IS a new global financial crisis imminent? Yes, says George Soros, the multi-billionaire and hedge fund pioneer. No, says James Gorman, CEO of investment bank Morgan Stanley, who called Soros’ prediction “ridiculous”.
This variance of views comes at a moment when there are signs of a financial breakdown in Italy, and of money flowing out of emerging economies, including Turkey, Argentina, Indonesia and Malaysia.
Some economists have been warning that the boom-bust cycle in capital flows to developing countries will cause disruption, when there is a turn from boom to bust.
All it needs is a trigger, which may then snowball as investors in herd-like manner head for the exit door. Their behaviour is akin to a self-fulfilling prophecy – if enough speculative investors think this is the time to move, it may well happen.
Soros told a seminar in Paris last week: “The strength of the dollar is already precipitating a flight from emerging market currencies. We may be heading for another major financial crisis.”
His prediction may not be widely shared.
“Honestly, I think that’s ridiculous,” said Gorman of Morgan Stanley.
This exchange reminded me of a South Centre debate held in Geneva in April, when we hosted the two authors of a book titled Revolution Required: The Ticking Time Bombs of the G7 Model.
Peter Dittus and Herve Hannoun are recently retired top officials of the Bank of International Settlements (BIS), an association of 60 central banks. You can’t get a more conservative establishment, which is also famous for its research.
Yet, the two men wrote a book warning of “ticking time bombs” in the global financial system because of the reckless policies of the major developed countries, known as the Group of 7 or G7.
Nothing short of a revolution in policy is required to minimise the damage of a crisis that is about to come, they say.
At the Geneva meeting, Dittus and Hannoun pointed to several “time bombs” in the developed countries. For them, the main problem is “the G7 debt-driven growth model”. The major countries, except Germany, have lax fiscal policies with high government liabilities as a ratio of GDP.
In particular, the United States has an irresponsible fiscal policy which it has exported to the other countries, except Germany. The US administration has expanded new expenditure and tax cuts by over US$1tril, with no funding other than more debts, with a fiscal deficit around US$1tril in 2019.
The G7 central banks have also become the facilitators of unfettered debt accumulation. The near- zero or negative interest rates were a huge incentive to borrow, and extreme monetary policies have destroyed any incentive for fiscal rectitude. The G7’s total debts in the third quarter of 2017 was around US$100tril.
According to the authors, the G7’s extreme monetary policies since 2012 have undermined the foundations of the market economy, whose key elements have been broken. Long-term interest rates are manipulated, valuations of all asset classes are deeply distorted, sovereign risk in advanced economies is deliberately mispriced, and all these do not reflect the fundamentals.
They warn that the unprecedented asset price bubble engineered by the G7 central banks is a ticking time bomb that is ready to burst. The US Federal Reserve has dealt with the bursting of every asset bubble of the last 20 years by creating a larger bubble.
They warn that the quantitative easing policy of recent years may shift to a worse policy of government debt monetisation.
Although central banks at first promised that large-scale government bond purchases are a temporary measure for monetary policy reasons, they are shifting to a different concept – that of a permanent intervention of central banks in government bond markets.
This is seen as a way to solve the sovereign debt crisis in major advanced economies, by transferring a growing part of government debt to the central bank: 43% of G7 government bonds in major reserve currencies are now held by central banks and other public entities.
The G7 central banks are facing a dilemma. They have to choose between highly risky scenarios: policy normalisation or government debt monetisation?
For the time being, the Fed and the Bank of Canada are slowly but rightly leaning towards normalisation, while the European Central Bank and the Bank of Japan are dangerously heading towards continuing the debt monetisation experiment.
Here is the dilemma. The G7 central banks’ policy normalisation is the only option consistent with their mandate and a return to market economy rules. But when they eventually exit from their unconventional policies, they will contribute to the bursting of the asset price bubbles they had engendered.
This could well be the worst financial crisis ever experienced, as the level of debt and the artificial level of asset prices have no precedent.
But an even worse systemic crisis would result from the continuation of current policies, leading central banks to cross the rubicon of government debt monetisation.
Perpetuating these policies, with zero or negative interest rates and large-scale purchases of government debt, would encourage fiscal deficits and public debt expansion. Public debt monetisation, by transferring more government bonds to the G7 central banks’ balance sheets, would destroy the market economy.
This analysis by the ex-BIS officials reveals why a new financial crisis is brewing. Changing the recent policy will lead to a crisis now, but continuing with the same policy while buying time, will lead to an even bigger explosion.
Their analysis complements that of Yilmaz Akyuz, the South Centre’s chief economist and author of the book, Playing With Fire.
Akyuz goes further in analysing the impact a global crisis will have on developing countries. Since the 2009 global crisis, the developing countries have built up new and increased vulnerabilities to global financial shocks.
Their financial sectors have established more links to international finance. For example, there is now a high percentage of foreign ownership in developing countries’ stock markets and government bonds.
A big outflow of these foreign funds may cause the countries a loss of foreign reserves, currency depreciation, higher external debt servicing, higher import prices and falling asset prices.
Malaysia still has strong economic fundamentals and is nowhere near a crisis. It might have reached a critical point if the massive borrowings for unviable projects had gone on longer. But measures are now being taken to stop the unnecessary spending and damaging debt build-up, and thus avert a crisis.
It would be wise, however, to monitor and analyse what is happening globally, as these will significantly affect the economy. Scenarios should be established on what may happen externally, including the onset of a new global crisis, how this may affect the economy in various ways, and to prepare for various measures that can be taken.
Dealing with the domestic economic issues should go together with preparations to cope with changing external situations. Though we may not be able to control what happens abroad, we can take measures to respond appropriately.
Martin Khor is executive director of the South Centre. The views expressed here are entirely his own.