Global debt and the (next) financial crisis

Dr Bryce Wilkinson
The National Business Review
19 October, 2018

Global debt is now higher relative to global income than in 2009 according to the latest International Monetary Fund statistics. This is despite the imposition of much more stringent financial regulation since the 2008 financial crisis. How worried should we be?

A current mainstream view is that the world economy is in better shape in some important respects but global economic risks are rising.

Financial crises typically have multiple causes. Differences in regulatory quality is one factor.  The US appears to be particularly prone to banking failures. Its global dominance makes this an important consideration. Canada is the epitome of stability in comparison.

The 2008 financial crisis emanated in the US. Government saw home ownership as a good thing, particularly for the least credit-worthy. Being on the property ladder helped people feel worthwhile and secure.

Banks responded accordingly. Irresponsible mortgage lending occurred. Two massive state-controlled institutions fuelled the funding of securitised mortgage loans of dubious quality. (When mortgages are repackaged as tradable securities they are said to be securitised.) Rating agencies grossly underestimated the credit risks. Fund managers and banks bought the over-rated bonds, globally, with insufficient care. The regulators did not keep up.

Incentive structures became aligned with these pathologies. By securitising their mortgages, the originating banks shifted the poor credit risks to those who were relying too much on the rating agencies to assess them accurately. The banks and mortgage brokers got rewarded for quantity, not quality.

Housing boom

Excessive mortgage lending fuelled a housing boom. Homeowners felt richer. Too many people, including some rating agencies, decided the boom would continue indefinitely. Home buyers who could not afford to service their mortgages for long could still expect to come out ahead by selling their house in short order at a handsome capital gain. As always, folly and greed went hand in hand.

The financial boom was not restricted to the US. An expert in the Icelandic 2008 financial crisis spoke in Wellington last week about Iceland’s experience. In Iceland, recently privatised banks threw caution to the winds and created a credit boom funded by offshore finance.

The resulting economic boom appeared to be a win-win for all Icelanders. That is all too easy to understand. Governments can seek to claim credit for high asset prices and economic growth that is overly debt-fuelled. Is the US president not doing that right now? Regulators who lack government support can feel suborned. The current term for undue passivity is “regulatory forbearance.”

Those who were fastest to perceive that what was happening in the US was fraud on a grand scale knew a large financial crash was in the making. The prices at which these securitised mortgages were trading were far too high. One market way of bringing prices down would be to sell the securities at today’s prices under a delayed payment arrangement. If prices fell in time, these short-sellers would buy at the lower price and thereby make a profit from the delayed payment situation.

Unfortunately, there was no ready market instrument for selling short. That absence arguably kept prices up, fuelling the boom for longer.

In time, market instruments of a related nature developed. They included credit default swaps. The prices at which these swaps traded showed which issuers were most thought to be at risk. The results were profound.

When the global crash finally happened, governments raided taxpayers’ pockets to bail out people who did not deserve to be bailed out. They did so to prevent a meltdown of the financial system.

Mountains of public debt resulted from the bailouts, particularly in Europe and the US. The banking collapse in Iceland was particularly spectacular. Iceland found itself US$180 billion in debt when its gross domestic product was only US$12 billion.

Will the vast additions to banking regulation since the crisis be effective? Of course, its promoters have to express confidence as do regulators who see their role as being to enhance investor confidence.

Is it different?

However, it is easy to find sceptical, unaligned experts. Political incentives endure to foster debt-fuelled short-term economic growth. The cry that “this time it is different” will always resonate; it is what people want to believe. Big banks are bigger than ever.

So what is the current outlook? Last week, the International Monetary Fund updated its six-monthly World Economic Outlook. The headline announcement is only a very modest (0.2 percentage point) reduction in the global rate of economic growth for 2018 and 2019. So far so good.

Of deeper concern is its warning that political risks have increased. Key risks arise from trade tensions and the potential shift against a rules-based world trading system. It also sees the fiscal deficit/ public debt situation in the US as “unsustainable.”

In short, the World Economic Outlook is discreetly pointing a sizeable finger at US government trade war and deficit risks.

There is modest comfort for New Zealanders. The IMF finds that countries with stronger fiscal positions before the crisis and more flexible exchange rate regimes rode through it better.

We can be thankful that successive New Zealand governments have maintained a free floating exchange rate regime since 1985 and have largely adhered to the prudent debt provisions in the Fiscal Responsibility Act 1991.

Dr Wilkinson is a senior fellow at The New Zealand Initiative.

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