The Coming Financial Crash?
A long read from Robert H. Wade on the manias expanding the latest economic bubble and why current models are not fit to predict when it will burst.
Jeremy Grantham, co-founder of Boston-based fund manager GMO, says: “The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance and hysterically speculative investment behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929 and 2000.” [i]
Recovery from the North Atlantic Financial Crisis (NAFC) of 2007-09 – described by Grantham as “the long, long bull market” – was distinctly K-shaped. In the US and Europe, the wealthiest 1 % recovered pre-crisis wealth levels within a few years, while it took much longer – around 2017 – for the bottom half of the wealth distribution in the west to regain precrisis wealth levels. The wealth distribution was very polarized before the NAFC, even more polarized by 2020.
At the start of 2007 the bottom half of the US wealth distribution held 2.1% of the nation’s wealth, the top 1% 29.7%. At the start of 2020, the figures were 1.8% and 31.0%. So in 13 years the bottom half lost 0.3% from 2.1% while the top 1% gained 1.3% of total wealth on top of 29.7% and boosted their savings ready to invest in stocks and businesses and houses, art works, yachts and sports teams.
Now, many retail investors - who during the Covid pandemic have been able to work from home without significant loss of income but have been limited in their normal spending - are pouring into popular stocks, sending share prices of even unprofitable companies soaring like fourth-of-July skyrockets.
Global equity market capitalisation as a percentage of global GDP shot up from 320% at the start of 2019 to 357% by the end of 2020. This increase of almost 40 percentage points in only two years is super-fast compared to the increase from 2013 to 2019 of only 20 percentage points, from 310% in 2013 to 320% in 2019.
Global debt has also grown explosively. The Institute for International Finance (a trade body for global banks) estimates that global debt hit a new record of , with the public spending on the covid pandemic contributing “only” $24 trillion to that figure. (One million seconds equals 11 days; one billion seconds, 32 years; one trillion seconds, 32,000 years.)
Wall St margin debt exemplifies the bigger picture. Brokers lend margin debt to “investors” for them to play financial assets. Just before the 2008 financial crash, it peaked at $400 billion. By a year ago, April 2020, it reached $480 billion. Then in the past year to March 2021 (even after Archegos crash) it almost doubled to reach $820 billion. [ii]
Is this “irrational exuberance”, in Alan Greenspan’s phrase, “mania” in plainer English? Optimists (including some at Goldman Sachs) say it is “rational” and “safe”, thanks to rising asset prices and very low interest rates. And they say that unlike the run-up to the NAFC, banks now are not overstretched, having been forced to raise their capital base since the crisis.
Will asset prices keep rising and interest rates stay low? The answer depends on inflation. If inflation remains low and the Federal Reserve sustains monetary stimulus, asset prices will keep rising, raising the potential for a crash. If and when there is a big jump in inflation and a belated monetary tightening, a financial crisis and deep recession is on the cards.
This assumes that monetary policy will be relied on, not fiscal policy. That is likely, because the wealthy much prefer monetary policy to fiscal policy as a source of macro stabilization. Monetary policy tends to benefit the rich disproportionately. They hold most of the assets whose prices rise with low interest rates, while the non-rich rely on “trickle down”.
The upshot is that the world economy is now in a debt trap. Levels of debt and equity valuations are so high that central banks cannot tighten monetary policy without posing a serious threat to economic stability. Given that the wealthy oppose higher taxes on them as part of a fiscal policy response to inflation, governments face a cruel choice between raising interest rates and risking economic crisis (due to monetary tightening when debt levels are already extremely high), and not raising interest rates and facing higher inflation, which can also be a cause of economic (and political) crisis. But come what may, governments will have to allow a higher level of inflation to inflate away some of the debt.
In short, the world economy now (1) carries explosive levels of debt, and (2) is in a debt trap, in the sense that central banks have to be very careful how fast they raise interest rates. But when is the turning point likely to happen – even perhaps the beginning of another major crisis resembling 2007-09? Remember what Jeremy Grantham said, but remember also that Warren Buffett and millions of bruised amateur and professional investors attest to the dangers of trying to predict the stock market or wider economy over the short run of a couple of years. It is not random so much as horribly complex, as chaos theory tries to explain.
Mania in top executive remuneration
The other side of the equity and debt trends are the soaring levels of executive remuneration since 2007-09. In the past pandemic year many top executives have received even larger increases than normal while their companies have struggled. Boeing had an exceptionally bad year in 2020, with the workhorse 737 Max grounded after two deadly crashes, losses of $12 billion and some 30,000 workers dismissed. David Calhoun, chief executive, was rewarded with $21 million in compensation. Norwegian Cruise Line barely survived at all, because cruising stopped. The company lost $4 billion. Its compensation committee doubled the CEO’s pay to $36 million. Hilton hotels made big losses while its CEO received compensation worth $56 million, according to the company’s annual filing. But a Hilton spokesperson said his real compensation for 2020 was only $20 million, a slight fall from 2019. [iv]
Best of all is the story of London-listed drugmaker Indivior. The company maintained bonuses (on top of salary) of more than 1 million shares, worth more than $1.5 million, to former CEO Shaun Thaxter, notwithstanding that he was languishing in jail for six months and paying a $600,000 fine for causing the company to feed false safety information about medication used to treat opioid use disorder to a state regulator. [v] On May 7 2021 at the annual shareholders’ meeting, 38 percent of shareholders voted against the company’s pay report – but the vote is advisory, not binding on the company.
These examples fit the global pattern: the ratio of executive compensation to average worker pay has grown fast for decades. CEOs of US listed companies made on average 61 times as much as their typical worker in 1989; today, 320 times. [vi]
Mania in political leaders’ speaking fees
The Financial Times reports that former prime minister David Cameron charges £120,000 per hour for speeches through Washington Speakers Bureau, which describes him as “one of the most prominent global influencers of the early 21st century”.[vii] Donald Trump, Nigel Farage, Boris Johnson, Victor Orban and many others who wish ill of the European Union and wish to “make Great Britain great again” do have good reason to thank him.
While Cameron charges per hour, others charge per speech. Theresa May, since resigning as prime minister, has charged £115,000 ($150,000) per speech, “earning” around $1.3 million on the speaker’s circuit in her first post-prime minister year. Tony Blair charges up to $431,000 (£330,000) per speech; in one case, $431,000 for a 20-minute speech ($360 per second). He has made multiple millions on speaker’s circuits since he left office in 2007. Obama (post-president) and Biden (pre-president), both earned around $400,000 per speech. Bill Clinton’s fee is up to $750,000 (£574,000) per speech – this one for a speech to Ericsson executives in Hong Kong 2011. Bill and Hillary together made $153 million (£118 million) in speakers’ fees in 2001 – 2015.
Donald Trump claimed the world record, for a speech to the adult education firm The Learning Annex in 2005: $1.5 million. But lawyers later confirmed that this was a typical Trumpian four-times exaggeration; the correct figure was $400,000. [viii]
It would be fascinating to study this market for speakers. A distinguished Financial Times economic columnist told the author that he was (almost) embarrassed how much he could “earn” from speeches, amounts which dwarfed his Financial Times salary. Struggling academics would be particularly interested to know what price to bid for.
Mania in non-fungible tokens (NFTs)
The signs of financial mania keep multiplying. The explosive growth of non-fungible tokens (NFTs) is another example. An NFT is a unit of data stored on a digital ledger, called a blockchain, that certifies a digital asset to be unique and therefore not interchangeable. NFTs can be used to represent photos, videos, paintings, and much more.
An NFT for the painting by the artist known as Beeple, consisting of micro paintings added one a day for 5 years, was sold at Christies recently, starting at $100 and fetching $69 million dollars (paid in cryptocurrency by the inventor of a cryptocurrency). As with other NFTs, the buyer did not actually take possession of the painting to hang on his wall; he simply bought a non-fungible claim to the painting. The electric power needed to generate the code for the claim to Beeple’s picture equalled the annual electricity consumption of 13 average English households. 33 bidders participated in the auction, of whom Christies had prior knowledge of just three (meaning that people from beyond the “respectable” art world are buying art NFTs). Meanwhile, the New York Times reporter who first reported on NFTs made his article into a NFT and sold it for multiple thousands; and a Croatian tennis player sold a piece of skin from her elbow in the same (bizarre) way. Who is buying, and why? [ix]
Mania in super-yachts
Bloomberg says the market for elephantine “super-yachts” is booming. Jeff Bezos of Amazon has recently acquired a 130-meter, three-mast sailing vessel for $500 million, top of the range. But even at that size it could not accommodate a helipad, because of the sails. Bezos’ partner is a helicopter pilot. So, they got the obvious solution: another boat to come behind, bringing the helipad.[x]
Here is another example of how the K-shaped recovery from NAFC in 2007-09, supercharged by the effects of the pandemic in 2020-21, has produced today’s overflowing money funds looking for returns everywhere and anywhere: soccer’s short-lived Super League.
For more than three decades European soccer has sustained a balance between, on one hand, elite teams stocked with stars from around the world and global fans so numerous as to tempt broadcasters to pay hundreds of millions of dollars to show their games, and on the other, tiered domestic leagues with teams rooted in localities big and small, sharing revenues up and down, and moving up and down the leagues according to results. Then on 18 April 2021, it leaked to the public that a weird consortium of US hedge funds, Russian oligarchs, European tycoons and Gulf royals planned to seize control of the revenues of the world’s most popular sport by creating a closed European Super League, underwritten by JPMorgan Chase to the tune of E 3.25 billion. A dozen or so of Europe’s most famous, most successful clubs had already signed up, meaning that they would mostly divorce themselves from domestic competitions and compete against each other. The new globalist owners would ensure their returns were stable by eliminating the risk of any club falling out of the competition. They gave no regard to the views of managers, players and supporters.
The public outcry, particularly in Britain, was swift and vicious. To cut a long story short, the plan quickly collapsed as the English fans demonstrated their fury, as the British government threatened legal action to block it, and as television networks and sponsors came out against the plan.
In this particular case, super-super-money did not prevail against fans and mere super-money.[xi]
Mania in All Blacks
As of mid-May 2021 the Silicon-Valley-based private equity company Silver Lake is in the process of buying a controlling stake in the commercial revenues of by far New Zealand’s best-known sports brand and one of the most successful teams in international sport ever, having won more than three quarters of its matches over the past century -- despite a tiny population of less than five million people.
Silver Lake has some US$79 billion in assets under management, and is heavily invested in technology firms and in sports franchises (including basketball and the company which owns Manchester City, one of the clubs in the Super League insurgents). It offered US$ 278 million to buy a 12.5% stake in the commercial revenues of the All Blacks, sufficient to give it much control over the brand. Silver Lake says that it (with its billions of dollars of sports assets) can generate far more money from a product like the All Blacks than can New Zealand Rugby, the governing body: an All Blacks television channel broadcasting around the world, X-games, massive jersey sales branded with the players’ numbers, and all sorts of other commercial activities; and pay players at international super-star salaries and bonuses.
New Zealand Rugby strongly supports the project, as do all of New Zealand’s provincial rugby unions (operating with sizable losses during the pandemic). They agree with Silver Lake that New Zealand Rugby, drawing on the resources of a national community of less than five million people, cannot sustain the excellence of the All Blacks – as well as the provincial teams, the successful women's teams, and the grassroots game without generating more money. The best players, men and some women, are being gobbled up by overseas competitions in Europe, UK and Japan, and lost to the New Zealand game.
But the New Zealand Rugby Players’ Union has come out (late April 2021) against the sale, and negotiations continue (with “fur flying in all directions”). In the meantime, the New Zealand community should pay close attention to the “mixed” record of private equity firms. Their standard strategy is to buy a brand, load the firm with massive debt as they cut costs (services, employment) and extract “profits” for themselves, then sell the heavily indebted firm. They may have made the firm more competitive enough to flourish despite the debt load. But commonly the firm finds it difficult to flourish, because forced to keep cutting costs and services in order to sustain debt repayment. Beloved Debenhams, on UK High Streets for more than a century, was bought by three US PE firms in 2003, saddled with $1.2 billion in debt, sold in 2006, and struggled thereafter to survive with that debt load. It went out of business in 2020. Of course, Debenhams and the All Blacks are not closely comparable. But Debenhams is just one of a multitude of cases where PE firms force priority to short-term profits, extracting value more than creating value. New Zealand beware. [xii]
Defects in the macro forecasting models
Back to the turning point question. The horrible complexity being admitted, it is also true that our mainstream macroeconomic models are almost designed so as not to give accurate forecasts of the onset of crises. Take the build-up to the 2007-09 crisis.
After the crash, it was commonly said that “no one saw this coming” (the Queen even interrupted her reading of a pedestrian speech on opening LSE’s New Academic Building in November 2008 to glance up and ask the audience impromptu, “Why did no one see this coming?”).
Dirk Bezemer trawled through vast amounts of economics literature to identify who, before 2008, forecast fairly accurately what was to come in terms of crash and its effects. He used several explicit criteria to identify accuracy (fairly detailed, a specific causal mechanism, published in public domain, and more). He identified around 12 economists out of many thousands.
They had in common they did not use models of the standard type – the Dynamic Stochastic General Equilibrium (DSGE) model. This is the type of model used by IMF, World Bank, OECD, Bank of England, etc. Amazingly to the outsider, DSGE models have no significant financial sector; they are “real economy” models (so, hundreds of real economy variables, few financial variables, which are made dependent on the real economy variables rather than having exogenous influence). As Bezemer says, “These CGE [computable general equilibrium] models do not include a separate financial sector, ruling out finance-induced recession by design. Money supply and interest rate variables are included in these models, but they are fully determined by real-sector variables such as the output gap.” [xiii]
No wonder that none of the main public entities (e.g. those listed above), using models of this type, came close to forecasting in 2006 and 2007 what was to come; they forecast benign conditions ahead for the US, the West, the world. As Ben Bernanke said in 2010 (by then chair of the Federal Reserve), “Standard macroeconomic models … did not predict the crisis, nor did they incorporate very easily the effects of financial instability”.
In contrast, most of the 12 economists who forecast accurately used “flow of funds” models, notably developed by Wynne Godley, Randall Wray and others at the Levy Economics Institute.
In 2012 I talked with Professor Mike Wickens, well-known British macro economist (former Secretary of the Royal Economic Society). He told me of his book, Macroeconomic Models (Princeton U Press 2008). Did you include flow of funds models, I asked. “No”, he said dismissively. I told him Bezemer’s findings. He was not impressed. He did not include flow of funds models “because they are not real models”. A strange reply, given that these “real” models failed spectacularly to forewarn, while some “non-real” models did forewarn.
The main forecasting agencies still use DSGE models with emasculated financial sectors. Bernanke, having just admitted that the models did not predict the crisis nor readily incorporate the effects of financial instability, went on to defend them. He said that the models work well for non-crisis times. “Do these failures of standard macroeconomic models mean that they are irrelevant or at least significantly flawed? I think the answer is a qualified no…. The standard models were designed for non-crisis periods, and they have proven quite useful in that context.” [xiv]
An odd argument. It implies that the conditions prior to the crisis – the Great Moderation for which the models allegedly worked well – did not contain vital causes of the crisis. It is more plausible to argue that a crucial test for the worth of a theory or model is that it be able to predict recessions and depressions as a possible outcome of mechanisms internal to the model. Yet neoclassical macroeconomics has no such theory. Its models imply a depression is virtually impossible, and turn their back on the theories of Keynes, Kalecki, Hyman Minsky, Charles Kindleberger and Paul Sweezy which long ago showed how financial crises and economic depressions can be generated endogenously by mechanisms within the theory of capitalism. As Minsky epigramed, “stability breeds instability”.
The models rest on the theoretical foundation of rational expectations and equilibrium. In another sign of non-learning, the American Economic Association at its annual meeting in 2011 sponsored a session on “the 50th anniversary of rational expectations”, which turned out to be a celebration rather than a wake. When one of the proponents was asked what economics would be like in 50 years, he was adamant that rational expectations and equilibrium would still be at the heart of the discipline.[xv]
Clearly, playing host to a disproportionate density of high-IQ analysts and students is no levee against misconceived theory. So be warned when you hear, today, that the growth forecast ahead from 2021 is very upbeat. It is not clear that we have learned the lesson which Bezemer says is the main thing the 2007-09 crisis teaches us: “that the financial sector is just as real as the ‘real economy’”. On the other hand, also remember that a stopped clock shows the time accurately twice a day. [xvi]
We move towards a new prevailing policy approach by moving away from what we don’t like, crossing the river by feeling for the stones, rather than by building a new machine (though some may pretend they do it like that). The New Deal/Keynesian economics and early multilateralism emerged from people moving away from the horrors of the 1910s and 1920s; the Neoliberal/Public Choice/Washington Consensus revolution of the 1980s emerged from people moving away from the stagnation and social paralysis and strikes of the 1970s; and now we have a turn towards more active government (as yet unnamed) emerging from a complex combination: the K-shaped recovery after 2007-09, disruptions of digital technology, increasingly tense geopolitics between the US, China and the EU, climate change, and as though this was not sufficient, the pandemic and the success of state-led vaccine programmes. Note that the several past techno-economic paradigms lasted roughly the same length of time: 1880-1929, 1930-1979, 1980-2020.
The standard economic forecasting models are unable to grasp policy paradigm change, and are almost designed to be upbeat (as the climate models are designed to be scary). [xvii] But we have ample if not systematic evidence that the level of “financial fragility” is dangerously high in much of the west, especially the US and the UK, China too; reflecting very high levels of wealth and income inequality, now combined in the west with pandemic effects. Just imagine if we go into a period of recurring pandemics and frequently interrupted economic functioning, coming on top of continuing wealth and income concentration at the top, widespread water shortages, desperate migration into anywhere in the west,[xviii] upheaving national politics, and multiplying geopolitical tensions between the west and China and Russia.
Beyond strengthening regulation of finance (and enlarging the scope for utility-style public-sector provision of finance, aimed at a low rate of profit), business and political leaders must stop being so mulishly unquestioning of billionaire wealth and act to reduce it. The post-Covid world has wide popular support for more progressive taxation (the US tax system is not progressive at all, when regressive social security, property and consumption taxes are counted and when the progressivity of the federal income tax is discounted by the treatment of capital gains and carried interest). If we go forward without a real increase in income support for the vulnerable and more progressive taxes on income, wealth and profits, “populism” of the Trump/Orban/Netanyahu/Johnson variety will continue to spread and deepen, fuelled by the (broadly correct) perception that the gains of globalisation and technological advance have been pocketed mostly by the rich while those lower down the hierarchy have carried the economic insecurities. Political identities in mass publics are currently in flux to the point that civil society organizations may be able to make new space to question cultural tenets about extreme wealth being a sign of merit and benevolence. We may look back on the past decade as the start of deep changes in how we live, work and govern.
Just when will elevated financial fragility tip into financial instability? It has often happened in September. Carpe diem.
Robert H. Wade is a Global Policy Advisory Board Member and a professor of political economy and development at the London School of Economics. He is the author of Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization (1990, 2004), which won the American Political Science Association's Best Book in Political Economy award, 1989-91. He won the Leontief Prize for Advancing the Frontiers of Economic Thinking in 2008.
An earlier version of this post appeared on the LSE's International Development blog.
[i] Quoted in John Plender, “Market froth sends an investment risk alert”, Financial Times April 15 2021, emphasis added. Plender is the source of the later figures on equity capitalisation and global debt.
[ii] Gillian Tett, “Margin debt levels flash red yet again”, FT 30 May 2021
[iii] Robert Kaufman and Stephan Haggard, Backsliding: Democratic Regress in the Contemporary World, Cambridge University Press, 2021
[iv] David Gelles, “Hard times, big payouts”, New York Times (International) April 27, 2021
[v] Attracta Mooney and Hannah Kuchler, “Indivior faces shareholder revolt over bonus for jailed ex-CEO”, FT 6 May 2021.
[vi] David Gelles, “Hard times, big payouts”, New York Times (International), April 27 2021
[vii] Financial Times, “Cameron plan for UK-China investment fund fades”, 4 May 2021.
[ix] As for cryptocurrency, Buffett says it is good only for drug dealers and tax avoiders. Charlie Munger, Buffett’s 97 year old right hand man, says it is like buying and selling turds in the hope you can get out before the other fellow realizes what he is holding.
[x] Farhad Manjoo, “Why did I think we could get rid of billionaires?”. New York Times (International), 13 May 2021
[xi] Tariq Panja and Rory Smith, “How the Super League scheme fell apart”, New York Times (International), April 26 2021
[xii] I have a remote vested interest here. As an undergrad I played for the Otago junior provincial rugby team. Otago is the home province of Otago University.
[xiii] Dirk Bezemer, “No one saw this coming – or did they?”, VoxEU, September 30, 2009, emphasis added
[xiv] Ben Bernanke, 2010,”On the implications of the financial crisis for economics”, Conference co-sponsored by the Center for Economic Policy Studies and the Bendheim Center for Finance, Princeton University, Princeton NJ: US Federal Reserve. Both emphases added.
[xv] Steve Keen, Debunking Economics, 2011, London: Zed Books, 456-7.
[xvi] Robert Wade, “From global imbalances to global reorganisations”, Cambridge J. Economics, v. 33, n. 4, July 2009; “Reflections: Robert Wade on the global financial crisis”, interviewed by Alex Izurieta, Development & Change, v. 40, n. 6, 1153-1190, 2009; “The global slump: deeper causes and harder lessons”, Challenge, v.52, n.5, Sep-Oct 2009; “The economy has not solved its problems”, Challenge v.54, n.2, March-Apr 2011..
[xvii] Steve Koonin, Unsettled: What Climate Science Tells Us, What It Doesn’t, and Why It Matters, 2021
[xviii] Over the weekend of 8-9 May 2021 more than 2,100 migrants arrived by boat at the tiny Italian island of Lampedusa. Under Italian law, migrants arriving by boat cannot claim refugee status. Migration into western Europe and North America will continue to inflame western politics for the rest of this century.