The Next Financial Crisis

In late 2007 the US housing bubble burst, reducing confidence in the financial system, and then in the real economy. Four key stages are identifiable; an asset price bubble, a shock strong enough to burst the bubble, pessimism among investors, and then a recession. Escaping one of these stages, requires brave and active policy making – or extraordinary circumstances.

Regrettably, perhaps the two most significant events in the economic past have been failures to escape. Take the Wall Street Crash and following Great Depression; stock prices were rose, investor confidence fell, banks stopped lending and the economy ground to a halt for over 10 years. In this instance, despite some active government policy in the form of Roosevelt’s New Deal, it was the extraordinary circumstance of World War II that boosted demand enough to pull the US out of its depression. Similarly, in 2008; house prices and private debt rose, an interest rate hike increased defaults, confidence and lending fell, then the economy sank into recession. Policy makers responded more aggressively this time. The Federal Reserve, Bank of England and European Central Bank freed up credit by; lowering their base rates to a fraction above zero percent and pumping $2.5tn into financial institutions in the third quarter of 2008 alone. Alongside Obama’s $1tn of stimulus packages, and other fiscal responses, these measures averted a Great Depression-esque 10-year stagnation. They, however, may have made another crisis almost inevitable.

The inevitability of another crisis rests on the existence of a bubble and the possibility of a shock. Perhaps worryingly, the current economic climate provides a number of places to look for each of these. Some are in the UK alone, others are external, some are the fault of private sector exuberance, others may be misjudgements by policymakers. Also, these factors are not distinct. One bubble may be inseparable from another, as may the bursting of one bubble be inseparable from the bursting of another.

It is the culprit of the 2008 crisis, the housing market, that we turn to first in search of the next crisis. The current growth of 8% in UK house prices closely resembles the 9% experienced in the US during the mid-noughties. But a similar rate of growth does not guarantee an equally dangerous bubble. Only rising asset prices that promote excessive speculation, or fail to reflect the true long-term value of assets, pose a risk. So, is our current housing market exhibiting these features? Can it be compared to the US situation?

There has been an increase in real demand for housing from net migration figures around 330,000 and growth in second home ownership. But some of the increase comes from dangerous speculative activity. The rapid and unfaltering growth in prices is encouraging both foreign and domestic investors to make houses investments, rather than homes. It is this activity that lifts the market price of a house above its true value – which is self-reinforcing. Low interest rates, currently at half a percent, are the most important contributor to this speculative demand, the vast differential between the cost of borrowing and returns from owning property encourages property purchases on credit. There are some limits on mortgage size relative to income; they are far above having any impact on the market, requiring that fewer than 15% of loans are less than 4.5 of income is too lenient when the actually figure is only at 11%.

Another reason for shakiness in the housing market is the quantity money borrowed by buy-to-let investors, which has returned to its pre-crisis peak and increased by 10% last year. These borrowers are more likely to sell if interest rates rise; 60% would fail the Bank of England’s stress test if mortgage repayments rose by only 3 percentage points. A fall in house prices could also be dangerous, 45% would sell their property if house prices dropped by 10%, triggering a further fall and corresponding sales.

This bubble growing, rather than bursting, relies on low interest rates. Their rise off the near-zero mark will threaten to destroy confidence. But not only the housing market is affected by a rate rise, or the thought of a rate rise. The resulting drop in economic growth will reduce the revenues, and then confidence, of firms. The stock market is already trading below its moving averages suggesting that it is on the way down from a peak, and market volatility has spiked in the last few months. Sentiments are perhaps even gloomier than the actual figures; RBS has advised clients to brace for a ‘cataclysmic year’ and predicted a greater than 20% fall in the FTSE100 through 2016.

Weakness in emerging markets (EMs) is worsening this outlook. Stemming firstly from the fall in commodity prices; the Bloomberg commodity index is half of what it was 5 years ago – an index which represents much of what emerging markets export. And secondly from China’s reaching of the point at which it cannot rely on migration and low wages for growth. There is less cheap excess labour in the countryside to supply to the industrial cities – which forces employers to pay higher wages that are less competitive internationally. EMs are also vulnerable to rate rises in the west. The rise to 0.5% by the Federal Reserve was not enough to do serious damage, but further rises will encourage investors to back from EMs to the US in search of higher interest rates, potentially destabilising them. And now is a time that EMs are particularly vulnerable to shocks, given average private debt ratios around 110% of GDP – with China in particular at 200%. More worryingly, they are further above their long term averages than the USA and UK were in 2008.

But how will these slowdowns, and maybe an EM crisis, affect the UK? Emerging markets place a large and growing role in the global economy, and an even larger one in the hyper-globalised UK. Direct UK bank claims to China, Hong Kong and other EMs are about half of GDP – nearly twice the exposure to Europe; and 23% of our exports go to emerging markets. Despite these figures, the damage from an EM crisis would not be debilitating, the Bank of England’s stress test suggests that even a fall in Chinese growth from 7% to 1.7% – and the resulting financial downturn – would not prevent UK banks from performing their core functions.

Probably the greatest risk to the British economy is what will happen when it offloads the assets it bought when it embarked upon QE. £375bn of government bonds will have to be sold off. As this, alongside the Fed’s £3.1tn, is unwound, liquidity – cash – will be soaked up and yield on government bonds will rise. This will force banks, across the world, into adjusting their portfolios to meet their liquidity requirements, causing instability. And, will encourage investors to sell the assets they own and move into bonds; causing an outflow of money from some areas of the economy (and EMs). The resulting financial panic could be enough to trigger a crisis. The real economy might also be affected, there will be strong deflationary pressures – which could push us far below 0 inflation if the unwinding is premature – and a hit to the public finances via increased debt interest repayments. But, in reality, because of the relatively small scale of British QE, and the fact the UK banks have little exposure to US Treasury Bonds, the impact will be felt more elsewhere.

Despite some worrying indicators, there doesn’t seem to be enough weakness in the British economy for another 2008-style crisis to be inevitable. Provided that there isn’t an EM crash substantially worse than the BofE’s stress test, and the rise back to tighter monetary policy is well managed, the economy should be safe from shocks the time being. Not only this, new financial regulation and increased capital buffers should protect the banking system far better than the light touch regulation we had before the crisis in 2007.

Contributed by Michael Tallent, editor-in-chief.

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