Are the claims of an imminent financial crash justifed or hysterical? (These are notes prepared for Nights with Bryan Crump. 18 September 2018)

A senior and respected economist recently remarked that he thought that there was a danger of an economic crisis precipitating a financial crisis rather than the other way around. He was reflecting on the current trade war which Trump is escalating by raising more tariffs on Chinese imports. Could it lead to a financial crisis?

In contrast, the financial crisis which was precipitated by the Wall Street Crash in 1929 with echoes in Europe led to a nasty cross-Atlantic trade war a few years later which intensified the Great Depression.

The trade war is already in progress. Perhaps it is ‘wars’. Thus far Trump is taking on Canada, China, the European Union, Japan and Mexico – even little old New Zealand is suffering from his steel protectionism. The US may be the largest economy in the world but it is less than half of those on this list (add the rest of East Asia, so dependent are they on supply chains passing through China and Japan).

Despite other countries retaliating with hiked tariffs, the fallout from the war is not too evident. .It takes time for the battalions to get into position. Business saw it coming and took avoidance measures, but their effectiveness will run out. Then the consequences of disrupted supply chains will become nasty.

Curiously, the most prominent reports of the disruptions are from the US, probably reflecting the bias in our news sources; there may be similar stories in Asia and Europe.

The American reports are all about downsides. My impression is that America may already be more divided than when it first went into Vietnam. Recall the picture of Lyndon Johnson with the caption ‘bully with an airforce’. As angry as we all were then, I look at it sadly today. LBJ was one of the outstanding domestic US politicians of recent times. (We tend to forget his wins in civil rights and the war on poverty.) But he had little grasp of international affairs.

Trump is certainly not a domestic politician of LBJ’s calibre, while his grasp of the international economy seems tenuous. Property development does not provide much insight into the automobile industry.

Through my lifetime America has got into big wars which with hindsight they regretted. Often pigheaded politicians thought they had no alternative, despite their military advisers being more cautious. Trump’s economic advisers are not nearly so enthusiastic either.

So, we seem likely to end up with a long, bruising trade war which causes global trade and economic activity to contract. Will it precipitate a financial crisis?

There is a lot of talk of one in the popular press. It is easier to publish a hysterical headline promising another great crash than to give the same space to coolheaded analysis.

Perhaps underneath is the widespread belief that one day there will be the mother-of-all-crashes which will destroy the capitalist system. The belief has been around, in one form or another, since at least 1848.

It is reinforced by the misunderstanding that the 2008 Global Financial Crisis was not predicted. In fact there were numerous professional economists – mainly eclectic Keynesians rather than ideological monetarists – who were puzzling about the state of the world financial system before 2008. They knew something was wrong but they did not understand the full complexity of what was going on. I know, because I was following them closely; you can easily trace the unease in my published writings.

I do not see a similar unease among professional economists today. Certainly they have a list of problems, but imminent global financial crisis is not high on it. Fallout from a trade war is.

None of those currently promising a financial crisis have had good prediction records before the 2008 GFC; perhaps they are generals fighting the last war. Certainly their analysis, such as it is, seems to replicate the one they should have had before 2008. There is rarely any mention of trade wars.

The essence of their analysis in that debt levels are too high, and need to come down. Let’s agree the levels are high but before getting to any conclusion, let’s try to explain why.

The world economy is going through a period of slow economic growth. The debate is wide ranging and there is no settled agreement even among eclectic Keynesians.

One view is that fiscal policy under a neoliberal framework means that deficit financing is restricted. Break that headlock, stimulate aggregate demand and the economies of the world can return to steady growth. An alternative view is that the world is entering a period of slower long-term economic growth because today's significant technological innovations are not as important as those of a century ago,

Forgive me if I skip the detailed analysis. Crucially, when there is stagnation and yet savings continue, the debt to GDP ratio rises. The higher ratio need not imply that the economy is unhealthy – merely that it is stagnant.

The drift to poor health starts when investors seek speculative returns. One is in the sharemarket, which can turn into a speculative bubble with the return coming from the unsustainable capital gains.

Additionally there is likely to be over-borrowing in the boom of the housing market. Like the sharemarket, it is prone to be driven by capital gains from rising house prices.

New Zealand's broken finance sector illustrates a third possibility. Property developers had hoped to make a good profit but they proved overambitious and investors lost their savings.

An even more extreme variation is financial instruments which amount to Ponzi schemes – the crypto-currencies are the current examples. Assuredly they will crash – the crypto-currency market lost $60b in a day recently. That is painful for those who invested in them but it does not necessarily mean there will be a general financial crisis.

For that to happen, there has to be a large number of borrowers who are unable to service their debt. Ponzi investors never could; on the whole those investing in property development schemes used their own savings which get destroyed not borrowings. The same largely applies to the share market; one can borrow but not in the way investors were doing in 1929 – it was a kind of Ponzi strategy called ‘investing on the margin’.

That leaves two possibilities. One is that if interest rates rise, some home owners may find themselves unable to service their mortgages. Have the financial institutional lenders who take the hit through nonperforming loans made sufficient provision for this? (They did not in the US in 2007 and the complex web of lending between the institutions nearly brought down the capitalist system; fortunately, governments bailed out the private sector.)

A similar thing could happen in the corporate sector. Despite the construction sector booming, a number of its companies recently collapsed. Their story is too complex to squeeze in here, but you cannot rule out the same thing happening in, say, the export sector – a business in a strong market, cocking up its cash flow or debt (not too difficult during a trade war) and going under. What happens to those who have invested in the business (including subcontractors)? If enough of such businesses go under, what next?

It is this last scenario which that economist had in mind. I’m afraid it is too complex to generate a hysterical headline. Those making them may have been wrong last time, but it is just possible they may seem right next when the next one happens sometime in the future – although in a rather different way to their hysterical accounts.