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September 18th 2018 print

Peter Smith

Another GFC?

The meltdown of 2008 was misdiagnosed, mostly by those with an ideological barrow to push. Thus have we been treated to sermons about greed, derivatives and, of course, the sins of capitalism itself. Wrong, dead wrong. To a large extent it was the product of government interference

stock crashDepending on how you date it, on or before the collapse of Lehman Brothers in September, 2008, it is now ten years since the start of what most of the world called the Great Recession and we called the Global Financial Crisis (GFC). For no other reason than it is ten years on, so far as I can tell, forebodings of another meltdown currently abound, from JPMorgan and Warren Buffet, for example, among many. Well here’s hard news: something like it will happen again.

Something like it has always happened at irregular intervals. The trick is to predict the next cause and its timing. Simply predicting a recurrence is banal, even for talking-head economists and other assorted financial experts.

All economic meltdowns have a common factor. Assets held by broad segments of market participants turn out to be worth much less than their book value. But that is rather like attributing all deaths to organ failure. True, but not very illuminating.

The GFC, like its predecessors, was not definingly salutary. Each financial or economic crisis, however you want to refer to it, is very unlikely to repeat itself. Each one, in other words, is differently formed. And the nature of each beast is that it creeps up all unbeknown. If its menace was on open show beforehand it would likely be thwarted.

Take the GFC. First it is necessary to dispel the myth. The myth is that capitalism imploded in 2008. So-called neoliberalism was laid bare, plunging the world into despair. Kevin Rudd had much domestic and international leftist company in pushing this line. Nice line. But not true.

The GFC was completely misdiagnosed. It is hard to find any account of it that doesn’t attribute importance to greed, to the complexities of derivatives and, of course, to capitalism itself. Greed is a common human trait not peculiar to the GFC. Derivatives are fine if the underlying security is sound. And capitalism, the least-worst economic system ever devised, can’t be blamed for being capitalism and having its ups and downs.

However, the severity of this particular ‘down’ was not the product of untrammelled capitalism. To a large extent, it was the product of government interference. Its starting point was the generation in the United States, over more than a decade, of vast numbers of mortgage loans to people who had little or no chance of being able to repay them. From there it is a question of identifying what caused this to happen. As in most catastrophes, a number of mutually-reinforcing factors can be identified:

  • The Community Reinvestment Act (signed by President Carter in 1977 and subsequently strengthened by President Clinton) systematically induced banks into lending into poorer communities.
  • This process was reinforced by ability of banks to get these loans, and the risk of their default, off their books by selling them to the government-sponsored mortgage companies Freddie Mack and Fannie May.
  • And this all occurred within a pervasive spending and borrowing culture promoted by years of loose monetary policy.

The common thread throughout these factors is the offending hand of government, not the free market. It is imaginative fiction in these circumstances to blame greed; or derivative trading; or, most particularly, to blame capitalism. But I want to get back to the innate difficulty of predicting the causes and timing of the next crisis.

No economic models predicted the GFC. While perhaps one or two commentators can be found years before warning of an impending sub-prime mortgage predicament, model builders and their models were oblivious to the danger. And why wouldn’t they be. How exactly do you model bankers making bad mortgage loans en masse under the influence of vote-seeking politicians and their creature, the Community Reinvestment Act?

Barney Frank (chairman of the US congress House Financial Services Committee) earnestly, right up to the last, vouchsafed the financial health of Fannie Mae and Freddie Mac; though they had engaged in buying junk for a decade or more. How do you model Barney’s blarney? And then how do you factor in rating agencies awarding triple-A status to derivative securities consisting of packaged junk? The answer is that you can’t and you don’t.

So, what is ticking away now and when will it explode? If any notable knew they probably wouldn’t be telling. First, they would have already positioned themselves to earn squillions. Second, and consequently, they would not want to give warning of the impending meltdown in case it was thwarted.

My own (grain of salt) view is that we are not close to another serious meltdown. Too many people are talking about one a-comin’. This is a fair sign that one ain’t a-comin’ soon. But let me bold. Sell if Donald Trump looks like being beaten in the 2020 presidential election by Pocahontas or Spartacus or by any of the new breed of socialist Democrats. Otherwise enjoy the Trumpian ride.

Peter Smith, a frequent Quadrant Online contributor, is the author of Bad Economics

Comments [8]

  1. Alice Thermopolis says:

    “It is imaginative fiction in these circumstances to blame greed; or derivative trading; or, most particularly, to blame capitalism.”

    Is “The Big Short” imaginative fiction? https://www.youtube.com/watch?v=csQUNX-xnBc

    “So, what is ticking away now and when will it explode?”

    Perhaps the consequences of central banking’s largest-ever experiment in unconventional monetary policy (QE, etc.).

    Five months ago, the Institute of International Finance reported that global debt had reached an “all-time high” – $237 trillion in 2017 — more than 327 percent of global GDP. Since 2007, debt has increased by a stunning $68 trillion. That’s an average rate of $7 trillion a year. In developed markets, the ratio of debt-to-GDP is now around 380 percent. In emerging markets – which have begun to worry international agencies – the ratio is also above 200 percent.

    “The incipient monetary policy normalisation in the major economies raises tough challenges, exemplified by continued loose financial conditions. Normalising too slowly could give rise to overheating and financial stability risks, while moving too fast could trigger disruptive market reactions and harm the economic recovery.” (BIS, Annual Economic Report, 24 June, 2018)

    “…..there are reasons to believe the downward trend in real rates and upward trend in debt over the past two decades are related and even mutually reinforcing. True, lower equilibrium interest rates may have increased the sustainable level of debt. But, by reducing the cost of credit, they also actively encourage debt accumulation. In turn, high debt levels make it harder to raise interest rates, as asset markets and the economy become more interest rate-sensitive – a kind of “debt trap””. (BIS Annual Report, 24 June, 2018)

    Rana Foroohar, a New York-based Associate Editor at the Financial Times, summed it up in a column this month. She urged the US Fed to pay more attention to financial market bubbles. “When 10 per cent of the US population owns 84 per cent of the shares, asset price increases do not create inflation, but inequality.”

    “Does anyone doubt this mega-bubble will eventually burst?”

    • Peter says:

      “Is “The Big Short” imaginative fiction?” No it isn’t Alice. But shorting sound derivative securities would be loss making. The securities were not sound because the underlying mortgages were bad. And you therefore have to ask why. And this is what I tried to answer.

      “Does anyone doubt this mega-bubble will eventually burst?” Leaving aside the premise that it is, as you describe it, ‘a mega bubble’, the answer is no. Financial and economic crisis have always happened and always will. The question is when and how severe. In our own modest way we can all short the market. Just buy some put options. But when, but when…

      • padraic says:

        Shorting bonds is one thing, but in 2008 investment entities (like superannuation funds) were shorting ordinary shares, to the detriment of mums and dads shareholders and average punters. These people protested that shorting was unethical but were told to go jump. When the fan blades were having trouble turning at the height of the GFC the Government of the day prohibited shorting of bank stocks but still allowed shorting to continue of non-bank stocks. How hypocritical was that? Meanwhile back at 2018 all stocks (including banks) are allowed to be shorted.

  2. GrahamP says:

    One factor not often mention is the record high oil prices prior to the GFC. I don’t know whether it was a significant factor in the defaulting of many “on the edge” mortgages but I do recall lots of stories in the US media about the problems of high gas (petrol) prices. Maybe it was the straw that broke the camel’s back?

  3. padraic says:

    Just an addendum to my earlier comments about shorting shares in the GFC here in Australia. Given that it was a Labor government that protected the banks over Joe Citizen at the time, it is faintly amusing to hear BS now talk about the Coalition supporting the “big end of town”.

  4. necessityofchoice says:

    There has NEVER been a period in recorded history – ie. At any time -where depositing your hard earned in a bank could garner you a negative interest rate. Yet in recent times we have seen the phenomenon in Switzerland, Denmark,Japan and elsewhere. It is surely insane to so punish lenders, and equally a measure of total despair for depositors to place their assetts in an institution where they are guaranteed to lose money.

    ‘So, what is ticking away now and when will it explode?’

    How about futures and options contracts?

    ‘the largest and most liquid futures and options contracts, CME Gold futures. The open interest on the 20/09/2016, at 100 troy ounces per futures contract, equates to 79,317,700 troy ounces[i]. The underlying COMEX/CME warehouse stocks on 23/09/2016 were roughly 10,687,512 ounces[ii], of which only 2,165,480[iii] were ‘eligible’ for delivery.

    So as of 2 years ago, contracts exceeded the ability to settle in the commodity (gold) by a factor of more than 36 times. Has the position improved in 2018? At this rate the Exchanges, are proving little better than the Bucket Shops of the last century.

    No Peter we don’t know when the crash will come but this one will be a doozie .

  5. Jody says:

    Put this into the mix with removal of imputation credits on Australian shares this makes it far less viable owning Australian shares. Thanks Labor (and you’re ‘dealing with’ CGT and negative gearing too in your massive wealth redistribution!). For a long time people have advised getting into foreign share markets, but I’ve always worried about currency fluctuations.

    The safest place for your money in another GFC is gold.

  6. necessityofchoice says:

    Jodie I agree. Gold has provided a store of value for going on 5,000 years. Fiat money has ALWAYS failed. The lesson of history is that people don’t learn from history.