After the great financial crisis of 2007 – 2008, regulatory authorities, worldwide, are engaged in continuous efforts to remove, in every way, financial risks. However, mistakes on their part are not lacking.
A typical example is the crisis of regional banks in the USA, which was triggered by Silicon Valley Bank, which until that time was the 16th largest bank in the USA. And in this case, as in many others, the mistakes made were considered very basic (for starters), as those in charge failed to address the risk of rising interest rates, which undermined the value of US Treasuries .
An unprecedented bank run followed both in Silicon Valley Bank and in other banks, while the crisis also involved the Swiss Credit Suisse, which ended up after many and critical consultations in the arms of UBS. Indicative was the statement by the head of the Bank for International Settlements (BIS) that the business models of the American banks were poor, the risk management procedures were tragically inadequate and the governance was deficient.
Of course, other episodes followed in the $26 trillion US banking market – the world’s ultimate financial haven. The most extreme case was the unprecedented quantitative easing in March 2020, during the Covid-19 pandemic.
Volatility has been exacerbated by volatility in the banking market as a result of regulators’ response to the financial crisis. In a market that provides vital support for collateral and hedging activities for global investors, there is great concern that the risky strategies of hedge funds will pose a destabilizing threat.
Meanwhile, the UK government bond market collapsed in 2022 as pension fund investment strategies struggled to cope with a sudden rise in yields.
Destabilizing activity
This destabilizing activity is enhanced, among other things, by the growth of private equities and the shadow banking system, which includes hedge funds, high-speed traders and other entities that operate in a less transparent and regulated environment than banks.
The proportion of global financial assets held by such non-bank financial institutions has risen from 25% after the 2007-2008 crisis to 47.2% in 2022 – higher than conventional banks’ 39.7%.
And no one can be sure what cyber threats or crypto assets might be lurking in this financial adventure playground where complex financial products proliferate. While private markets have soared, public funds have shrunk.
According to the OECD, more than 30,000 companies have been delisted since 2005, particularly in the US and Europe. These deletions have not been matched with new entries. Own share buybacks contributed to the shrinking of listed shares.
In this environment, which appears vulnerable to shocks, investors expect continued bailouts from central banks, a morally dangerous incentive for greater risk-taking and debt accumulation. Each of these disorders can be explained as the product of particular circumstances. However, they all reflect profound long-term changes in the role and structure of the global financial system.
A vital part of this development is the increasing reliance of many developed countries, including the US and the UK, on debt to fuel their economic growth. According to the IMF, debt in the 39 economies it classifies as developed has risen from 110% of gross domestic product in the 1950s to 278% in 2022.
This growth was largely financed from the 1980s by emerging Asian countries, notably China, which ran depreciated exchange rates to facilitate export-led growth. The resulting trade surpluses, combined with underdeveloped banking systems and poor welfare systems in these countries, led to huge surpluses of savings over investment.
In contrast to the pattern established by Britain in the late 19th century, when the British exported powerful capital to low-income countries, it now flowed from poor Asia to the wealthy West. This surplus of Asian savings was then supplemented by Japan, where an aging population meant lower investment opportunities and higher savings as baby boomers approached retirement.
Before the financial crisis of 2007-2008, a glut of imported savings pushed up interest rates while at the same time fueling a credit bubble that financed the housing boom in the US and elsewhere. When the system collapsed, these savings were directed into government and non-financial corporate debt.
The financial “environment” facilitated a massive capital-circulation operation to address these imbalances, with debt securities financing household consumption through the banking system and investment in mortgage securitization.
Although most focus on the Asian dimension of this excess, excessive austerity was a wider phenomenon.
In a National Bureau of Economic Research paper, Peter Chen showed that since the early 1980s investment stopped flowing out of household savings. On the contrary, corporate savings started to be the main source of financing, by two-thirds. The global labor market shock resulting from the entry of China and other developing countries into the international trading system has pushed down labor costs and increased corporate profit margins.
Financing costs and corporate taxes fell while dividends did not grow as fast as profits. Thus, the global corporate sector turned from a net borrower to a net saver. The most prominent cash hoarders today are the so-called Magnificent Seven US tech giants (Amazon, Alphabet, Nvidia, Tesla, Meta, Apple and Microsoft) who have led the rise in US stocks over the past year or so. According to rough calculations, their savings in 2023 are estimated to have exceeded 300 billion dollars.
The ultimate owners of these savings are wealthy households who, directly or indirectly, own shares in large corporations. The share of disposable income going to the very rich has been rising steadily since 1980, exacerbating inequality in many of the world’s largest countries.
Since the rich save most of their income, inequality has led to the accumulation of a large surplus of savings among the rich, which has grown alongside corporate profits. The increase in the savings of the wealthy is matched by excess savings entering the US from abroad.
These funds went into US government IOUs – so-called safe assets – and lending through the banking system and capital markets to US households. The combination of global financial imbalances and ultra-loose monetary policy after the financial crisis led to a debt glut.
From the mid-2000s to 2022 public debt in advanced economies rose from 76.8% to 113.5% of GDP, reflecting not only the strong interventions from that crisis and the Covid-19 pandemic, but also the ease of servicing the debt during taxation. Revenue fueled by economic growth exceeded the low cost of funding the US government. Such levels of debt have not been seen so far outside of wartime.
Similar story
Something similar happened in 2021 among non-financials, with outstanding bonds reaching a record $16.6 trillion, more than double the amount in 2008. The US accounted for 40% of total issuance during this period .
The main purpose of the capitalist system today is to refinance the debt that sustained economic growth, rather than to raise new capital. Shadow banks are usually involved in two-thirds of this refund. At the same time, equity issuance in the developed world has plunged and what’s left of it has shifted eastward.
In the 1990s, European non-financial companies accounted for 41% of all funds raised through initial public offerings with more than 3,500 IPOs during the period. However, they only collected 19% between 2012 and 2022.
European policymakers are concerned that domestic equity markets have failed to boost economic growth. But the numbers bear witness to the polarization of global industry and the shift to Asia, where investment still goes largely to capital-hungry physical plant and machinery, rather than the human capital and other intangible assets that dominate financial markets. needs of western companies.
Another reason for the decline in IPOs is that many private equity firms overpaid for buyouts during the period of extremely low interest rates. In fact, they hold $3.2 trillion in unsold assets that they are reluctant to sell back into the public markets until stock prices rise enough to minimize losses or generate a profit.
In addition to providing exit routes for individuals, the primary financing role of the global equity market is now to provide fresh capital to bolster corporate solvency in times of stress. In 2009, for example, after the financial crisis, listed non-financial companies raised a record $511 billion through the stock market.
The pattern was repeated during the 2020 pandemic, when the market raised $626 billion through the issuance of new shares by listed non-financial companies.
What risks to the economy and financial stability does this complex, debt-laden financial landscape pose?
Clearly, the accumulation of debt that exceeds the growth of national income cannot continue forever and raises questions about its sustainability. Among the prerequisites for its reduction are economic growth, relatively low interest rates and primary surpluses. Few major economies meet these conditions. The problem with debt that has been used to finance consumption is that borrowers must reduce consumption to repay their lenders.
This reduces aggregate demand because these savers are reluctant to spend funds on consumption. This feeds into an already depressing growth picture. The IMF predicts that growth over the next five years will fall to the lowest level in decades due to modest productivity growth, weaker demographics, weak investment levels and the scars of the pandemic.
In addition, governments are under intense pressure to both increase public spending and cut taxes, which is becoming an increasingly unrealistic expectation. After inflation returned, the biggest rise in interest rates in decades has added to the debt burden.
Regarding financial stability, he points out that an economy that relies on the constant supply of new debt to create demand is always prone to disruptions in financial markets. This implies that central banks must always have a ready backstop, loading their own balance sheets.
All of this may require a rethinking of the nature of risk inherent in financial markets. Economists and actuaries have long characterized government bonds as “safe” assets that provide a risk-free return. Many also claim that bonds provide security against the volatility of “risky” stocks. However, for a government bond to be considered truly risk-free, the probability of bankruptcy of the corresponding economy should be negligible and the respective government should be fiscally conservative. Reality often defies expectations.
But the declines in the bond market – from the highs to the lows – have historically been longer and/or longer than for stocks. Essentially bonds are not “safe” assets. Due to the negative correlation of stocks and bonds since the late 1990s the two assets in question acted as a hedge against each other, this period was the exception rather than the rule. It was essentially the product of strangely loose monetary policy and very low inflation.
The issues of rising default risk, fiscal prudence and high volatility raise particular questions for the US, which accounts for 44% of the global government bond market. It is noted that they manage the world’s pre-eminent reserve currency and are the main provider of “safe” assets to risk-averse global investors. These investors cannot escape the reality of growing budget deficits and debt, first under the Trump administration and now under President Joe Biden.
The US Treasury itself has declared the national debt unsustainable, and constant battles on Capitol Hill over its ceiling have brought the US dangerously close to bankruptcy.
Could the mighty dollar also be dethroned?
Such predictions have a history and have always been proven wrong, because the countries that offer real safe assets, notably Germany and the Nordic states in Europe, provide enough of them to meet a small fraction of global demand. Even with its chaotic politics, growing fiscal fragility and increasingly turbulent sovereign debt markets, there is still no realistic alternative to US economic hegemony.
All of this suggests that the Federal Reserve should continue to support the government bond market and the banking system. With the US and many others responding to debt-dependent growth by implementing short-term fiscal and monetary remedies rather than structural reforms, the financial system will continue to function as a gigantic problem driven by endemic imbalances and periodic crises.
