To someone living in the industrialized world in 1979, devastating financial bubbles were like smallpox pandemics or famine—tragedies most knew only through history texts and newspaper stories about poor countries. The last one to hit the US was a full half-century ago, when America’s stock market crashed spectacularly. Bubbles in major industrial countries were rare. Japan had never experienced a single one, ever. That made it harder to grasp what happened next.
First, in the mid-1980s, Japanese real estate values started soaring. As someone famously calculated, by 1990, the market value of the plot of ground beneath Tokyo’s Imperial Palace surpassed that of the entire state of California. Stock prices boomed too. When the Nikkei 225 index hit its all-time peak on December 29, 1989, its market capitalization was six times what it had been just a decade earlier.
Then came the pop. Fearing inflation, Japan’s central bank had started raising rates in mid-1989, and in the early months of 1990, the effects began to hit. As credit dried up, investors dumped stocks to cover interest on loans. By October 1990, the Nikkei had plunged 48%, erasing $3 trillion in wealth.
The real estate price collapse was even more brutal. Since property was collateral for countless trillions of yen worth of loans, the crash ripped gaping holes in bank balance sheets. By the decade’s end, the crash wiped out more than $10 trillion of Japan’s wealth and savings.
Weirder things awaited as the 1990s wore on. Not long after Japan’s crash, a similar double-whammy of bubbles in housing and stock markets hit, of all places, Finland. Norway next. Then Sweden. From the Arctic it swung back east, booming and busting its way through Thailand, Malaysia, Indonesia, and other Asian nations. On it flowed to the US, helping to inflate what became the dotcom bubble.
To top it all off, all the while, something strange and disquieting was happening in Japan. Its once-stunning pace of growth had slowed to a sputter. In fact, it hasn’t recovered since. In 2017, Japan’s economy was about 27% bigger than it was 1990, adjusting for price changes. For a little perspective, it grew by about the same magnitude in the six years from 1984 to 1990.
It used to be that Japan’s “Lost Decade,” as it was nicknamed, was marveled at as an economic oddity. No longer. A decade after the 2007-2008 global financial crisis, countries that have experienced Japan-style financial crises have suffered unusually anemic recoveries (at best). Their credit bubbles, meanwhile, didn’t truly burst. They simply moved on, decamping to emerging market bonds and Vancouver condos.
The models that used to explain how economies behave no longer do. They clearly don’t tell us when destructive financial bubbles are forming. And what they explain about recessions clashes with recent experience too. This is probably no coincidence. A growing body of research suggests that the role of credit as an engine of growth has warped the nature of both expansions and contractions. Since the mid-1980s, economic activity has increasingly tended to move in synch with “financial cycles,” often bucking the trusty old business cycle. As governments prepare for the next wave of recessions, they’d do well to heed the implication: that our standard, time-honored policies for fighting downturns have little effect on financial cycle-induced recessions. In fact, they fuel financial cycles all the more.
Does this mean we’re now teetering on the brink of another global financial crisis? Probably not. But as recent market gyrations and signs of weakening growth highlight, the ongoing churn of financial cycles has left economies everywhere more fragile than they were a decade ago.
A disruption in the business cycle
Between the end of World War II and the early 1970s, growth in industrialized economies tended to follow a tidy pattern of ups and downs that economists call the business cycle. In this model, spending is the current that charges economies. And economies expand when spending increases: as consumers buy more and more stuff. To keep up with this rising demand from households, companies boost their spending, too—investing in new factories and hiring new workers. And since workers are also shoppers, that, in turn, juices household consumption even more.
An economy can only produce so much with the resources it has, however. The business cycle tops out when businesses and households demand more than their workers and factories can sustainably produce. How does this usually play out? Eventually, after a few years of acceleration, unemployment levels have plummeted. With labor supply so tight, to retain workers, businesses give raises. Now households have even more money with which to consume. But the economy can’t keep up. As a result, prices start rising, too.
How do you stop prices from rising too fast? Easy—rein in demand. There are lots of ways a government might do this. But the tool most commonly used since the postwar era is monetary policy: the central bank hikes interest rates. That forces businesses to spend less, because higher borrowing costs make it more expensive to invest. More likely, though, the slowdown in business investment results in layoffs. Job loss, or even the mere fear of job loss, causes families to cut back consumption. Unemployment ticks up, output slides, and the country officially enters a recession—prompting the central bank to leap into action again, this time cutting rates. It takes time for cheaper borrowing costs to stimulate new investments, and if the slowdown is sharp enough, maybe the government boosts public spending to prop up demand in the meantime. After a couple of quarters, credit is flowing into the economy once again as people start building new factories and buying new homes. And lo’, a new expansion whirs into action. The cycle begins anew.
Though little recognized at the time, this process held the key to the uncanny stability of post-war growth. Inflation, it turned out, had an unexpected knock-on benefit. That is, the clocklike regularity of rate hikes every half-decade or so discouraged borrowing from getting so excessive that it drove up prices of houses, say, or stocks. Destructive financial bubbles never burst because they never got going in the first place.
Then, starting in the early 1980s, inflation stopped flaring up the way it used to. Throughout advanced economies, price growth slipped to unusually low levels, and stayed there. But because inflation had stopped threatening to spiral out of control, central banks saw no reason to hike interest rates either.
Taming the business cycle—or blowing up bubbles?
In the old business cycle model, keeping rates low made plenty of sense. After all, inflation picks up when the economy is “overheating”—typically, when wages are rising enough to boost spending and crimp margins, launching prices on a fast climb upward. Or to put it more abstractly, when there’s more demand than the economy is able to supply.
And, conversely, low inflation was a sign of too-weak demand. According to the logic of the business cycle, it reflected that the economy still lacked the capital needed to fund more risk-taking and get growth pumping. The conventional wisdom suggested that keeping rates low was sensible. Why hike if there’s no overheating?
In the West, at least, this approach seemed to be working. Throughout the 1990s, growth boomed, particularly in the US. By the early 2000s, many economists hailed persistently low inflation as proof that central bankers had ushered in a new era of prosperity. Between keg stands of their own Kool-aid, Western central bankers accepted congratulations for having tamed inflation and mastered the business cycle, creating a world where prices never swung out of control.
Except, we now all know that prices were indeed swinging out of control—and with increasing frequency and violence. But prices for Tokyo real estate or the ruble or NASDAQ stocks aren’t included in the consumer goods baskets whose prices are tallied to measure inflation. So with central banks sitting on their hands, borrowing costs stayed low. Credit, therefore, was plentiful. And credit, as is its nature, multiplied. Debt got bigger. Inflation stayed the same.
And so, therefore, did interest rates—which encouraged even more borrowing. Central bankers did not truly grasp their monetary policies’ ruinous side effect until Lehman Brothers collapsed. It turned out the business cycle that they thought they had tamed had simply broken down instead.
A “new” breed of recession
It’s not exactly that old-school business cycle-style recessions disappeared. Like old times, a couple of quarters after the central bank cut rates, the economy picked right up. The business cycle seemed to be working like it was supposed to.
In general, though, recessions had become increasingly rare and expansions distinctly longer. But when slowdowns did hit, they mostly proved unusually deep or painfully drawn-out. The most devastating downturns followed the bursting of bubbles.
As it happens, economists had been observing similar links between crises and financial bubbles all the way back in the 1800s. But during the postwar era, the study mostly faded from view. In fact, economists as a profession all but ignored how credit expansions influenced economic behavior. Among the few exceptions were the economists Hyman Minsky and Charles Kindleberger, though their work was considered far outside the mainstream.
The 2008 collapse drew new attention to Minsky’s work, in particular the concept of a what was deemed a “Minsky moment” that sets off a crash. The economist himself never used this phrase, notes Michael Pettis, professor of finance at Peking University and author of The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy.
Among Minsky’s most valuable insights, says Pettis, comes from how he imagined economies: as aggregates of zillions of individual balance sheets—the income streams and debts—that interlocked with each other, so that one entity’s assets are the other’s liabilities. “In an ideal world, every one of our balance sheets, there’ll be mismatched, but there’ll be mismatched in different ways so that whatever happens to you has no systemic impact,” Pettis says.
Systemic risk arises when an event induces people to structure their balance sheets in the same way. This invites what we often call a bubble: a synchronized swing in money and enthusiasm that blows up the prices of housing, stocks, or some other asset. As this process builds, rising prices confirm the apparent soundness of the investment, justifying high prices, and, in turn, appearing to diminish its risk.
“For example, let’s say interest rates are really, really low and liquidity is very ample, then all of us end up structuring our balance sheets in the same way—we borrow short-term to buy assets,” says Pettis. “As everyone does that, you create systemic risks because now something that hurts your balance sheet also hurts my balance sheet and lots of other people’s balance sheets. And to the extent that our liabilities are each other’s assets, we double up the pain.”
Building on Minsky’s insight, Kindleberger analyzed episodes of this behavior throughout history, culminating in Manias, Panics, and Crashes, his 1978 book that remains the seminal work on financial crises today.
However, in spite of its pioneering effort, a problem with this line of study remained: there was no agreed-upon way of measuring these events in history (let alone as they’re happening). This is hard for a couple of reasons. First off, the speculative assets in question can differ wildly—from South Sea Company share certificates to plots of Floridian swamp to bitcoin. This makes it hard to find comparable data (to say nothing of the fact that these bubbles have happened in scores of different countries, using dozens of different currencies, over centuries). On top of that, there’s no mainstream academic consensus on how, exactly, to measure credit expansions and their effects on asset prices in the first place.
Pinning down “financial cycles”
In the last couple of decades, however, economists have made progress at collecting and analyzing data that capture the dynamics that Minsky, Kindleberger, Pettis, and others describe. One such initiative has come from the Bank for International Settlements (BIS), an international financial institution popularly known as “the central bankers’ central bank” (in addition to that function, it also is a leading source of global financial research and information). Led by Claudio Borio, its chief economist, the BIS has tested dozens of variables to find which most accurately predict big financial booms and busts, and the fluctuations in output that accompany those. Through this research, BIS economists have developed what they call a “financial cycle,” self-reinforcing interplays of credit, asset prices, and risk perception that amplify the ups and downs of business cycles. These cycles tend to move in tandem with credit and prices of housing and, to a lesser extent, stocks and other assets. To track these financial cycles, Borio and his colleagues have devised a composite of financial activity proxies—namely, medium-term changes in real credit, a country’s credit-to-GDP ratio, and real home prices.
In the business cycle regime, inflation tends most accurately to capture cyclical changes in economic activity. However, Borio’s research suggests that since the mid-1980s, these financial proxies reflect the pattern of ups and downs in output more accurately than inflation does. The financial cycle measures also prove to be better predictors of severe recessions than the yield curve (a recession signal popular among the financial media).
“The implication is that recessions can occur now even without a significant increase in inflation and that we need to focus much more on the financial side than we did in the past,” says Borio. “Think of this, if you like, as we had shifted from inflation-induced to financial cycle-induced recessions.”
He and his colleagues found that once financial cycles finally “turn,” things look different from traditional business cycle too—recessions tend to be deeper, longer, and all around uglier. Or as Borio explains, “it is the boom that sows the seeds of the subsequent slowdown. That’s what a cycle is all about.”
The good news is, since the 2007-2008 crisis, central bankers have become much more vigilant in monitoring markets for property, stocks, and bonds for frothiness. (Less helpfully, the media too has embraced bubble-watch as a regular pastime, warning of imminent financial crises stemming from things like student loans and fracking debt with Chicken Little-ish regularity.) But woefully little progress has been made on confronting the economic problems and policy challenges left hanging by the last crisis.
The wrong tools
Offsetting contractions created by the business cycle is a fairly straightforward affair. The challenge was that the higher borrowing costs previously needed to douse inflation ultimately worked too well and wound up quashing demand. Our recession-fighting arsenal is designed to revive it, by cheapening credit to stimulate private spending, upping public outlays to boost demand until rate cuts take effect. This double barrel of expansionary fiscal and monetary policy has saved us time and again in the decades after WWII.
But these same monetary and fiscal tools don’t really work on the strange new species of slowdowns that follow bubbles. That’s probably because these new types of financial cycle-induced downturns are what economists call “balance-sheet recessions.”
Imagine the Minsky concept of interlocking balance sheets that Pettis explained. As credit expands and bubbles build, businesses and households borrow heavily to fund spending. Rising asset prices give them more collateral that can be used to take out more loans. When financial crises finally hit, people scramble to sell their investments to cover their debts. Plummeting stock portfolios and homes values wipe out wealth. Even though much of this might be paper wealth—meaning, the gains made people feel rich, but didn’t actually put money in their bank accounts—it has the psychological trauma of making people feel poorer, which makes them more desperate to save (instead of spend). But even though their wealth has collapsed, the value of their debts remains—it still must be paid. Worse, as the crash induces businesses and families to cut their spending, sales drop and layoffs begin. That leaves people stuck with less income paying down the same amount of debt as before. Since spending is the engine of an economy, this process can reinforce itself for years—or as Japan illustrates, more than a decade.
This gets to the core problem with traditional monetary policy. Keeping interest rates low prevents debt from collapsing the economy altogether. But monetary policy doesn’t help stimulate the risk-taking needed to jolt the economy the way it does during business-cycle recessions. When people are overwhelmed by their debts, they want to cut their burden, not add to it.
By keeping interest rates so low throughout the 1990s and early 2000s, central banks let credit keep multiplying itself, giving way to the biggest bubble yet. After that finally gave way to a spectacular crash, followed by a deep global recession, central banks pumped even more credit into the system.
It’s hard to argue that this response wasn’t necessary to stave off a global depression. But rather than deflate the bubble that wrought so much devastation on their own economies, the central bank response instead sent an unsustainable wave of debt sluicing around the planet. They didn’t get rid of the financial imbalances. They merely pushed them elsewhere—and made them bigger.
The global economy: bubbly and imbalanced
One of the defining features of the weird new financial cycle era that began in the mid-1980s is that capital suddenly became unstoppably global—a consequence of increased deregulation of finance in advanced economies and “financial liberalization” of poorer nations’ stock and bond markets as they opened up to foreign investors.
And so, therefore, did financial bubbles. However, a decade of unconventional monetary policy from the rich world’s central banks has intensified this dynamic. Money borrowed at nearly zero interest in New York can be invested for a handsome profit in, say, Chinese bonds, or securities used to fund Polish real estate.
Emerging markets will ultimately bear a lot of the brunt. Some, like Turkey, already are. Its own interest rates are much higher than those set by the US central bank, the Federal Reserve (The Fed), and the European Central Bank (ECB). That means it’s vastly cheaper to take out loans in euros or dollars than in Turkish lira. Unsurprisingly, when Turkey was booming a few years back, that’s exactly what Turkish businesses did, borrowing around $142 billion in dollars and euros, as of Q3 2018. The problem is, since most of these Turkish businesses earn revenue in lira, when the lira lost value throughout 2018, those debts suddenly became massively more expensive to pay.
Now, it’s easy to scold Turks for a dunderheaded reprise of the very mistakes that led to the Asian financial crisis of 1997. But it’s also possible this pattern keeps repeating because there’s something more systemic at play.
When Western central banks unleash quantitative easing (the buying of government bonds and other securities to increase the money supply and make borrowing even cheaper), they squeeze interest margins so tightly that it makes domestic banking barely, if at all, profitable. Small wonder that these banks would seek out customers in Turkey and other emerging markets. In the dynamic Minsky articulated so brilliantly, it didn’t matter that this was obviously the same kind of thing that ended up killing South Korean firms in 1997. Once a few companies start taking out cheap loans, other firms follow suit simply to compete.
Turkey is an extreme example, but it’s hardly alone. For instance, banks have lent $3.7 trillion in US-dollar loans to emerging market companies—double the amount before the 2007-8 financial crisis, according to the BIS.
With so much debt hanging over the world economy, the question is: will the next recession trigger the next financial crisis? The answer could depend on where you look.
Where does that leave us?
First, the good news. Some countries like the US and UK, which were hit hard by the financial crisis in 2007-2008, are finally doing a lot better (give or take a hard Brexit). In fact, the BIS measures of those countries’ financial cycles suggests neither is nearing bubble territory. For these two countries, as well as Spain, France, and Italy, the BIS suggests that building financial momentum could help boost growth.
Again, the financial cycle view doesn’t mean that a business cycle-style recession can’t happen. For instance, the BIS’ financial measure didn’t pick up the 2001 recession because it was so mild. Borio says that given where the US is in its financial cycle, something along those lines could happen again. “If there was to be a slowdown in the US economy [in the immediate future, the composite financial indicator] wouldn’t capture it,” he says. “But, of course, according to the indicators, it wouldn’t be a serious downturn anyway.
It also doesn’t mean the US, for instance, is debt-free. One downside of analyzing growth prospects through national aggregates is that it can obscure how changes in economic growth and financial conditions affect different groups of people within a country.
To turn to a concrete example, the 2007-8 financial crisis devastated American homeowners. But US corporations emerged in much better shape. Roles have now reversed. While American households struggled to clean up their balance sheets after the crisis, unprecedentedly cheap money courtesy of the Fed and other central banks stoked a huge new bubble in US corporate debt.
Similarly, among those countries that weren’t hit hard by the 2007-2008 crisis—Australia, Canada, and a few Nordic nations, for example—now seem to be approaching a financial cycle turn.
The choppy seas of financial cycles across various countries and sectors highlights why traditional monetary policy is such a blunt instrument: by making it cheaper to borrow and invest, central banks unquestionably saved borrowers, but blew up new financial imbalances in the process.
Now, after a decade of excessive quantitative easing, the Federal Reserve (the Fed), the European Central Bank (ECB), and the Bank of Japan (BoJ) must at some point start sucking up that extra money by hiking interest rates and drawing down their balance sheets (while the Fed has been doing both, the other two haven’t yet started). The challenge is to do that without triggering panic—a particularly dicey move in the markets that are especially frothy.
The effort hasn’t been going swimmingly; in fall of 2018, the perception that the Fed was going to raise rates faster than expected sent stock prices swan-diving and caused the US market to raise borrowing costs.
The reckoning this market frenzy augured has been deferred for now. In late January, Fed chairman Jerome Powell softened his stance; it’s now unclear whether the Fed will raise interest rates at all in 2019. Meanwhile, the economies of Japan and most of Europe are looking peaked of late. The ECB and the BoJ have mentioned that they’re mulling more quantitative easing. Oh and let’s not forget the newest central bank of note, the People’s Bank of China, which just loosened its own financial conditions with a stunning $480 billion gush of bank loans in January alone.
The global economy is in an increasingly shaky state—which is why it’s hard to dismiss the case that more easy money is necessary. After all, what central banker wants a global recession—and the loss of tens of millions jobs that will entail—on his hands? If it is indeed a lack of demand that’s keeping the global economy from shifting into a sustainable gear of growth, then that will turn out to be the right call. But if it’s instead too much debt, disguised as too little demand, that’s ailing the world, the next adjustment, when it finally comes, will be far, far worse.
Where does that leave us? Or, more to the point, where does that leave the planet’s most powerful governments and central bankers? They after all have one of the toughest jobs in the world: softening the blow of the next recession. By neglecting to confront the cycle that created the last global downturn, they’ve made that challenge even harder.