Of Threats Old and New
Finance and financial innovation are two of the most important influences in the world today.
This fact doesn’t get many headlines, but it is hiding there in the shadows and only tends to gain the spotlight when some kind of disruption sends financial markets into some kind of disorder.
Over the past sixty years or so, financialization and financial engineering have helped to generate globalization and the integration of world markets. Credit inflation has been behind the growth of nations and the growth of global economy.
Behind this financialization have been governments that have built vast programs to meet social needs and keep their people working. Furthermore, as Ruchir Sharma, chief global strategist at Morgan Stanley Investment Management, has commented in the New York Times, financial markets “have grown so large because every time they stumbled, central bankers rescued them with easy money.”
Furthermore, “When markets rose sharply…as they have in recent years…the authorities stood by, saying they are not in the business of popping bubbles.”
Mr. Sharma provides the data to support his claims.
“By the eve of the 2008 crisis, global financial markets dwarfed the global economy. Those markets had tripled over the previous three decades to 347 percent of the world’s gross economic output….”
Thus, Mr. Sharma goes back until the late 1970s to measure this expansion. But, it was in the 1960s when the trend toward credit inflation really began, particularly in the United States. This was the time when government programs for housing and welfare really took off and when Keynesian economic policies became the standard approach to simulating economic growth.
Furthermore, the economic efforts of the United States helped to underwrite globalization, and in fueling the global economy, the US dollar became the dominant reserve currency of the world. In the latter part of the 1970s, this expansion really took off.
But, it was in the period that included the Great Recession and the subsequent recovery that the US dollar really became the foundation of the world’s liquidity. Ben Bernanke, former Federal Reserve Chairman, explains this very well in his memoir of the period, “The Courage to Act.”
During this period, the major central banks of the world…in the United States, Europe, China, and Japan…grew by more than three times, from $5 trillion in total assets to $17 trillion to support the economic turnaround and following recovery.
The Federal Reserve System had total assets of just over $0.9 trillion before the financial crisis hit and reached a peak of about $4.5 trillion in late 2014 before tapering off to $4.2 trillion, currently.
The European Central Bank now foots about €4.7 trillion, whereas in late 2008, total assets were about €1.5 trillion.
Today, global financial markets stand at 360 percent of the world’s gross domestic product, “a record high,” according to Mr. Sharma.
Global financial markets now stand at $290 trillion.
Analysts, including Mr. Sharma, seem to believe that the risks of the next economic downturn come from the financial side of the economy and not from the production side of the economy, where they used to come from.
Mr. Sharma claims that “there are hundreds of new risks” in this world we now live in, let alone the “old” risks we are still aware of.
The risks in this “new” world seem to be connected with how the investors shift their pools of money around. For example, Mr. Sharma talks about how big banks shifted their lending focus from “risky mortgage lending” in 2008, which resulted in the collapse of security prices in this area, which caused financial institutions to recognize the losses that existed on their balance sheets.
Today, Mr. Sharma contends that there are many new threats, like in corporate borrowing and the “so-called” non-bank lenders all over the world. If something changes…lending shifts, interest rates move in different ways, perceived risks change…money would be re-allocated in a different way. And, sectors would be impacted, money might move to other areas, under-water debt would have to be recognized, and financial distress may arise causing further dislocations and disequilibrium.
One example of this is the impact that Federal Reserve interest rate increases are having on emerging market economies and markets. Money is shifting away from those countries that are heavily in debt through dollar-denominated bonds.
Another example has to do with the risk averse funds in the world that have sought “safe haven” investment opportunities in countries like the United States. If the attitudes of investors change, vast amounts of money could shift which could cause major changes to world outlooks.
In the case of the United States, international investors seem to be getting very nervous about the trade war going on between the US and China. This increase in political risk appears to be resulting in outflow of some of the risk averse monies that had been placed in the United States. This is resulting in a rise in the yields on US Treasury securities that the economist Martin Feldstein of Harvard University believes could cause a major US downturn.
These examples indicate that the financial markets are so “global” now that financial “shocks” can come from almost any place. As Mr. Sharma claims, “there are hundred of new risks” in this world today and new risks will continue to “pop up” and create more possibilities for stress.
This concern seems to be creeping into the process of choosing the next president of the European Central Bank.
The current president, Mario Draghi, will be leaving office “next autumn.” The jockeying for his replacement has already moved into public attention. Many believe that it is Germany’s turn to name the next president and the leading internal candidate is Jens Weidmann, the current president of Germany’s central bank.
The problem is that Mr. Weidmann has “shown open criticism” of some current ECB policies, especially the policy of quantitative easing that Mr. Draghi has built. Mr. Weidmann is a solid proponent of low inflation and minimizing the amount of debt the central bank purchases.
A shift from Mr. Draghi to Mr. Weidmann could cause a significant shift in the allocation of international funds. The impact of this change could be worldwide.
Finance is a global concern today. Its size dwarfs the productive capacity of the world by almost four times. National independence seems to be swallowed by its dominance. And all this makes it more and more difficult to know where the next disruption is going to come from.