The risks for financial markets in 2015 are both economic and non-economic. First, there is concern that policy measures are exhausted and authorities impotent in the face of low growth and deflationary pressures. The ECB president, Mario Draghi, has said options are limited. Takehiro Sato, a Bank of Japan board member, summarised the limits of its powers, saying prices are “not a variable that can be directly controlled by a central bank”.
Second, social stresses are increasing. High unemployment has persisted despite stabilisation and recovery in many economies. For those with work, income levels are stagnant or falling and working conditions are deteriorating.
Third, economic pressures combined with rising inequality are driving political changes. Major parties in many countries have lost support to more extreme and populist parties, such Greece’s Syriza, Spain’s Podemos and Italy’s Five Star party.
Economic difficulties and loss of faith in traditional political parties helped the rise of fascism and communism in the 20th century. Writing in The Spider’s House, Paul Bowles noted: “If people are living the same as always, with their bellies full of food, they’ll just go on the same way. If they get hungry and unhappy enough, something happens.”
Fourth, despite a few vocal and well-financed deniers, environmental change is increasingly becoming a factor. Hurricanes, floods, droughts and fires all have an economic cost and a disruptive influence.
Fifth, geo-political risks are rising. Nationalism is resurgent in Russia, China, India and Japan, driving political tensions. The rise of Isis threatens to overturn a Middle East order that dates back to the 1916 Sykes-Picot Agreement. Deep-seated religious and ethnic divisions will be difficult to resolve. The risk is that the region becomes a series of failed states, dominated by warlords. In East Asia, China is embroiled in territorial disputes with its neighbours.
Sixth, weak economic growth and high unemployment feed political extremism. They encourage geo-political risk-taking as nationalist leaders seek to divert attention from domestic economic weakness. Government spending to revive growth increases sovereign debt. This keeps monetary policies loose, making eventual normalisation ever harder.
Financial markets and investors prefer to ignore these risks. They rely almost exclusively on continued monetary stimulus. Reduction of US Fed liquidity injections is being offset by looser policies in Japan, China and Europe, supporting asset prices. Falling oil prices also underpin optimism, boosting incomes in advanced oil-consuming economies and supporting consumption. Markets are ignoring the fact that low rates, abundant liquidity and decreasing commodity prices are, to varying degrees, the results of weak economic conditions.
Few of the problems behind the recession of 2008 have been resolved. In its 2012/2013 annual report the Bank for International Settlements wrote: “Central banks cannot repair the balance sheets of households and financial institutions. [They] cannot ensure the sustainability of fiscal finances. And, most of all, [they] cannot enact the structural economic and financial reforms needed to return economies to… real growth.… What central bank accommodation has done during the recovery is to borrow time… but the time needs to be used wisely.”
Current policies have encouraged financial risk taking rather than economic risk taking. The risk of a financial system crisis is now high. But there is no sign that the divergence between financial markets and the real economy is likely to fall. The investment strategist Michael Hartnett illustrated the perverse logic now needed to justify current asset prices: “I’m so bearish, I’m bullish… Memo to self: always buy stocks and credit on a negative GDP…”
The position is worse than in 2008. Weaker government finances make it harder to support the economy. With interest rates at zero and liquidity abundant, options are restricted. Emerging markets are weak and will not contribute to global growth as they did after 2008. A new crisis will be like a virulent infection attacking a body whose immune system is compromised.
Satyajit Das is a former banker and author of ‘Extreme Money’ and ‘Traders, Guns & Money’Reuse content