A Shot Across The Bow

The recent IMF (International Monetary Fund) report was a shot across the bow, a warning that the world might be entering a new financial crisis. The threat could stem from global central banks which have been encouraging excessive risk taking in the markets. More than half a decade of ultra low borrowing costs, induced by the central banks through loose monetary policy, such as quantitative easing (QE), which involved the purchase of bonds at an unprecedented level, has reduced interest rates and pumped the system with liquidity. QE has fueled investment but it has been the wrong type of investment in the economy. Years of QE has done little to stimulate the productive type of business investment. Instead, the central banks loose monetary policy has aided and abetted speculative financial investment and blown up asset bubbles in equities, bonds, real-estate and even in some alternative investments, such as classic cars, wines etc.

What about growth in developed economies returning to levels seen before the 2008 financial crisis? The IMF believes that this is unlikely, so perhaps this downturn in economic activity in the developed economies is more than just a business cycle, maybe we are seeing a systematic decline in economic activity among the developed economies.

The problem plaguing developed economies is that there is far too much debt in the system and not enough growth. The IMF has highlighted the problem of stagnant growth. In the Euro-zone there is now no growth and deflation is creeping in and the consensus among economist is that the bloc is likely to experience another contraction. The Japanese economy is again in contraction. Japans economy shrank at an annual pace of 6.8 per cent in the second quarter after spending got slammed by a sales tax hike that kicked in from April. Has the US economy really reached escape velocity? Economists have slashed US Gross Domestic Product (GDP) forecast for Q3, nevertheless, they see steady growth of 3 percent for the year ahead. The UK's budget deficit continues to grow exponentially and the trend is unlikely to be reversed ahead of the 7 May 2015 general elections. While the economy is in a relatively better shape than its neighbouring countries on the continent in Europe, the economic recovery is unbalanced. The recovery in UK manufacturing and construction remains subdued and there are fears that low levels of interest rates have created a property price bubble, particularly in London.

The historic low levels of interest rate now means that speculative investment is rampant. The lengthy low interest environment hasn't spurred on productive investment, which could explain why growth levels have been so disappointing in developed economies. It seems that all loose monetary policy has done is to fuel rampant speculation in financial activities. In other words, loose monetary policy and low interest rates have spurred on the accumulation of debt for the purpose of financial gambling.

A Frankenstein monster, called the shadow banking system has grown beyond the control of governments and financial regulators. The shadow banking system entails the off balance sheet activities, all the transactions that banks and large institutions don't want to put on their balance sheet, which would normally be monitored and registered. It is a kind of secret world where activities are opaque. The shadow banking system conducts mysterious operations beyond the preying eyes of governments and regulators and it’s no small corner shop operation either. In the US the shadow banking system is massive, many times bigger than the US economy, which is valued at 16.7 trillion US dollars. The shadow banking system in the UK isn't as big yet, nevertheless it is growing rapidly. So there exists a massive financial intermediary, which operates out of sight of government and regulators. It’s a law unto itself and is just brewing away. But is it important?

Very much so. In fact one of the factors that made the financial crash of 2008 so severe was the collapse of the shadow banking system. The unregulated, off balance sheet activity of the shadow banking system in 2008 fed back into the main banking system and also brought everything else down with it.

In many ways we are seeing the return of the conditions which brought about the last financial crisis of 2008.

Howerver, this time we also have the added problem of an escalation in global tensions that was not a feature back in 2008. The tensions between Russia and the West over the Ukraine, which has culminated in tit for tat sanctions on Russia and the West is being blamed by many in Germany for the recent economic slow down in growth.

Perhaps in many ways the process is just cyclical, the economy goes through a period of a large credit cycle when there is an enormous build-up of debt and credit in the system, then it falls over itself. A massive credit default magnified by leveraging then follows. That is what drove the financial crisis in 2008. Ideally what should have happened following this enormous build up of debt and credit, is that the economy should have picked up and accelerated out of debt. Unfortunately, that just didn't happen and the world economies are burdened with huge debt, which is likely to turn into a big problem sometime in the future.