A Third Wave of Financial Crisis?
After Lehman and the Eurozone, will China and oil cause another calamity in the markets?
January 19, 2016
Seven years after the post-Lehman crisis, memories of the disaster are still fairly fresh. Whenever things get wobbly, many people in financial markets are still inclined to sell first and ask questions later.
We also saw this in the euro crisis hysteria of 2011-2012. In both cases, policy mistakes and the vulnerability of the financial sector allowed contagion to spread like wildfire, turning smallish incidents into big crises.
No surprise then that there are worries that the correction of the earlier borrowing binge in some emerging markets and the concerns about China could now cause a third wave of crisis comparable to those of 2008 and 2011.
I consider that risk as small, for three reasons:
1. Problem origin
In 2008 and 2011, the trouble was right at home (i.e., in the developed countries). In 2008, it originated in the big real estate markets of the U.S., UK and Spain.
In 2011, the world’s second-largest economy, the eurozone, descended into turmoil for a while as the ECB neglected to assume its role as lender of last resort. Today, the trouble is mostly in far-flung places.
2. Liquidity reserves
Households, companies and financial intermediaries have built up huge liquidity reserves after Lehman. On balance, they should be less vulnerable to shocks.
The suggestion that problems in the energy sector could bring down many other parts of U.S. industry looks unlikely.
3. Once bitten, twice shy
Policy makers remember the mistakes they made in 2008 and 2011. They will strive hard to not make them again and do their utmost to prevent any potential problem in parts of the financial industry from turning into a systemic issue.
That age-old insight holds for policy makers as well as investors. The result is a stark contrast.
While markets worry more than in the past that modest fundamental issues could spark a major crisis, the risk of that actually happening is probably much smaller than it was when households, companies and financial intermediaries had fewer reserves and when policy makers were less watchful.
That nevertheless leaves a further risk. Could a sustained sell-off in equity markets, overdone as it may be, by itself shatter business and consumer confidence so badly that the economy takes more than a temporary breather?
The risk looks all the more pertinent as we could observe an apparent asymmetry in recent years. Remembering the Lehman accident, households and companies do react to bad news.
But cautious as they have become, they react less strongly or more slowly to good news such as the windfall from lower oil prices or the wealth effect from higher real estate and equity prices than before.
Otherwise, consumer demand could have been even stronger on both sides of the Atlantic last year.
As usual, one cannot fully dismiss the risk of a panic that feeds on itself. Stuff happens, as a former neocon would have put it. But beyond a possible modest and temporary impact, that risk does not seem to be huge.
1. For China itself, the still juvenile equity market plays only a marginal role in financing the real economy. In some respects, it still resembles a casino more than a genuine market.
2. In the eurozone, confidence should be more fragile than in the U.S. because the last recession ended only in spring 2013 in the eurozone — rather than in spring 2009, as was the case in the United States. Also, the eurozone is more export-dependent than the U.S. and hence more vulnerable to external shocks despite some cushion provided by the exchange rate.
But even in the eurozone, the previous correction in equity markets by 19% from mid-April 2015 to late September 2015 had no impact on business or consumer confidence.
Instead, economic sentiment as measured by the European Commission rose modestly further from 103.8 in April to 105.6 in September and 106.8 in December 2015.
Neither the Greek electoral “noise” of June/July nor the earlier round of Chinese turbulences in August/September interrupted this.
Of course, the second serious equity market correction within nine months may now do more damage. But the evidence does not point to a potential downward spiral.
Instead, the windfall from low oil prices should help to contain the damage. Raw material producers or other emerging markets in trouble may be forced to sell assets, which could theoretically depress prices.
But the beneficiaries of low commodity prices have two options available to them: They can either save much of the windfall. That would give them ample cash to buy such assets.
Or they could spend the money, which would boost demand growth and brighten the economic outlook. Either outcome should ultimately support markets in the Western world.
A bumpy ride
Still, there are some serious risks in 2016. They stem mostly from the political sphere.
That right-wing populists have made gains on both sides of the Atlantic complicates the political calculus, in Europe even more so than in the United States, as the institutions of a multinational Europe are more fragile than those of the one-nation U.S.
Brexit could be a serious shock, to name just one obvious political risk. But concerns that China or the fall in oil prices could trigger a major crisis rather just a temporary upset in the developed world look overdone, in my view.
True, China’s necessary transition from simple industrial catch-up to less buoyant but cleaner and more service-driven growth has become bumpy.
However, China still has the means to support domestic demand almost as it pleases. A savings rate of more than 40% of disposable income gives it plenty of capital to plug financial holes.
The Chinese slowdown and the recession in some other emerging markets may well cost the developed world some 0.5 percentage points of GDP growth. But most of that slowdown was known last year already.
Amid strong domestic demand in the developed world, this may make the difference between, say, roughly 2.5% rather than 3% growth in the U.S. and between roughly 1.5% rather than 2% growth in the eurozone.
It should not make the difference between growth and stagnation, though.
Concerns about China could cause a third wave of economic crisis comparable to those of 2008 and 2011.
China’s still juvenile equity market plays only a marginal role in financing the real economy.
Concerns that fall in oil prices could trigger a major economic crisis looks overdone.
Chinese slowdown may well cost the developed world some 0.5 percentage points of GDP growth.