Amid the current market turmoil, there is a sense the world is revisiting the financial upheavals of 2008 which almost tipped the world economy into depression. What’s going on this time?
Unlike the global financial crisis, this is not a crippling crunch in the banking or payments and settlements systems. At least not for now.
Instead, the world economy and markets are going through a rough patch that has been years in the making. The tough times are also being amplified because governments have fewer ways to respond to them. The immediate cause of the turbulence is in my opinion the erosion of three anchors that had kept markets steady, or even rising, despite deteriorating fundamentals.
First, the actual and feared impact of the coronavirus is destroying supply and demand simultaneously. This has undermined the momentum of global economic growth.
Second, central banks are no longer seen as able to repress financial volatility through injections of liquidity and ever-lower interest rates. Policy interest rates are already negative in Europe.
Third, Saudi Arabia’s decision to launch an oil price war, which has sent the price of crude down more than 40%, has imperiled the viability of small oil companies and undermined parts of the corporate bond market.
As a result, elevated asset prices have begun to fall back to where fundamentals suggest they should trade. Because this correction is happening in a disorderly manner, there is in my opinion a huge risk of collateral damage to the financial world and the real economy. If the world economy based on the coronavirus comes to a worldwide stand still, where is then the bottom line for financial markets?
Today’s turbulent markets recall how they behaved in the financial crisis 12 years ago. So does the growing likelihood of recession among a lengthening list of countries that already includes Germany, Italy and Japan. Even so, today’s situation, as unsettling as it is, differs in an important way.
Because it did not originate among banks, it does not endanger the nerve centre of all modern, interconnected market-based economies, namely their payments and settlements systems.
Unfortunately, today is also different form 2008 in less reassuring ways.
Governments are starting their race to address today’s turmoil from a lagging position. For far too long, they pursued an unbalanced economic policy mix that relied on monetary policy to support growth. Too much policy ammunition has also been fired inefficiently – such as last month’s 1.5 basis point rate cut by the US Federal Reserve, which was ill-received by markets.
To stop what could become a vicious cycle, where a worsening real economy drags down markets and markets then drag down the economy, governments must in my opinion since mid of February do several things.
They must use laser-targeted measures to create a sustainable economic floor. These could include medical measures that help contain the virus, such as free coronavirus testing; policies to protect society’s most vulnerable, such as free treatment to Americans without health insurance, and ways to ease specific financial market malfunctions, such as illiquidity.
These measures must also use a co-ordinated “whole of government” approach. There has been too much reliance on central bank action to boast growth; governments must now pursue true productivity-enhancing reforms, otherwise the financial and economical market will turn them into “firefighters”.
Lastly, there must be supplementary international co-ordination to establish what collective actions can be deployed. The faster this is done, the stronger in my opinion the economic turnaround will be. That eventual recovery will be turbocharged by extremely low mortgage rates and energy prices, both of which boast consumer purchasing power. The quicker the markets see this coming, the faster they will snap back. And this time, unlike in 2008, if actions have been taken in the right directions, that snap back and economic recovery should rest on more genuine and lasting underpinnings.