Are Financial Crises the New Normal?

Are Financial Crises the New Normal?

June 17, 2014

The policy-making committee of the Federal Reserve Board meets again tomorrow, and the news won’t be encouraging. The one-percent decline in GDP in the first quarter disposed of the Fed’s forecast for 2.9 percent growth this year, and they have to lower it to the range of 2.0 percent to 2.5 percent. That’s just what the IMF did yesterday, forecasting as well that the United States won’t reach full employment again until 2017. So the Fed will leave interest rates at rock-bottom levels through at least next year. But Fed chair Janet Yellen will also continue to wind-down the quantitative easing program, because doing otherwise would signal big troubles ahead for the U.S. economy and scare the daylights out of the markets. In short, happy days are still out of reach, and there’s little the Fed can do about it.

We know it could be a lot worse, since it was much worse not very long ago. And it is much worse in other places. Consider Argentina: On Monday, the Supreme Court refused to let the Argentine government arbitrarily void its contracts with selected American lenders. So, now Argentina — with admittedly the world’s most irrepressibly, irresponsible, freely-elected government — may face another sovereign debt default by the end of the month. And according to the ratings agencies, the place next in line for a debt default is Puerto Rico. If it happens, the Obama administration will have to swallow hard and bail out our island Commonwealth — or risk economic chaos there and new problems for important banks here and in Puerto Rico.

Across the pond, Yellen’s counterpart at the European Central Bank (ECB), Mario Draghi, continues to work overtime to stave off a European financial crisis. Two years ago, Greece, Spain, Portugal and Italy were all teetering towards sovereign debt crises, until Draghi stepped in and pledged that the ECB would purchase as many of their bonds as it took to support their debt markets. Two years later, those debts continue to rise, though not as fast as before. But their economies are still not productive enough to attract the foreign investors they need to support their large public debt burdens. And the large European banks which hold more of those bonds than anyone except the ECB are still unprepared to weather a serious crisis. Yet, you wouldn’t know it from official pronouncements: Wolfgang Münchau reported this week in the Financial Times that the “adverse scenario” designed by the ECB to stress-test those banks’ ability to weather a big shock is, in certain respects, more optimistic than the ECB’s own forecast.

Finally, while China blusters that its renminbi should be an exchangeable, global currency on par with the dollar, the flood of credit it unleashed to maintain high growth in recent years has left much of its banking system technically insolvent. And its “shadow banking system” — the network of arrangements that many Chinese municipalities and businesses use to borrow funds outside the regular banking system — is in equally precarious shape. The only things protecting China from its own financial crisis are strict credit controls and the fact that the renminbi is not an exchangeable currency, which insulate it from the judgments of global capital markets.

The fact is, financial crises have become as common as they were in the 19th century before the rise of central banking. This new cycle started in Latin America in 1985–1986, followed by Spain, Japan and Sweden in 1990–1991, moved on to Mexico in 1995 and East Asia in 1997–1998, and then to the United States in 2008–2009. The European Union has barely skirted its own crisis for the last three years, and the strains are intensifying in China. In ways that no one understands, the ultimate source of these cascading crises almost certainly lies in the globalization of capital markets. Until we figure out how and why this is happening, everyone’s prosperity will be hostage to upheavals that governments cannot control and can only barely manage.