reality has thankfully proved them to be wrong. Higher borrowings and money printing, Brexit and the imbalance in the balance of power that the loss of the UK will have, particularly for the smaller countries, is a major risk that many people would prefer to ignore. Brexit looks as if it may be a Pyrrhic victory for the continental Europeans. The slump in commodity prices, and the price of oil in particular, together with the weakness of the dollar, give cause for some concern in the medium term. Some oil producers are heading for disaster in a race to the bottom, racking up deficits. Imbalances seem to be on the increase as never before. The money supply is increasing without its effects being passed on fully to the real economy. The market has no appetite for it, and this surge of liquidity deepens the ditches even further. The economy seems to have reached an impasse with debt growing faster than wealth creation. Interest rates have hit the floor (less than zero percent in some cases), but the world's debt burden has nevertheless increased by over 200% of world GDP, which is about 40% more than in 2008. The system might be compared to a bike setting off a full speed, which could tip over if it slows down too much. Low interest rates have fuelled stock market and real estate speculation, as we mentioned above. The financial markets are no longer worried because there are on an overdose of monetary morphine, so to speak, which stops them feeling any pain and leaves them seeing economic events through rose-tinted glasses. We have averted our eyes from the vulnerabilities and to a certain extent created new imbalances. The world has never before been so much in debt as it is now (a paradox for Europeans who are tightening their belts), whereas history tells us that every crisis in the past has had its origin in excessive debt. That really is a worry, surely? Stock market capitalisations have hit unprecedented levels. We are being told that robots are about to change the way we live, and also that they may make us obsolete in the fullness of time. It is easy to understand the fears of some of the doomsayers.
"Nothing has changed" (David Bowie)
But "sleep peacefully, good people!", the politicians are telling us. We have replaced private debt with public debt, and will try to fix it in due course. The problem has been shifted from one place to another without being resolved. Total debt has continued to rise irreparably. The banking system has certainly been consolidated, more in appearance than in fact. We may hope that the complex short-circuit mechanism that has been put in place will work if it is needed. We may hope that systemic risk will be avoided or at least mitigated. Not being just a little worried would be absolute folly. Always being negative and pessimistic about everything is hardly any better. There are risk situations that need to be borne in mind and watched carefully. We need to believe that our contemporaries have learnt from their mistakes and that what happened in the past will not happen again. We at least know that we have been able to withstand one unique catastrophe in modern economic history. Unfortunately, having withstood one major storm in no way guarantees we will be immune and safe from the next one. The economy is transforming so fast that the main risk is that things run out of control or move too fast for the brakes to be put on. World digitalisation is a source of hope and progress, but also risks that we must no longer ignore. In the final analysis, has nothing really changed? At the end of the day, is everything still the same? No, we think not. We are stronger. Each crisis has been allowed to arise through a collective lack of understanding that has created a sort of blind spot on risk, which has stopped us having a clear view of everything that is sneaking up on us. On the other hand, no one is ever strong enough to withstand storms, so the best defences are vigilance and prevention. Let us hope that this one really will be the last for a very long time.
François Masquelier, Chairman of ATEL