This is an article by Robert H. Wade on the potential of an incoming financial crisis.
What is the probability of a big financial crash and recession in the US and across western financial markets – e.g. before end of 2024? Professor of Political Economy and Development in the Department of International Development Robert Wade analyses past crises and current trends to consider this question.
Warning lights flashing red
Jeremy Grantham, co-founder of Boston-based fund manager GMO, says: “The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance and hysterically speculative investment behaviour, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929 and 2000.”
Recovery from the North Atlantic Financial Crisis (NAFC) of 2007-09 – which Grantham describes as “the long, long bull market” – was distinctly K-shaped. In the US and Europe, the wealthiest 1 % recovered pre-crisis wealth levels within a few years, while it took much longer – around 2017 – for the bottom half of the wealth distribution in the west to regain pre-crisis wealth levels. The wealth distribution was very polarized before the NAFC, even more polarized by 2020.
At the start of 2007 the bottom half of the US wealth distribution held 2.1% of the nation’s wealth, the top 1% 29.7%. At the start of 2020, the figures were 1.8% and 31.0%. So in 13 years the bottom half lost 0.3% from 2.1% while the top 1% gained 1.3% of total wealth on top of 29.7% and boosted their savings ready to invest in stocks and businesses and houses, art works, yachts and sports teams.
Now, many retail investors – who during the Covid pandemic have been able to work from home without significant loss of income but have been limited in their normal spending — are pouring into popular stocks, sending share prices of even unprofitable companies soaring like fourth-of-July skyrockets.
Global equity market capitalisation as a percentage of global GDP shot up from 320% at the start of 2019 to 357% by the end of 2020. This increase of almost 40 percentage points in only two years is super-fast compared to the increase from 2013 to 2019 of only 20 percentage points, from 310% in 2013 to 320% in 2019.
Global debt has also grown explosively. The Institute for International Finance (a trade body for global banks) estimates that global debt hit a new record of $281 trillionin 2020, with the public spending on the Covid pandemic contributing “only” $24 trillion to that figure. (One million seconds equals 11 days; one billion seconds, 32 years; one trillion seconds, 32,000 years.)
Wall St margin debt exemplifies the bigger picture. Brokers lend margin debt to “investors” for them to play financial assets. Just before the 2008 financial crash, it peaked at $400 billion. By a year ago, April 2020, it reached $480 billion. Then in the past year to March 2021 (even after Archegos crash) it almost doubled to reach $820 billion.
Is this “irrational exuberance”, in Alan Greenspan’s phrase, “mania” in plainer English? Optimists (including some at Goldman Sachs) say it is “rational” and “safe”, thanks to rising asset prices and very low interest rates. And they say that unlike the run-up to the NAFC, banks now are not overstretched, having been forced to raise their capital base since the crisis.
Will asset prices keep rising and interest rates stay low? The answer depends on inflation. If inflation remains low and the Federal Reserve sustains monetary stimulus, asset prices will keep rising, raising the potential for a crash. If and when there is a big jump in inflation and a belated monetary tightening, a financial crisis and deep recession is on the cards.
This assumes that monetary policy will be relied on, not fiscal policy. The wealthy much prefer monetary policy to fiscal policy as a source of macro stabilization, because monetary policy tends to benefit the rich disproportionately. They hold most of the assets whose prices rise with low interest rates, while the non-rich rely on “trickle down”.
The upshot is that the world economy is now in a debt trap. Levels of debt and equity valuations are so high that central banks cannot tighten monetary policy without posing a serious threat to economic stability. Given that the wealthy oppose higher taxes on them as part of a fiscal policy response to inflation, governments face a cruel choice between raising interest rates and risking economic crisis (due to monetary tightening when debt levels are already extremely high), and not raising interest rates and facing higher inflation, which can also be a cause of economic (and political) crisis. But come what may, governments will have to allow a higher level of inflation to inflate away some of the debt.
In short, the world economy now (1) carries explosive levels of debt, and (2) is in a debt trap (central banks have to be very careful how fast they raise interest rates). But when is the turning point likely to happen – even perhaps the onset of another major crisis resembling 2007-09? Remember what Jeremy Grantham said, but remember also that Warren Buffett and millions of bruised amateur and professional investors attest to the dangers of trying to predict the stock market or wider economy over the short run of a couple of years. It is not random so much as horribly complex, as chaos theory tries to explain.
It is not hard to conjure up the conditions which bring Trump or worse to power in 2024, and a further erosion of democracy world-wide – which has been in steady regression since 2005.
Mania in top executive remuneration
The other side of the equity and debt trends are the soaring levels of executive remuneration since 2007-09. In the past pandemic year many top executives have received even larger increases than normal while their companies have struggled. Boeing had an exceptionally bad year in 2020, with the workhorse 737 Max grounded after two deadly crashes, losses of $12 billion and some 30,000 workers dismissed. David Calhoun, chief executive, was rewarded with $21 million in compensation. Norwegian Cruise Line barely survived at all, because cruising stopped. The company lost $4 billion. Its compensation committee doubled the CEO’s pay to $36 million. Hilton hotels made big losses while its CEO received compensation worth $56 million, according to the company’s annual filing. But a Hilton spokesperson said his real compensation for 2020 was only $20 million, a slight fall from 2019.