Why am I not predicting another Great Financial Crisis?
The answer can be found in the 'Bailout State'
There can be no clearer signal of a massively inflated financial bubble than this story from the Financial Times of Saturday, 29 November, 2024:
The crypto entrepreneur who paid $6.2m for a banana taped to a wall has eaten the art work in an onstage spectacle, declaring that, like a digital asset, “the real value is the concept itself”.
Justin Sun, the Chinese-born founder of cryptocurrency platform Tron, who was charged by the US Securities and Exchange Commission last year over fraud and other securities law violations, also hailed Donald Trump for his support of the crypto industry.
Sun ate the banana at an event in Hong Kong on Friday that came amid a crypto boom that has gathered pace since Trump’s election victory this month, with Bitcoin surging to record highs.
My world changed with the publication of a book in 2006 that predicted the Global Financial Crisis. Against my strong preference - I had signed away rights to the title - the publisher insisted on calling it The Coming First World Debt Crisis. The book was written in 2005-6, and I was convinced that by the time of publication in September, 2006, the crisis would have happened, and my book would be out of date. How wrong I was - and how grateful to the publisher, as the title has served me well.
My thesis was mainly based on the systemic economic imbalance caused by high levels of private and public debt relative to real output and income in Anglo-American economies. I did not believe these imbalances were sustainable, and expected them soon to implode. (I was not alone in this analysis. There were many others that shared my concern, including Bill White of the BIS, John Paulson a hedge fund manager and Prof. Steve Keen.)
Back in 2007, according to McKinsey (2018) the world’s total debt (government, non-financial corporations and households) amounted to 198% of global income (GDP).
That proved unsustainable, and duly imploded.
By 2020 global debt had reached 256% of GDP (IMF 2021).
By 2024, global debt had risen to a whopping high of $315 trillion in Q1, 2024 - 331% of global GDP, according to the Institute for International Finance, in May, 2024.
And yet there has been no equivalent implosion to that of the Great Financial Crisis 2007-9.
How can that be?
A new, globalised and de-regulated banking system
In the real world, where work is done, people are employed, things are made, grown and produced, global income (GDP) in 2023 was estimated at $105 trillion.
In the shadowy world of globalised markets in money, the total value of financial assets amounted to approximately $450 trillion by the end of 2022. (FSB). (Financial assets include cash, stocks, bonds, mutual funds, and bank deposits owned or managed by regulated commercial banks on the one hand, and in the de-regulated ‘shadow banking’ sector managed by asset managers, pension funds, private equity firms and hedge funds.)
The value of those liquid financial assets have to be maintained and increased in value if for example, pensions are to be paid in the future, debts honoured and insurance claims satisfied. That means the money/liquidity must be invested in real assets that generate income - rent, interest, capital gains or profits.
Given that $450 trillion of liquidity far exceeds real income from economic output, the consequence of investing $450 trillion in fixed and existing assets like London, Shanghai and New York property, or in commodities like gold and Bitcoin is predictable: the value of those assets will inflate - wildly.
Owners of inflating assets - as Justin Sun would confirm - find their wealth spiral to giddying, stratospheric heights.
Milton Friedman and Anna Schwarz explained the cause of the inflation in their book A Monetary History of the United States, 1867–1960.
Inflation is everywhere and always a monetary phenomenon, resulting from and accompanied by a rise in the quantity of money relative to output.
I am grateful to Prof. Pettis for reminding us of those last three words, so often forgotten when reciting the first part of that famous sentence. 1
Too much money chasing too few income-generating assets causes asset wealth to inflate - a happy state of affairs for the world’s billionaires and oligarchs.
That is, until those same assets deflate.
The ’shadow banking’ system - where about $217 trillion is parked - is growing at an annual rate of around 6-9% - significantly faster than the traditional commercial banking system, with more and more loans being granted by what the FSB prefers to call ‘nonbank financial intermediaries’.
And while the shadow banking system is busily expanding the global supply of debt to financial elites, those debts are leveraged against the presumed value of existing collateral (assets) - including digital assets, where
the real value is the concept itself.
Unfortunately for the rest of us, the de-regulated ‘shadow’ system is closely tethered to the regulated financial system operating in the real world where we work, make and grow things.
Big Government and Big Debts
The foundation of the ‘shadow’ banking system is collateral.
Collateral, or assets, are vital to the operation of ‘shadow’ markets in money – where cash is offered in exchange for collateral. The collateral is repurchased later by the lender at a higher value - which higher value represents ’the interest’ or ‘return’ on the loan, and is paid by the borrower.
Collateral provides a guarantee of repayment. Both the interest rate (or ‘haircut’) on the repurchase agreement (repo) and the collateral, are vital to the stability of the globalised system.
It may come as a surprise, but government debt, far from being the bogey depicted by so many, constitutes the very foundation of the shadow banking system. OECD states issuing public debts, have become “collateral factories” for private finance as Prof. Daniela Gabor has argued.
The global economy now transforms things – land, grains, energy, metals, brands - even a banana taped to a wall - into income-generating assets. (The banana generated a price of $6.2 million!)
They are assets whose value in the present are calculated on the basis of yet-to-be-actualised future income streams.
The valuation of assets
Reflecting on the banana taped to a wall, we are reminded of Justin Sun’s extraordinary insight: “the real value is the concept itself”. (Emphasis added)
An asset is a property title that must be constantly valued as a balance sheet item but often cannot be precisely and readily traded.
The Great Financial Crisis was caused by a failed asset valuation. By the realisation that “the concept itself” had no calculable value.
BNP Paribas announced in August, 2007 that
the complete evaporation of liquidity in certain market segments of the US securitization market has made it impossible to value certain assets fairly – regardless of their quality or credit rating. (Emphasis added)
Big Government and Big Banks - the ‘Bailout State’
So why has the system not yet failed? Why has there not been a repetition of the sub-prime meltdown?
Why am I not predicting another Great Financial Crisis?
The answer can be found in the ‘Bailout State’.
Because the shadow banking system is so large (47% of global financial assets) and because it so interconnected with High St banks, its failure would bring down the global economy.
The response of the authorities after the GFC was the step-by-step construction of a too-big-to-fail regime for Wall St banks and other financial institutions.
On the 18 May 2020: CBS News’s Scott Pelley interviewed the governor of the mighty Big Bank that is the Federal Reserve. The Fed had just bailed out the shadow banking system in March, 2020, at the height of the pandemic crisis.
Scott Pelley asked the governor: ‘Has the Fed done all it can do?’
Jerome Powell was emphatic:
Well, there is a lot more we can do. We're not out of ammunition by a long shot. No, there's, there's really no limit to what we can do with these lending programs that we have.
So relax folks.
There may be giant bubbles floating around, but thanks to the Bailout State, everything is fine and dandy for Bitcoin billionaires, Silicon Valley oligarchs and Asset Fund managers - and their representative in the White House.
Professor Michael Pettis reminded readers of the full quotation from Friedman and Schwarz in his Carnegie Endowment Fund article of August, 2024.
The bailout state, as it stands, cannot save us. Without addressing wealth concentration, it perpetuates inequality. Without recognizing ecological limits, it accelerates environmental collapse. Without reforming political power dynamics, it entrenches plutocracy. True resilience requires a systemic transformation: redistributing wealth, realigning economic priorities with sustainability, and democratizing power?
Surely something has to give when, as you say, "The ’shadow banking’ system - where about $217 trillion is parked - is growing at an annual rate of around 6-9%." With a reasonable set of assumptions, in just five years the $217 trillion will be $300 trillion. I assume "So relax folks" is tongue-in-cheek.