Are We On The Cusp of a New World Economic Crisis?
Economic Crisis For Beginners
To put it briefly, a financial crisis is a scenario where asset prices take a huge plunge in value. In response, the key stakeholders of the economy such as financial institutions, businesses and consumers are unable to pay their debts.
Each financial crisis is caused by a completely different set of events. What’s interesting to note though is that the behavioural patterns by the partakers share a lot of similarities. Panic seems to be the driving force behind financial crisis as investors overreact to overvaluation or depreciation of assets prices.
The usual pattern sees investors indulging in a continuous, uncontrollable string of selling. That causes asset prices to fall even more, escalating the crisis and causing the economy to enter a recession.
Have we Dealt with the 2008-09 Global Financial Crisis?
The 2008 crisis is considered to be the most significant and noteworthy event since the Great Depression of 1929. Facing an unprecedented amount of mortgage debt, the U.S. Government was forced to drive interest rates almost down to zero. It also had to take on debt and bail out financial institutions that were doomed to fail.
The Emergency Economic Stabilization Act of 2008 accounted for over $700 billion of spending and quantitative easing. These moves were essential in saving the economy from crashing and re-establish financial stability. 10 years down the line and the United States economy has made huge strides in recovering.
The question that still looms though is obvious: are we finally out of the woods? Can we safely say the 2008 real estate crisis is behind us?
The story of recovery has been impressive for the US with corporate profits recording notable highs. The unemployment rate is at an 18-year low. In addition, the Dow Jones Industrial Average is nearly 4x better since hitting rock bottom in 2008. The data speak of a very promising recovery but the scars of the recession remain open.
The Dodd-Frank Wall Street Reform Act was primarily put into place to prevent banks from undertaking excessive risk. The Act also allowed the Federal Reserve to reduce the size of the banks that become too big to fail. The reform established a new and safer status quo for major banks. Nonetheless, many still argue that it did not really create an environment of certainty.
The bipartisan bill, crafted by Senator Mike Crapo in 2018 was the first piece of deregulation of the original Act. The most important part of the bill was redefining the threshold at which banks were considered too big to fail. That threshold used to be at $50 billion in assets, but was changed to $250 billion. Quite a big upswing someone could say.
If that wasn’t enough, the Trump administration did not exactly sprinkle optimism with how it’s handled the financial sector. The people appointed to lead federal agencies have put a stop to legislation targeted to tame major financial institutions.
Crisis prevention does not only happen with internal regulations. Having the support of other major players in the global economy creates a veil of safety. Such help can be critical in avoiding a crisis turning into a full-blown depression.
The Trump administration has removed this cushion as the United States has withdrawn from some important international alliances. These include countries like Canada, the UK and Germany.
Is a New World Economic Crisis Closer Than We Think?
Life works in cycles and economies are no exception to that. The global economy is expected to dip at some point. The severity of that dip and whether we’re able to manage it, is what we should be concerned about. How can you possibly prepare for such a thing and what are the telling signs if there are any?
You would think that having gone through a crisis just a decade ago would have groomed us to avoid treading on risky grounds. The reality is that public debt is well above the one recorded during the crash in 2008. Additionally, the financial system has a lot of unregulated parts that could spiral into a crisis at any point in time.
The International Monetary Fund is the industry standard for analyzing global economic data and foreseeing trends that might hurt the economy. The problem with the IMF is the that its miscalculations, have caused it to lose credibility amongst economists and government executives. Firstly, it failed to predict the crisis in 2008. Secondly, it miscalculated the Bank of England’s post-crisis recovery.
Just because the IMF has been wrong in the past, we shouldn’t completely discard its findings in the future. After all, where could we base our arguments, predictions or warning signs if not on the data accumulated by the IMF?
Shadow banking system
A shadow banking system refers to the unregulated financial intermediaries assisting credit creation for the global financial system. The rapid growth of these establishments came in the aftermath of banking reform such as the Dodd-Frank Reform Act. That created a parallel vain for unregulated lending and unknown risk.
According to the IMF, the US is the only country where shadow banking assets are greater than regulated banks assets. Some could argue that shadow banking has aided the sector by providing liquidity. The fear of the unknown though is much greater. There’s no data, no oversight and no information on how shadow banking works.
At the end of 2013, the IMF stated that shadow banking accounted for almost 30% of systemic risk in the US. What’s interesting to note is that shadow banking in emerging markets like China is also on the rise.
It is believed that shadow banking in China is a $10 trillion ecosystem according to Bloomberg. That’s scary to say the least. This ecosystem is a sleeping “monster” that keeps on growing. Nobody knows when it’s going to wake up or how it’s going to behave.
The usual tug of war is both an expectation and a reality when it comes to world trade. Countries will nudge and demand and try to get the best out of trade agreements. It shouldn’t though because global economic stability is more vulnerable than anyone of us think.
The ongoing tense relationship between US and China is something to pay a lot of attention to. Situations like this one that can throw the economy off balance. For prosperity and long-term economic health to exist, investors, businesses and central banks need to feel security, stability and safety. If something serious was to happen between the US and China, the road to recovery would be long and painful.
Currency fluctuations, global politics, the digital economy
When it comes to preparing or trying to predict an economic crisis, the variables are endless. What are the most important factors though? Let’s prioritize.
Global debts and currency fluctuations is nothing new as it happens on a daily basis. The US dollar drops, the British pound surges and financial markets react accordingly. The balance between a healthy economy and a crash though is fine and delicate. The fear that markets will overreact to these fluctuations treads on the same thin line.
Now let’s take a look at the importance of global politics.
Even though these events might take place in a single country, their effects echo through the global economy as a whole. Take Brexit for example. Whether the UK chooses to leave or stay, the implications that come with it are huge. That trickles down to currencies, markets and international trade so the outcome should be not taken lightly.
Last but not least comes the rapid growth of the digital economy. That includes newfound digital currencies like bitcoin, an entire fintech sector and a lot of questions about cybersecurity and regulation.
This statement by the IMF puts things into perspective. “Despite its potential benefits, our knowledge of its potential risks and how they might play out is still developing. Increased cyber-security risks pose challenges for financial institutions, financial infrastructure, and supervisors. These developments should act as a reminder that the financial system is constantly evolving, and that regulators must remain vigilant to this evolution and ready to act if needed.”
Is a new world economic crisis about to unfold? Nobody really knows. If history is anything to go by, the best way to tackle such an assumption is to be prepared and alert. The effects of the crisis have tantalized advanced economies for a decade now.
For further reading on the possibility of a new world economic crisis, read the IMF’s 2018 Global Financial Stability Report.