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Is This Downturn A Repeat of 2008?

Crashes differ, so be cautious about your assumptions
Friday, January 4, 2019, 10:01 PM

Even people who don't follow the stock market closely are aware that the global economy is weakening and appears to be heading into recession.

For those who track the stock market, the signs are ominous: the U.S. was the last major market to notch gains this year and in October the U.S. market followed the rest of the global markets into an extended slide which has yet to end.

Just as sobering, key sectors such as oil, banking and utilities have crashed with alarming ferocity, reaching oversold levels last seen in 2008 as the global financial system was melting down.

These sectors crashing sends an unmistakable signal: the global economy is heading into a potentially severe recession and assets will not be rising in value in a recessionary environment. So better to sell risk-assets like stocks now rather than later, and rotate the money into safe assets such as Treasury bonds.

And indeed, households now own more Treasuries than the Federal Reserve--a remarkable shift in risk appetite.

Many other indicators of recession are in the news: auto and home sales and global trade are all slumping.

Are we in a repeat of the global financial meltdown and recession of 2008-09? The sharp drop in equities is certainly reminiscent of 2008. Indeed, the December decline is the worst in a decade. Or are we entering a different kind of recession, the equivalent of uncharted waters?

And if we are entering a recession, what can central banks and governments do to ease the financial pain and damage? We can’t be sure of much, but we can be relatively confident central banks and states will respond to the cries to “do something.”  This poses two questions: what actions can central banks/states take, and will those policies work or will they backfire and make the recession worse?

A good place to start is to revisit the 2008 crisis and attempt to understand its sources and how central bank policies reversed what appeared to be a snowballing collapse of global finance-- a meltdown that would have sent the global economy into a deep freeze.

Adam Tooze's recent book Crashed: How a Decade of Financial Crises Changed the World is a forensic autopsy of the crisis, and though I have yet to read the book, I refer to Tooze's recent article in Foreign Affairs magazine for his take on the basic mechanics of the 2008 crash and central banks' responses.

The story of the criminal fraud embedded in the subprime mortgage market meltdown is well known.  But as Tooze points out, these losses were less than those of the dot-com crash in 2000-02, so why did the subprime mortgage market meltdown almost collapse the global financial system?

Tooze identifies two key dynamics:

  1. Global finance had become highly integrated and leveraged by 2008--what we call hyper-coherent; in Tooze's words, "extraordinarily tight connections between U.S. and European finance."
  2. Non-U.S. banks, especially in Europe, had borrowed heavily in dollars to participate in U.S. financial markets.  When the panic started, global capital flows dried up and non-U.S. banks no longer had access to credit denominated in US dollars.

As capital flows and short-term lending dried up, a liquidity crisis took hold: non-U.S. banks couldn't get their hands on enough dollars to meet their obligations.

Unable to borrow dollars, their only choice was to dump their U.S. assets, panic-selling that would have crushed the valuations of U.S. stocks, real estate and mortgage-backed securities.

U.S. banks would have then been forced to reprice their assets lower, declaring huge losses on their portfolios that would have triggered (in Tooze's view) a  contagious bank run as the banks would have become insolvent (i.e. their assets would be less than their liabilities).

To stave off this banking crisis and a collapse in U.S. equities and real estate markets, the Federal Reserve quietly provided trillions of dollars of short-term credit to European banks, and opened currency swap lines with other central banks to supply however many dollars those banks needed to restore liquidity to their banking sectors.

To put some numbers on these dynamics: according to Tooze, global capital flows dried up 90% from 2007 to 2008, and global exports plummeted 22% within 9 months.

The long-term result of this global dollar shortage and emergency Fed policies of providing trillions of dollars in short-term USD credit and USD currency swap lines is that the dollar is more dominant now than it was before the crisis.

The USD is now the anchor commercial currency for countries representing 70% of global GDP, up from 60% in 2000. As Tooze explains, "The world's central banks effectively became offshore divisions of the Fed, conduits for whatever dollar liquidity the financial system required."

This interplay of over-reach, credit, currencies and policy responses is complicated, so let's try to summarize what happened in 2008:

  1. Banks began relying more on short-term lines of credit than on cash deposits. This left them vulnerable to funding crises when credit dried up.
  2. When short-term credit dries up, this is a liquidity crisis: when credit-worthy borrowers can't roll over their debts, this forces them to liquidate assets, panic selling which then crashes the valuations of those assets. This selling feeds a self-reinforcing feedback to reduce risk by tightening lending and dumping assets which further exacerbates the crisis.
  3. The solution to a liquidity crisis is for a central bank to open the credit and currency swap spigots wide open, which is what the Fed did.

Liquidity crises are thus relatively straightforward: providing emergency lines of credit solves the initial crisis.  Insolvent creditors can then be liquidated and losses written down in an orderly fashion.

But not all downturns are liquidity related. A conventional business-cycle recession occurs when too much credit has been extended to marginally creditworthy borrowers to fund investments in overvalued assets.

As lending to marginal borrowers / buyers is reduced, assets decline and these two conditions--tightening credit and declining asset valuations--trigger defaults which drive further tightening of credit and a self-reinforcing sell-off of assets.

Simply providing more short-term credit won't solve this credit/business cycle downturn, though it might help safeguard creditworthy borrowers from being forced into insolvency or fire-sales of assets.

If lenders in the banking and shadow-banking sectors are overleveraged and have extended loans on overvalued assets to marginal borrowers, the only real solution is to deleverage by writing down bad debts and taking losses on assets which have declined in value.

There’s a third kind of recession: the popping of credit-asset bubbles such as the dot-com stock bubble in 2000-02 and the housing bubble in 2007-08. The Fed and other central banks didn’t stop at providing liquidity; they bought assets (mortgage backed securities and Treasury bonds) to put a floor under asset markets and support a reflation of risk assets such as stocks and housing.

Articles like this "In A World Of Warnings, "This Is The Biggest Yet" indicate there is great uncertainty in the global financial system.  This is reflected in the skittish volatility of stock markets as every rally is soon sold and the distress that’s visible in credit markets.

This suggests market participants are no longer confident about central banks’ diagnosis of the global economy’s malaise and the efficacy of their response.  If central banks and states misdiagnose the current downturn, their policy responses could make the situation worse. It’s also possible that policies that worked in the past will fail to deliver the desired results this time around.

The 2008 crisis resulted from hyper-coherent, overleveraged banks and overvalued markets exacerbated by a liquidity shortfall in USD-denominated credit. Have these conditions melted away or are they still present? It can be argued that banks have lowered their leverage, but the tight connections in global finance remain in place.  By many measures, valuations in risk-on assets such as equities and real estate are as extended as they were in 2007-08.  As for dollar shortages, many believe this is still an issue.

If the current recession is the result of credit exhaustion, i.e. companies and households cannot afford to borrow more or don't want to borrow more, increasing liquidity won't be effective.

If the current downturn isn't a liquidity issue, it’s not clear what the central banks can do to maintain elevated valuations in stocks and real estate, other than buying these assets directly and in quantities large enough to offset the sort of mass liquidation we’re now seeing. Direct purchases of assets such as bonds and stocks by the major central banks have supported asset valuations for the past decade, and now that the Federal Reserve has increased interest rates and begun reducing its balance sheet, the Fed’s implicit support of high asset valuations has come to an end.

The problem with bailing out markets with direct asset purchases is, as Tooze notes at the end of his article, central banks no longer have a political carte blanche to "do whatever it takes." He also noted that China was not participating in the currency swap lines in 2008, and so a credit crisis in China might be more difficult to contain than the European-U.S. credit/liquidity crisis of 2008. By 2015—three long year ago—Chinese businesses had already borrowed $1.7 trillion in foreign currencies, the majority being U.S. dollars. Assuming the trend continued to the present, we can estimate the sum now exceeds $2 trillion—not a trivial amount even in a large economy like China’s.

It seems the current market downturn (and looming recession) is not a repeat of either the dot-com recession (the result of the collapse of an asset bubble that was concentrated in one sector, technology) or the 2008 global financial meltdown and recession. The current downturn arguably shares traits with three different kinds of recession: the popping of asset bubbles (like the dot-com and housing bubbles bursting), credit-currency mismatches and a panic move to de-risk (like the 2008 meltdown) and a classic business-cycle recession of credit and demand exhaustion. This will complicate the analysis and response of central banks, companies, investors and households.

In Part 2: The 8 Systemic Failure Points Of The Global Economy, we analyze the biggest risks confronting policymakers and investors alike, as both struggle to avoid the worst of the danger to come.

And we explain why, despite its many very real weaknesses, the US economy and its markets may be positioned to fare better than the rest of the world as the reckoning unfolds.

Click here to read Part 2 of this report (free executive summary, enrollment required for full access).

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16 Comments

Uncletommy's picture
Uncletommy
Status: Platinum Member (Offline)
Joined: May 3 2014
Posts: 649
Great overview, Charles!

I think CHS has concisely nailed what we are to expect over the coming months and , perhaps, years. The millenials have reached a stage in their collective consciousness where they have realized that "Mom and Dad" did what they could with what they had. The abundance of the Post-WWII era has eroded to a new level where resources will be the limiting factor in affluence. Is it possible that a rational, global "cooling-off" period is in the cards; or are we facing an accelerated zero-sum philosophy that will bring all of us, rapidly, to our knees. Despite Mr Trump's bravado, Mr. Powell may be the best possible alternative for a return to a rational world economy. Or ,possibly, it may happen by default!

cestin's picture
cestin
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Posts: 18
Global currency reset hypothesis

Charles,

I've seen you comment on past Bradon Smith (http://www.alt-market.com/) blogs, where he suggests this market crash is being engineered for the purpose of using and International Monetary Fund bailout with their Special Drawing Rights acount.  That any other source of bailout by central banks would 't be accepted, so the SDR would gain acceptance because it's got more balance based on its basket of 5 currencies - including the Chinese yuan, which could become partially gold-backed to build trust.  No other bloggers seem to give credence to Smith's proposed endgame.  What are your thoughts on its feasiibility?

cmartenson's picture
cmartenson
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Posts: 6027
Great article Charles!

Really nice.  Part II is awesome as well.

It seems to me that once valuations become hopelessly untethered from reality, then psychology is everything. Rationalizations become the most important aspect of 'keeping everything going.'

For example, everyone is worried about whether the Fed pauses or not, or what the pace of rate hikes will be.

I've been in a rather lonely position of jumping up and down over in the corner yelling "it doesn't matter!"

Why doesn't it matter?  Because these 'rate hikes' are not removing any liquidity from the market ecosystem.  In times past a rate hike meant going out into the banking ecosystem and removing cash until the new higher rate of interbank overnight lending was achieved.

That is, the rate was the after-effect of the liquidity manipulation.  With less liquidity out there, loans cost more (interest rates go up) because there's less cash around to lend out.  

Now?  The rate is the function of whatever the Fed sets the IOER (interest on excess reserves) rate to.  Want a rate 0.25% higher?  Then just give banks 0.25% more on their IOER.

In other words, a higher rate of market interest is no longer associated with 'less liquidity.'  There could be more, less or the same amount.  They are now decoupled from one another.

Will loans be harder to come by with these new higher rates of interest?  Nope.  There's the same amount of cash floating around ready to do whatever. 

So now whether a loan gets made or not is strictly a function of the psychology of the moment.  Does the bank feel like making a loan, or not?  But it won't be a shortage of pile of cash hanging around with nothing better to do that causes a loan to be delayed.

There are still $1.567 trillion (with a "t") of excess reserves in the banking system.  Trust me, that's a boatload of liquidity still.  The pre-crisis levels were typically below $2 billion (with a "b")

So I don't think it fundamentally matters in the slightest if the Fed raises more or pauses.  But it does matter psychologically...mainly because most market participants are unaware of the enormous technical difference between a pre-IOER rate hike and a post-IOER 'rate hike.'

The former removed liquidity that cause rates to rise, the latter simply causes rates to rise and leaves liquidity untouched.  With ample liquidity there's ample money for loans.  Nothing is being pinched or starved for anything.

Well, except for the derelict nation states and zombie companies that cannot survive a 2.5% rate of interest.  But that's another story for another day.

 

cestin's picture
cestin
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Posts: 18
@Chris

What about you, Chris - have you encountered Brandon Smith's global currency reset hypothesis, and if so, what do you think about it as an explanation for why the Feds are relentlessly raising interest rates and QT? 

See links for details about Brandon's economic endgame hypothesis:

 http://www.alt-market.com/articles/2403-the-economic-end-game-explained 

http://www.alt-market.com/articles/3310-the-economic-end-game-continues 

http://www.alt-market.com/articles/3229-the-new-world-order-will-begin-with-germany-and-china 

charleshughsmith's picture
charleshughsmith
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Posts: 740
great comments and a few notes

Uncletommy, thank you for posting the chart of money velocity.  This has puzzled the conventional economists for years, and my own theory is that since most of the "money" (credit) has flowed to the top 5% which invests  more than the bottom 95%, who spend most of their income/gains, money velocity has naturally stagnated: give a multi-millionaire a line of credit and she'll use it to buy productive assets, not spend more in the real economy. Moneydumped into assets doesn't have much velocity.

Cestin, I respect Brandon's work and am a Patron of his (i.e. give him a few bucks monthly via patreon). The problem with SDRs is they are nothing but a basket of fragile fiat currencies, and so they can't be any stronger or more valuable than the fiat currencies that are constituent parts of the SDR.  If the fiat currency system implodes, SDRs will implode since they're just a basket of national currencies.

A One-World entity would be better off launching their own strictly limited cryptocurrency like bitcoin that is independent of national fiat currencies.

Chris, you describe an aspect of the financial system that I have struggled to grasp, so thank you for the explanation.  This recent article discusses the consequences of the Fed paying interest to banks (i.e. "free money") reserves:

https://www.wsj.com/articles/the-feds-obama-era-hangover-11546374393 The Fed’s Obama-Era Hangover.

The gist of it (as I understand it) is that the Fed doesn't control interest rates as tightly as we've been led to believe.

I agree that psychology (Keynes "animal spirits") is the determinant of many of these moving parts, including household and business borrowing and spending.  If creditworthy borrowers no longer want to borrow, and the bottom 80% have maxed out their credit, the economy rolls over regardless of what the Fed does.

As a side-note, the WSJ article referenced here explains why China is now seeking overseas investnment cash. In other words, it's becoming more like the US.  This suggests China is far more fragile than it lets on:

https://www.zerohedge.com/news/2019-01-04/tectonic-shift-chinas-economy-... "A Tectonic Shift In China's Economy Has Largely Gone Unnoticed By Investors"

davefairtex's picture
davefairtex
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Posts: 5737
rates matter

Banks don't make loans, people and businesses borrow money.  The distinction is really important.

In Japan, nobody borrowed money, and 30 years of deflation was the result.

In a more healthy economy (i.e. more healthy than Japan), raising rates reduces the number of people and businesses willing to borrow money.

While the Fed only controls the short end, if they raise rates on the short end too high, that will cut off a fair amount of borrowing - unless you can make a profit with 20% money, you won't borrow it.

So even just raising IOER does the job.  While it doesn't reduce the amount of base money (which is they way they used to do it), raising IOER will affect private money creation.  And private money creation is a lot larger than base money.

Of course, lowering rates doesn't always induce people to borrow more.  Witness: Japan, last 30 years.  And Europe; rates below 0 hasn't done much to move the needle except keep the zombies alive.

But raising rates almost always results in people borrowing less.  Which directly affects the rate of private money creation, thus affecting liquidity overall.

 

 

Locksmithuk's picture
Locksmithuk
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Posts: 146
CHS
charleshughsmith wrote:

... a lot of things, none of which are related to my question below

 

Charles, have the latest financial shenanigans strengthened / hastened / changed your intention to retire to SE Asia? It always sounds appealing, but I don't think I could hack the humidity.

charleshughsmith's picture
charleshughsmith
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retirement in SE Asia

Right now we're "retirement age" but taking care of / arranging care for our elderly moms (88 and 90), so retirement per se is off the table.  As I might have mentioned somewhere on PP.com, I think the question is more "working comfortably" than retiring comfortably, and so digital/remote work you like would be a plus while living in SE Asia (or something like teaching English, etc.)  I'm also getting a bit more wary of political-social instability, even in nations that are currently stable.  As for humidity, I hear you. Hawaii has a pretty comfortable range of weather and humidity, and my roots in Hawaii go back to 1969, so that's the preferrsed solution at this juncture for us.

That said, when the purchasing power of social security and other retirement incomes drop, SE Asia retirement facilities may well be the only assisted-living/care home many Americans will be able to afford.

charleshughsmith's picture
charleshughsmith
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rates matter

Good point Dave.  To Chris's point, psychology matters too.  I remember reading that in the late 1980s during Japan's credit bubble, bankers were visiting small businesses to push loans the businesses didn't really need. In a booming economy with animal spirits flowing, people will borrow at higher rates b/c they reckon they'll still make profits from the leverage (ditto US housing bubble in 2005 as rates rose). When people sense it's harder to make a profit with higher cost leverage, they stop borrowing.  So the risk-on, risk-off mood matter, too.  Right now rates are rising and the mood is risk-off, so it's a double whammy.

cestin's picture
cestin
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re: SDR's

Charles,

You said:

"The problem with SDRs is they are nothing but a basket of fragile fiat currencies, and so they can't be any stronger or more valuable than the fiat currencies that are constituent parts of the SDR.  If the fiat currency system implodes, SDRs will implode since they're just a basket of national currencies."

A couple of thoughts:

- A stock market crash associated with a "Lehman-like event" that requires immediate liquidity to keep the global banking system solvent, wouldn't be a "fiat currency system implosion".  Not yet, anyway.  However, a market crash/bank insolvency couldn't accept another Fed bailout - particularly if there were multiple world markets crashing and multiple bank "events".  

However, the 5-currency basket that makes up the SDR would have more balance because of its diversity.  In addition, the Chinese yuan could become partially gold-backed if that were needed to build further trust in the SDR.  It's not a coincidence that China's currency was only recently added to the SDR basket.  

And what's the alternative bailout source for such a crisis?

Brandon would certainly agree with your comment on needing a crypto-currency as a global reserve currency.  He suggests that would come into play AFTER the initial use of the existing SDR for a bailout.  He also suggests that the cryptocurrency used would benefit those who control it, unlike our popular cryptocurrencies such as Bitcoin.  A "back door", for example. 

At the time of the "bailout", all the currencies would be weighted as they are now in the basket.  However, in the following year or two, the US dollar would fall greatly in value relative to the SDR (be it still a basket of currencies or a new cryptocurrency), because the US would no longer have the support of the world holding its debt, that comes from having the global reserve currency.  So the US dollar would fall in value, causing great inflation in the US, and REQUIRING greater austerity in the US fiscal spending.  Cutting social programs (and military spending?).  China, as a producer - not a consumer like the US- would have greater economic strength, similar to Germany under the Euro. The US would become more like Greece, under the Euro, with great austerity, and a much lower standard of living. 

Does this explanaiton of the details of a global reset make sense, Charles?

debu's picture
debu
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Posts: 241
Recent Tooze Lecture at the LSE

...at this link.

There is some good stuff on the LSE Public Lecture podcast site.

A recent one by Jonathan Haidt (a David Collum favourite, I believe) titled "The Coddling of the American Mind" was well worth a listen. 

 

charleshughsmith's picture
charleshughsmith
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SDRs

THat's certainly one possible pathway. Any reduction in dependence on the USD would be welcome, i.e. a rebalancing of all major currencies.  But there are other pathways as well. The euro could effectively cease to exist, to be replaced by a new DM, but without the liquidity of the ECB.  As noted in this article, China's trade balance is about to go negative, implying a new need for capital inflows from outside China.  

https://www.zerohedge.com/news/2019-01-05/china-censors-economics-profes...

I can also invision the US and China separately preferring to keep their own currencies due to national interests.  If China were to float its currency (depeg from the USD), it may conclude there's no payoff to joining an SDR.

Lots of feedback loops and agendas in play, we'll just have to see how it plays out.

pgp's picture
pgp
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Posts: 224
Levels of Manipulation

Global economic deterioration is certain, the greatest fear however is that no matter where you live or how you live our democratically elected establishment dictators will leverage the tools of control, the army, police, secret services, media, banks, central banks and corporate leaderships to maintain the status quo.  The oppression might be more subtle in countries like the USA where people believe the constitution will magically protect them.  In Europe however the oppression is already happening.

What does that oppression look like currently?  It looks like taxes.   Not just income tax, savings tax, sales tax or service tax but in the form of draconian regulations that force everyone to take health insurance or pay huge pension premiums on retirement benefits they might never collect.

The economy might collapse but just as the ruling elite have done before throughout history, it is just the level of manipulation that changes as economic malaise spreads.  Devaluing currency is just the beginning.  The wealthy middle class, those in the 10th to 20th percentile for example, could fair the worst; those representing the voting minority who garner no sympathy from the have-nots of the remnant middle and lower classes.  The people who actually worked for their wealth.  These will be an easy target for bankrupt governments. 

Remember the fate of the Jews running businesses or owning property in, post-depression, circa WWII Germany.  We all think gas chambers and firing squads are affectations of an unenlightened era when religious tolerance was nonexistent and human life was cheap. 

The truth is the human animal hasn't changed in thousands of years.  Faced with starvation and poverty, today's societies can still be driven to war and antisemitism but instead of rounding up Jews after the next wave of economic disaster it might be wealthy populists that get crucified.  Pick a label, red, proletariat, capitalist or populist it doesn't matter humanity has this habit of focusing hatred on an idea and persecuting innocent minorities if it helps achieve control.

Snydeman's picture
Snydeman
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Posts: 639
Maybe I'm not understanding it

But wouldn't ANY global currency essentially suffer from the same issues plaguing the Euro

thc0655's picture
thc0655
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Posts: 1743
Yes, but

We can expect the new global fiat regime to last decades and give the elites that much more time and license to keep looting and consolidating their power.

gkcjrrt's picture
gkcjrrt
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Joined: Sep 20 2016
Posts: 14
pgp wrote:... but instead
pgp wrote:

... but instead of rounding up Jews after the next wave of economic disaster it might be wealthy populists that get crucified.  Pick a label, red, proletariat, capitalist or populist it doesn't matter humanity has this habit of focusing hatred on an idea and persecuting innocent minorities if it helps achieve control.

Well, this time they might go after the neocons, who are hardly innocent, given the wanton murder and country destruction their policies have wrought.

Bad behaviour usually get people in trouble over the long run - and if those individuals who wreak the havoc are associated with an ethnic group - the innocents of that group end up getting the brunt of the blow black.  That is why it is important to disavow any association in advance.

 

This 15 year old NY times article is prescient - too bad it was largely ignored - we may have gotten rid of Bush, but not the war monging neo cons and their continued plan to destablize and bring permanent war  to the middle east.

https://www.nytimes.com/2004/01/06/opinion/the-era-of-distortion.html

 

 

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