Preventing a Financial Crisis: Why China Won’t Open Its Economy (w/ Chris Balding)

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So how justified is the pessimistic China story of doom and gloom?
I agree with their analysis.
And I disagree pretty strongly with the conclusions they draw.
And here’s what I mean by that, everything that the China pessimists talk about with
regards to overcapacity, excess debt, all of that is true.
And, in fact, it’s probably, in reality, worse than even what they say.
They’re entirely right about what that typically leads to.
Here’s where I differ significantly, I see a potential financial crisis as the last outcome in the China story.
And there’s a very simple reason for that.
And it has nothing to do with finance or economics.
And it’s this, if there is a China crisis, of what you and I would mutually agree upon
is a true financial crisis, 2008, you know something like that, that is what would become
the once a century event.
That would be D-day, that would be the communists rolling into Moscow, that would be 1989, all
rolled into one event.
Beijing knows this, OK?
Beijing will do everything possible to prevent a financial crisis from taking place.
Now, I need to be perfectly clear, that doesn’t mean that they’re going to make good policy
decisions.
It most definitely does not mean that they’re going to make good policy decisions.
But it does mean that their objective is to prevent a financial crisis, at all costs.
When the US government was looking at some of the decisions it made in 2008, it made
a very clear, conscious decision, we are not going to rescue some of these firms, we are
not going to rescue specific asset holders in the decisions they’ve made.
Now we can debate whether or not that was the right decision, but there was a very clear
decision, we’re not going to do this, we’re not going to allow specific pain or events
to unfold.
Beijing does not have that option.
Someone I trust quite seriously on these issues said, it is Beijing’s objective to become
Tokyo, not Thailand.
And what they mean by that is, they are very willing to turn it into a long, grinding mess,
but they are absolutely, under no uncertain circumstances, willing to let it become a
financial crisis.
Because if it is a financial crisis, that changes everything we know about China, overnight.
That is the once a century event, and Beijing is going to do everything they can to prevent
that from happening.

The Biggest Emerging Market Debt Problem Is in America

A decade after the subprime bubble burst, a new one seems to be taking its place in the market for corporate collateralized loan obligations. A world economy geared toward increasing the supply of financial assets has hooked market participants and policymakers alike into a global game of Whac-A-Mole.

.. Historically, there has been a tight positive relationship between high-yield US corporate debt instruments and high-yield EM sovereigns. In effect, high-yield US corporate debt is the emerging market that exists within the US economy (let’s call it USEM debt). In the course of this year, however, their paths have diverged (see Figure 1). Notably, US corporate yields have failed to rise in tandem with their EM counterparts.
.. In what is still a low-interest-rate environment globally, the perpetual search for yield has found a comparatively new and attractive source in the guise of collateralized loan obligations (CLOs) within the USEM world. According to the Securities Industry and Financial Markets Association, new issues of “conventional” high-yield corporate bonds peaked in 2017 and are off significantly this year (about 35% through November). New issuance activity has shifted to the CLO market, where the amounts outstanding have soared, hitting new peaks almost daily.
.. These CLOs share many similarities with the mortgage-backed securities that set the stage for the subprime crisis a decade ago. During that boom, banks bundled together loans and shed risk from their balance sheets. Over time, this fueled a surge in low-quality lending, as banks did not have to live with the consequences.
.. Furthermore, not only are the newer issues coming from a lower-quality borrower, the covenants on these instruments – provisions designed to ensure compliance with their terms and thus minimize default risk – have also become lax. Covenant-lite issues are on the rise and now account for about 80% of the outstanding volume.
.. As was the case during the heyday of mortgage-backed securities, there is great investor demand for this debt, reminiscent of the “capital inflow problem” or the “bonanza” phase of the capital flow cycle. A recurring pattern across time and place is that the seeds of financial crises are sown during good times (when bad loans are made). These are good times, as the US economy is at or near full employment.
.. The record shows that capital-inflow surges often end badly. Any number of factors can shift the cycle from boom to bust. In the case of corporates, the odds of default rise with
  1. mounting debt levels,
  2. erosion in the value of collateral (for example, oil prices in the case of the US shale industry), and
  3. falling equity prices.

All three sources of default risk are now salient, and, lacking credible guarantees, the CLO market (like many others) is vulnerable to runs, because the main players are lightly regulated shadow banking institutions.

.. A decade after the subprime bubble burst, a new one seems to be taking its place – a phenomenon aptly characterized by Ricardo Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas as “Financial ‘Whac-a-Mole.’

.. Like the synchronous boom in residential housing prior to 2007 across several advanced markets, CLOs have also gained in popularity in Europe. Higher investor appetite for European CLOs has predictably led to a surge in issuance(up almost 40% in 2018). Japanese banks, desperately seeking higher yields, have swelled the ranks of buyers. The networks for financial contagion, should things turn ugly, are already in place.

 

From Economic Crisis to World War III

The response to the 2008 economic crisis has relied far too much on monetary stimulus, in the form of quantitative easing and near-zero (or even negative) interest rates, and included far too little structural reform. This means that the next crisis could come soon – and pave the way for a large-scale military conflict.

BEIJING – The next economic crisis is closer than you think. But what you should really worry about is what comes after: in the current social, political, and technological landscape, a prolonged economic crisis, combined with rising income inequality, could well escalate into a major global military conflict.

The 2008-09 global financial crisis almost bankrupted governments and caused systemic collapse. Policymakers managed to pull the global economy back from the brink, using massive monetary stimulus, including quantitative easing and near-zero (or even negative) interest rates.

But monetary stimulus is like an adrenaline shot to jump-start an arrested heart; it can revive the patient, but it does nothing to cure the disease. Treating a sick economy requires structural reforms, which can cover everything from financial and labor markets to tax systems, fertility patterns, and education policies.

Policymakers have utterly failed to pursue such reforms, despite promising to do so. Instead, they have remained preoccupied with politics. From Italy to Germany, forming and sustaining governments now seems to take more time than actual governing. And Greece, for example, has relied on money from international creditors to keep its head (barely) above water, rather than genuinely reforming its pension system or improving its business environment.

The lack of structural reform has meant that the unprecedented excess liquidity that central banks injected into their economies was not allocated to its most efficient uses. Instead, it raised global asset prices to levels even higher than those prevailing before 2008.

In the United States, housing prices are now 8% higher than they were at the peak of the property bubble in 2006, according to the property website Zillow. The price-to-earnings (CAPE) ratio, which measures whether stock-market prices are within a reasonable range, is now higher than it was both in 2008 and at the start of the Great Depression in 1929.

As monetary tightening reveals the vulnerabilities in the real economy, the collapse of asset-price bubbles will trigger another economic crisis – one that could be even more severe than the last, because we have built up a tolerance to our strongest macroeconomic medications. A decade of regular adrenaline shots, in the form of ultra-low interest rates and unconventional monetary policies, has severely depleted their power to stabilize and stimulate the economy.

If history is any guide, the consequences of this mistake could extend far beyond the economy. According to Harvard’s Benjamin Friedman, prolonged periods of economic distress have been characterized also by public antipathy toward minority groups or foreign countries – attitudes that can help to fuel unrest, terrorism, or even war.

For example, during the Great Depression, US President Herbert Hoover signed the 1930 Smoot-Hawley Tariff Act, intended to protect American workers and farmers from foreign competition. In the subsequent five years, global trade shrank by two-thirds. Within a decade, World War II had begun.

To be sure, WWII, like World War I, was caused by a multitude of factors; there is no standard path to war. But there is reason to believe that high levels of inequality can play a significant role in stoking conflict.

According to research by the economist Thomas Piketty, a spike in income inequality is often followed by a great crisis. Income inequality then declines for a while, before rising again, until a new peak – and a new disaster.

This is all the more worrying in view of the numerous other factors stoking social unrest and diplomatic tension, including

  • technological disruption, a
  • record-breaking migration crisis,
  • anxiety over globalization,
  • political polarization, and
  • rising nationalism.

All are symptoms of failed policies that could turn out to be trigger points for a future crisis.

.. Voters have good reason to be frustrated, but the emotionally appealing populists to whom they are increasingly giving their support are offering ill-advised solutions that will only make matters worse. For example, despite the world’s unprecedented interconnectedness, multilateralism is increasingly being eschewed, as countries – most notably, Donald Trump’s US – pursue unilateral, isolationist policies. Meanwhile, proxy wars are raging in Syria and Yemen.

Against this background, we must take seriously the possibility that the next economic crisis could lead to a large-scale military confrontation. By the logicof the political scientist Samuel Huntington , considering such a scenario could help us avoid it, because it would force us to take action. In this case, the key will be for policymakers to pursue the structural reforms that they have long promised, while replacing finger-pointing and antagonism with a sensible and respectful global dialogue. The alternative may well be global conflagration.

Another epic economic collapse is coming

.. the contraction probably will begin with the annual budget deficit exceeding $1 trillion.

.. The president’s Office of Management and Budget — not that there really is a meaningful budget getting actual management — projects that the deficit for fiscal 2019, which begins in six weeks, will be $1.085 trillion. This is while the economy is, according to the economic historian in the Oval Office, “as good as it’s ever been, ever.”

.. The fastest — 13.4 percent — was 1950’s fourth quarter, perhaps produced largely by bad news: The Cold War was on, the Korean War had begun in June, and fear of the atomic bomb was rising (New York City installed its first air-raid siren in October), as was (consequently) a home-building boom outside cities and “scare buying” of products that might become scarce during World War III.

.. Today, Shiller says, “it seems likely that people in many countries may be accelerating their purchases — of soybeans, steel and many other commodities — fearing future government intervention in the form of a trade war.” And fearing the probable: higher interest rates.

.. Jerome H. Powell, chairman of the Federal Reserve, says fiscal policy is on an “unsustainable path,” but such warnings are audible wallpaper — there but not noticed. The word “unsustainable” in fiscal rhetoric is akin to “unacceptable” in diplomatic parlance, where it usually refers to a situation soon to be accepted.
.. A recent International Monetary Fund analysis noted that among advanced economies, only the United States expects an increase in the debt-to-GDP ratio over the next five years.

.. among those economies, ours is performing especially well. What, however, if this is significantly an effect of exploding debt? Publicly held U.S. government debt has tripled in a decade.

.. the political class is more united by class interest than it is divided by ideology. From left to right, this class has a permanent incentive to run enormous deficits — to charge, through taxation, current voters significantly less than the cost of the government goods and services they consume, and saddle future voters with the cost of servicing the resulting debt after the current crop of politicians has left the scene.

.. This crop derives its political philosophy from the musical “Annie”: Tomorrow is always a day away. For normal people, however, the day after tomorrow always arrives.