By James H. Nolt
The lead article in the Wall Street Journal Tuesday, “Loan Market Pulls Back,” provides critical data indicating that the world economy is headed into another financial crisis. The proximate cause of this impending crash is broadly the same as every other in history, as I have argued several times in previous posts: bearish curtailment of credit.
When bearish financiers expect the economy is ripe for a crash, they sharply curtail credit, particularly to bulls that are the most extended and thus often heavily indebted. If the bears are acting strategically, they would have first built extensive short positions in asset classes most likely to crash when credit is tight. Therefore when the crash comes, many bulls will be forced to dump assets to meet debt payments. Others will go bankrupt. In either case, asset prices plunge, allowing bears to buy up discounted assets cheap and also cash in on their short positions.
The Wall Street Journal article describes the specific threat: Many debtors are unable to rollover old debts with new credits because the issuance of new credit this year is more than one third less than last year. Thus when loans come due, instead of paying off old debts with fresh borrowing, creditors will need to liquidate assets instead. This results in numerous highly motivated sellers of real estate, stocks, bonds, and other assets. As these “fire sales” cause asset prices to slump, more and more sellers may dump assets to limit losses, leading to a potential vicious circle of price drops until the reserve buying interest of bears finally kicks in and establishes a price floor.
The 2007-2008 financial crisis began in the subprime mortgage market, initially affecting mostly over-extended individual home buyers. But this time, according to the article, lots of the vulnerable debt is in commercial real estate and other loans areas. From previous articles I know these include student loans, but also various other categories of risky debt, often securitized, i.e., packaged into bonds backed by pools of debts, as in 2008.
The problem is not confined to the U.S., but is global. As I have argued in previous blogs, China has serious enterprise debt problems. Hong Kong banks are vulnerable to the spillover. Developing countries, especially those exporting primary products with weak prices, are facing debt issues. Europe has been wallowing in debt problems since the Greek crisis in 2010, but the recent British referendum for the United Kingdom to leave the European Union has cause more asset price drops and loan defaults throughout Europe. The same Tuesday issue of the Wall Street Journal has another front page article, “Italy’s Banks Loom as Europe’s Next Crisis,” revealing that one sixth of Italian and one third of Greek bank loans are non-performing. Some Italian banks have been hiding the extent of the problem by giving new loans to debtors who cannot pay their old ones, merely delaying the inevitable reckoning.
Last week I missed the chance to comment on the impact of the British referendum vote to leave the European Union. The worldwide impact is already profound. The British pound is now trading at its lowest dollar value in three decades. Don’t forget that this also means that all bonds and other debt contracts denominated in pounds have also likewise suffered global devaluation as a result, quite apart from the additional drop in loan values resulting from increased risk. The fall in value of so many assets in one of the world’s great financial centers could be another crisis trigger.
This bearish business reaction may be premature, and I am skeptical that Britain will indeed leave the EU in the end. The referendum is not legally binding. Parliament must pass the enabling legislation, along with regional parliaments in strongly pro-EU parts of Britain, such as Scotland. Even the London Parliament has a bipartisan two-thirds majority for remaining in the EU, so it is not clear whether the whim of a bare majority of the voters will prevail over parliamentary and business opposition. However, regardless of whether Britain eventually exits the EU, in the meantime the damage to business confidence has already been done. A financial crisis may occur before there is time to sort out the ultimate relationship between Britain and the EU.
The presidential election in the U.S. is also unsettling financial interests. Typically, both the Democratic and Republican parties nominate pro-business, pro-free trade candidates. This election is different. As I have argued in previous blogs, presumed Republican nominee Donald Trump defies the free-trade and pro-Wall Street (often leaning bearish) mainstream of the Republican Party. I predict Trump will lose, but the stakes are so high this time that many investors are unnerved.
I believe Trump will lose not only because he offends minorities and “politically correct” sentiments, as has been so often emphasized in the mainstream media, but also because he is protectionist and a bullish pro-debtor, reflecting his own interest as a real estate mogul. On both counts he is anathema to the pro-trade and pro-creditor business interests that dominate the Republican establishment. These include many multinational corporations, big banks, and other financial giants. Manufacturing interests are opposed to his campaign to deport their largely immigrant labor force. Media companies tightly tied with this business establishment are giving Trump a rough ride. It will get worse.
Yet even if Trump loses and Britain ultimately stays in the EU, or at least negotiates a package of agreements that preserve many of its EU ties, investors right now are so rattled and polarized by radical uncertainty from these and other worrisome issues that the likelihood of a severe financial crisis still looms large in the near term.
We are nearing what John Maynard Keynes in his Treatise on Money called a culminating point, when the economy seems poised on a brink, so bear and bull interests pile up opposing positions. A culminating point does not guarantee a crisis must occur. The relative balance of bear and bull interests does matter. This is hard to measure since so many investor positions are secret and can accumulate rapidly. However, the sharp reaction to the Brexit vote in Britain added to the drying up of credit as bearish financiers withhold it suggest that bearish interests may have gained an irresistible advantage. Since many bears are also leading creditors, they are in a position to create a self-fulfilling prophecy of falling asset prices by their own sudden unwillingness to lend. Bears are poised for another decisive strike.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Walters Art Museum. Photo shows the sculpture Bull Attacked by a Bear by Antoine-Louis Barye; Bronze, 1890]