Another troubling new-age investment is crypto. Given that they do not represent claims on real assets or cash flows, cannot be consumed, and have no alternative use, they are only speculative objects worth what people ascribe to them.
In addition, crypto assets are tightly held and traded between a small circle of investors creating "mutually supporting fantasies". While elements of blockchain technology may be useful for recording property claims, crypto is unlikely to replace fiat money and become a reserve asset given the fact that its volatility makes it an unreliable store of purchasing power always. Crypto assets then are, as one commentator termed them, "consensual hallucinations".
Declining cash flows and falling values interact with debt, the one thing that there is no shortage of. With nose-bleed levels of borrowings, households and businesses will struggle to meet obligations as incomes fall. Fiat money allows governments to continue the game by debasing the currency and purchasing power. They will issue new debt or create money, effectively paying interest and principal with new obligations that it cannot repay.
Despite the shocks not having flowed through fully, financial distress levels are rising. US business defaults hit a post-financial crisis high of 9.2 percent with rates for highly leveraged private equity loans and junk bonds reaching the highest levels since the pandemic in 2020. The International Monetary Fund has warned of rising levels of distress in commercial property. Delinquency rates on mortgage, auto, credit card and other consumer debt are increasing. Where America leads, others will follow. With tariffs and sanctions raising inflationary pressures, the probability of a return to ultra-low rates adds to the problem.
Falling values have multiple effects. As distributions decrease and losses mount, investors may sell their holdings or redeem funds, increasing pressure on prices and straining liquidity.
Trading liquidity of currencies, government bonds and large capitalisation shares has declined markedly. This reflects the consolidation of dealers and market makers after the 2008 crisis. It also reflects the reluctance to hold inventory because of higher capital charges. Trading is now dominated by specialised quantitative traders, electronic trading and fund managers, who are not providers but users of liquidity. In periods of turbulence, trading will be at disadvantageous prices and incur substantial trading costs.
Illiquid private investments and a mismatch with redemption terms offered to the investor increase the likelihood of gating or suspension of redemptions. Those with longer memories will remember that BNP Paribas' decision to halt redemptions at some of its funds due to the inability to value or trade the underlying securities was a pivotal part of the 2008 crisis.
Liquidity constraints will accentuate price falls. Unable to realise illiquid assets, investors will sell more liquid positions, driving values, including those of safe or unaffected securities, lower. Where they are unable to sell out of positions, they may hedge losses by shorting related assets, placing additional pressure on prices.
Price declines affect borrowings secured over financialised assets. Mortgages are collateralised by houses. With leverage mandatory to boost returns, there are significant volumes of debt supported by real estate, shares, bonds, fund investments and even artworks. As values fall, the loan-to-value ratios rises triggering margin calls soaking up available cash or requiring asset sales.
Reliance on collateral is flawed. Deposits or initial margins are probably inadequate because of artificially low volatility and pressure to increase business volumes without concern for excessive leverage. The problem of wrong-way correlation, where the underlying risk increases at the same time as the value of the collateral decreases, is underestimated. The ability to realise collateral as needed assumes liquidity, which in practice is limited.
The interactions between declining cash flow, falling values, high levels of debt and rising volatility will prove toxic.
Pathways of Contagion
An interconnected financial system acts as the main pathway for spreading the crisis.
Potential losses are sizeable. In 2008, around $1.3 trillion of US sub-prime loans triggered the global financial crisis. The exposure to riskier borrowers today is significantly higher. Global commercial real-estate exposure is around $21 trillion. Non-investment loans and bond outstandings are around $5-6 trillion. Equity margin loans in the US are around $1 trillion and globally, probably 3 or 4 times that.
Lending by regulated entities to the shadow banking sector is greater than $2 trillion globally ($1.2 trillion by US banks alone). Lending to hedge funds, private equity, private credit, and buy-now-pay-later companies is one of the fastest-growing parts of the banking system. Hedge funds currently manage around $4.5 trillion, up from $2.8 trillion in 2008. They have recovered from the significant fall in assets under management after the 2008 crisis and have grown by almost 56 percent since 2015.
Global bank equity is around $6-7 trillion. Banks are leveraged around 8 to 10 times. Large losses would place some banks at risk of insolvency and threaten financial stability.
US banks currently have around $500 billion in unrealised losses, representing 50 percent of their Common Equity Tier One Capital. Global losses are 3 to 4 times that. Liquidation of these holdings would crystallise these write-offs, reducing bank capital.
Resilience and Resolve
The wealthy have gained from rising asset prices.But these are phantom profits based on volatile market values. It is not cash in hand as the gains are unrealised. Investors are reluctant to sell because of fear of missing out on further appreciation. Many investors have taken out additional borrowings against these assets to fund spending. 50 percent of all US consumer spending now comes from the top 10 percent of income earners. The linkage between share and real-estate values and expenditure means that consumption expenditure may be less reliable than in previous downturns.
Any new crisis will be global as the principal drivers affect all economies. The impact of restrictions on trade and capital movements, one of the key factors in the expected downturn, is especially pervasive. The first-order effects of trade wars will be particularly damaging for Europe, China and Canada. Second-order effects from a decelerating global economy will be larger and more widespread.
Emerging markets, which have been under persistent stress, face problems. Those directly reliant on US trade, like Mexico, face major slowdowns. Asian, Latin American and African economies, integrated into Chinese supply chains, will be affected by the cage fight between the two great powers for supremacy. Lower commodity prices, as a result of slower demand, will affect raw materials producers. Remittances, the lifeblood of many emerging nations, will decline. Poorer countries, lower on the value chain and with limited ability to adjust, will be badly affected. Familiar vulnerabilities such as reliance on foreign investment, high debt, spendthrift policies, crony capitalism, corruption, dysfunctional rule and poor governance will be exposed.
Crises result in large loss of wealth. The US economy alone lost over $20 trillion in the 2008 financial crisis, although the number is disputed. There is the additional cost of support. In 2008, the US government committed around $ 2 trillion in interventions, bailouts and economic stimulus packages. The US Federal Reserve committed around $7.8 trillion in lending and asset purchases. Eurozone governments expended € 1.5 trillion in capital support and €3.7 trillion in liquidity support for the financial system. While some of the money was later recovered from sales of acquired assets and institutions, authorities still need to be in a position to make the required initial commitment.
Governments and central banks' ability to provide support is lower than in previous crisis. Chronic budget deficits, high public debt levels and the rising interest cost limit any new intervention.
Monetary policy is constrained by low interest rates that make large cuts difficult. Central bank balance sheets remain overextended due to legacy quantitative easing programs. Between 2007 and 2022 (when they peaked), the assets of central banks of the US, Europe, the UK and Japan increased from under $5 trillion to over $25 trillion. While now lower, they remain elevated at around $20 trillion. Central banks also have large unrealised losses on their holdings of bonds purchased at low yield due from rises in interest rates.
Another concern is availability of US dollars, in which a significant portion of capital flows are denominated. In past crises, there has been a significant reliance on currency swap lines provided by the US Federal Reserve to other central banks. The amount extended reached around $600 billion in 2008 and $450 billion in 2020 respectively, helping stabilise money markets. There is no assurance that this will occur this time due to the punitive American approach to its allies. Some European central banks have raised this possibility.
The Kindleberger Trap, named after the eponymous economist, identifies the danger that a fading power lacks the ability, but the ascendant one lacks the will to supply a reserve currency. This was a factor in the Great Depression with the Bank of England unable to act as the international lender of last resort and the US Federal Reserve unwilling to do so. It helped the crisis escalate into a full-blown economic collapse. Any change to the Federal Reserve's willingness to supply dollars would signal the end of its dominance as foreign ownership of US assets would diminish.
Assuming large-scale support from and bailouts by governments and central banks is optimistic.
The End of Illusions
The severity of the upcoming crisis is unknown. A real economy slowdown comparable to the 1930s is not inconceivable, with a deep and long global recession possible. Large financial excesses, particularly, the disjunction between cash flow and prices, make severe asset value adjustments likely.
The process has commenced with large falls in the value of financial assets. The real economy effects will take longer to emerge. As economist Rudiger Dornbusch noted: "the crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought."
In a 1974 essay The Year It Came Apart, Arthur Miller observed that "an era can be said to end when its basic illusions are exhausted". It is characterised by strangeness of the familiar and a deep-seated fear and uncertainty which nobody admits to. We have arrived at such a moment. To paraphrase Nassim Taleb, this crisis will follow a path that maximises damage.
(Satyajit Das is a former banker and author of numerous technical works on derivatives and several general titles: Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006 and 2010), Extreme Money: The Masters of the Universe and the Cult of Risk (2011) and A Banquet of Consequence – Reloaded (2021). ). His latest book is on ecotourism – Wild Quests: Journeys into Ecotourism and the Future for Animals (2024).)
This piece draws on material first published at the Nikkei Asian Review and The New Indian Express
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