Markets Panic as the Global Economy Enters a New Phase

6 MINS READFeb 12, 2016 | 00:14 GMT
Investors observe stock market data at an exchange hall in Beijing.
(ChinaFotoPress/Getty Images)
It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

The world is awash with financial drama. Markets are swinging rapidly between extremes. Stocks — particularly banking ones — are largely declining and safer assets, such as bonds and gold, are on the rise. Falling global banking stocks are bringing uncomfortable feelings of deja vu to those of us who worked through the 2008 crisis. Deutsche Bank, in particular, is being referred to in some circles as "the new Lehman Brothers." The German bank attempted to calm the storm on Wednesday by circulating plans for a sizable buyback of its own debt, demonstrating that it still has considerable finances at its disposal. Market concerns were somewhat eased as a result. However, Thursday saw Deutsche Bank's stock drop once more.

Economic analysts are generally scratching their heads in bewilderment. The world's banks do not seem to be any riskier than they were in 2015. They are certainly much safer and better capitalized than they were during the 2008 crisis. Some are arguing that the panic is caused by the Bank of Japan's decision to lower interest rates below 0 percent — more commonly called negative interest rates — on Jan. 29. These new rates bode ill for the banking sector because they charge commercial banks for holding reserves, hurting banks' profits as they become reluctant to pass on the costs to customers for fear of losing them.

But the argument is undermined by the fact that in Europe, the European Central Bank has been imposing negative rates on eurozone banks since 2014. (Sweden did so even earlier, in 2009 to be exact.) The banks did not greatly object, and there were certainly no dramas akin to what we are seeing now. Making the divergence even more extreme, the Bank of Japan took great pains in January to protect its banks from the costs of negative interest rates, something the ECB did not do.

Other observers are pointing to different factors. China's economic slowdown, evidenced by its currency travails, not only triggered Japan's interest rate cut, but also contributed to the drastic fall in oil prices. Low oil prices are subsequently being blamed for the banks' problems, because loans made to the energy sector are in danger of defaulting. And there are those who are concerned about emerging political scenarios, including a British exit from Europe and the erratic electoral race underway in the United States.

There is another cause for concern that is specific to Europe. New banking union rules, which came into effect in January, have incentivized investors not to hold EU bank stocks. Portugal punished foreign investors in a late December 2015 bailout in preparation for the new rules, and Italy is living in fear of a bank run. Again, fear is justified, but the fact that the sell-off involved not just European banks but U.S. and Japanese ones (as well as stocks outside the banking sector) suggests a wider story is unfolding.

In truth, the outlook for the banking sector appears bleak. Highly regulated, threatened by new financial technologies and facing an opaque but mortal threat of losing the power to create money, it is possible that investors are just stepping away from the sector. Nevertheless, the timing is suspicious. It is more likely that there is an underlying shift bringing all these factors into focus at once, driving the markets into a state of near-hysteria and spurring the torrent of bad financial news.

That shift began with the U.S. Federal Reserve's decision to raise interest rates in December 2015: This symbolized the end of easy money. In the aftermath of 2008, when the global economy experienced its worst financial crisis since 1929, Fed Chairman Ben Bernake took unflinching steps. Bernake is one of the world's leading academics on the subject of the Great Depression. He, along with other international decision-makers, learned from the disastrous policy choices taken during the 1930s Depression. As a fix, they flooded the global market with easy capital by adopting zero interest rates and quantitative easing policies. The gaping wound inflicted by the crisis was covered over with money and debt, a Band-Aid under which it was hoped the system might heal.

The problem is that it is time to take the Band-Aid off, but it is not clear whether the wound has healed. In some ways, the world has carried on as before. The rise and fall of the emerging markets, led by China, echoes the Asian boom and bust of the 1990s, or the Latin American cycle two decades before. Usually at this stage in the cycle, the baton passes to the developed world. Taking advantage of weak commodity prices to set off its own growth spree, growth for developed countries is less dramatic than that of the emerging markets due to its higher starting point. This still may be about to happen: The United States has been showing positive signs over the past 18 months, enough to inspire the Fed to make its move.

The big issue, however, is uncertainty. Seven years of zero interest rates and quantitative easing have never been seen before in history. There is no roadmap for what happens coming out of the post-2008 crisis phase. Those seven years were already new and unusual, but easy money was flowing, so it was not uncomfortable for markets or companies. What we are seeing now is the removal of the Band-Aid, and a first look at the wound underneath. Raised interest rates mean less capital is available, which means asset prices have to drop from their artificially inflated levels and companies find out what they are really worth.

The United States will most likely catch the baton it is being passed, providing much-needed growth and stability to the global economy — though this time it may not be helped by Europe, which is currently going through a painful breakup. But the danger is that the Band-Aid did not do its job and the wound is not healed. Prices could continue to fall and companies could see markets shrivel up and lay off workers, leading to rising unemployment and widespread misery. Of course, the Fed probably would not let this happen. Under such circumstances it would most likely open the floodgates and let capital flow out once again, putting the bandage back in place. That would be a path that has already been trodden by Japan, a country that has experienced two "Lost Decades" in which the economy failed to grow, though the population (largely sustained by government capital) didn't truly feel the effects.

Fear of the unknown explains why markets are on a hair trigger. Uncertainty has contributed to the drop in asset prices, but it has also caused overreactions to every piece of news that emerges. The world is transitioning, moving into a new part of the business cycle. At the same time, it is in the process of discovering whether the actions taken after the 2008 crisis truly averted a 1930s-style depression, or merely postponed it.

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