If there is a new global financial crisis, then what will governments do?

This is the third article in a series on the global financial crisis. Is a full-blown global banking meltdown in the offing? was the first, while the second dwelt on Where the dead bodies are buried in a new global financial crisis. Part 3 follows:

The complexity of the highly interconnected financial and economic system makes predictions about the exact sequence of events in a crisis foolish.

Founder of GMO Jeremy Grantham once noted in October 2008:  "I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don't. And I have no idea, really, how this will work out. I certainly wish it hadn't happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect."

The problems currently are within the global banking and financial sector. But financial dislocations feed back into the real economy. There are two primary channels. First, reductions in income and losses of capital affect earnings and savings. Depending on magnitude, it may decrease consumption and investments.

Second, a banking crisis reduces the availability of funding and increases its cost. Small and medium-sized banks play an important role in economies. In the US, banks with less than $250 billion in assets provide roughly 50 percent of all commercial and industrial lending, 60 percent of residential real-estate lending, 80 percent of commercial real-estate lending, and 45 percent of consumer lending. More stringent regulation, tighter lending standards and the likely consolidation in banking will also reduce the supply of funding.

The real-economy effects will intensify any economic slowdown driving new stages of the adjustment.

In most recent crises, governments have stepped in to bail out (that unpalatable 'B' word that must not be said) the financial system and broader economy. The widespread assumption is that this time will be no different.

However, there are important differences in the policy options available now compared to those present in 2008.

Debt levels are much higher meaning borrowing to fund bank rescues and support the economy is more difficult.

Interest rates are relatively low in nominal terms and negative in real (after adjusting for inflation) terms. Persistent inflation means that policymakers must grapple with keeping rates high or loosening monetary policy to prevent financial deterioration. While high interest rates may be ineffective against the supply side factors underlying higher prices, there remains a risk that inflation can become entrenched inflicting consequential damage. The scope for the magnitude of rate cuts needed (around 3 to 5 percent in past cycles) is limited.

Since 2009, the size of central bank balance sheets has grown significantly.

Since 2007, the US Federal Reserve balance sheet grew from just under $1 trillion (7 percent of GDP) to nearly $9 trillion (34 percent of GDP). Other central bank balance sheets have experienced similar growth -- the ECB is at more than 60 percent of GDP, the Bank of England's around 40 percent and the Bank of Japan's 127 percent. Further growth may be difficult especially given the large unrealised losses on their existing investments. The US Fed has around $330 billion of unrealized losses, nearly eight times its $42 billion in capital.

The recovery after 2008 was assisted by robust growth in emerging markets, led by China. These countries now have multiple challenges. Strong emerging market activity and Chinese credit expansion (bank assets increased between 2007 and 2022 from less than $8 trillion to over $60 trillion) are unlikely to cushion any downturn.

There are non-financial factors.

A fissiparous US polity faces gridlock on everything from increasing its debt ceiling, prosecuting the former President for promoting insurrection or influencing elections, to standoffs on women's reproductive freedoms and trans-gender rights. Social tensions are driving civic unrest everywhere, as evidenced by strikes and protests, for example in the UK and France. While there is deep-seated dissatisfaction with those with power, restive populations cannot agree on actions, seeking simple and quick solutions that do not require them personally to incur major costs or inconvenience.

The relative geopolitical stability of 2008 is in the past. Current tensions between major powers mean that the likelihood of a co-ordinated response is low. Instead, trade restrictions, sanctions, deglobalisation and containment now dominate discourse. It is difficult to see China rushing to the aid of Western economies and institutions at a time when the US and its allies are keen to restrict the rise of the Middle Kingdom as an economic challenger and great power rival.

The probable response is low rates, government support and generous infusions of money, the policies popularised by former Fed Chairman Alan Greenspan, the 'Maestro' to sycophants. Because it is expedient, easy money is seen as a solution when it is the issue. In essence, it will be another kick of the can down the road although the available tarmac is now much diminished.

The global economy may now be trapped in an easy money-forever cycle. A weak economy or financial crisis forces policymakers to implement expansionary fiscal measures and more monetary expansion. If the economy responds and the financial sector stabilises, then there are attempts to withdraw the stimulus. Higher interest rates slow the economy and trigger financial crises, setting off a new round of the cycle.

If the economy does not respond or external shocks occur, then there is pressure for additional stimuli, as policymakers seek to maintain control. All the while, debt levels continue to increase, making the position ever more intractable.

Economist Ludwig von Mises was pessimistic on the denouement.

"There is no means of avoiding the final collapse of a boom brought about by credit expansion," he wrote. "The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

Satyajit Das is a former banker and author of numerous 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), A Banquet of Consequences RELOADED (2021) and Fortune’s Fool: Australia’s Choices (2022). His columns have appeared in the Financial Times, Bloomberg,WSJ Marketwatch, The Guardian, The Independent,Nikkei Asia and other publications. 

This is part of the web-only series of columns on newindianexpress.com.

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