The next big financial crash is on the horizon – and this is where it's going to come from

The idea – shared in Tory and Labour circles – that we can become richer just by Parliament passing a law that says so is possibly the most stupid to emerge from the current intellectual poverty of the political classes

Sean O'Grady@_seanogrady
Thursday 10 August 2017 17:11
What goes up... Many factors could contribute to another recession and financial crash
What goes up... Many factors could contribute to another recession and financial crash

Not everything that goes wrong in an economy spurs a national, let alone a global, financial crisis and a subsequent recession on the scale of the one we endured a decade ago (and the baleful effects of which are still feeding through the economy). It’s also true that such “Black Swan” events by definition cannot be predicted. Even so, there are some fairly obvious, and some not-so-obvious red lights flashing away on the economic dashboard for Britain, for Europe and for the wider world.

China crisis

Quite a few distinguished economists have pointed to the go-go Chinese economy as a source of potential global problems, and they’re right to do so. The sheer size of the Chinese economy, second biggest in the world, means that it matters, not least because it is the leading buyer for the vast quantity of United States Treasury securities. Second, the Chinese economy, for all its brashness and export success, is not some sort of free-market paradigm but a deeply flawed, semi state-controlled opaque system where bad debts and failing enterprises are camouflaged by the authorities in Beijing, who value prestige more than productivity.

Thus, certain parts of the economy may well be far less stable then even we imagine.

Nowhere is this more true than in the Chinese banking system and the overhang of credit that threatens some with implosion, or having to be saved by further subventions from the Chinese state. Either way, loans forwarded to pay for investment or consumption based on assumptions about income and profit growth may well not be redeemed as the economy proves disappointingly sluggish. As with the crash in the West a decade ago, a loss of confidence in a few banks can soon spread systemically throughout the system, twisting local problems into a national spiralling disaster.

If the Chinese economy sneezes and is less able to lend more money to the Americans to buy more Chinese goods, then that will be bad news for America, too. The antics of Kim Jong-un are an obvious catalyst for some sort of financial panic – a far more potent weapon in reality than his nukes.

Protectionism

The ugly truth about Donald Trump’s promise to make America great again via protectionism is that, in the short term, he is right. Banging tariffs and non-tariff barriers on imports will indeed make companies build and invest and create jobs in the US. Americans as consumers will have to pay more for their cars and other goods they’ve been accustomed to freighting in from low cost bases in Mexico or Thailand, say, but as workers some regions will benefit.

As with all “beggar my neighbour” policies though the ratcheting up of tit-for-tat trade barriers worldwide, which began in the last crash, will simply choke off world economic growth, stifle improvements in productivity and lead to fewer jobs all round by the end of the sorry process.

A slow motion crash, but, as we saw in the 1930s, no less pernicious for that.

Car loans

It is no exaggeration to view these as the “new subprime”. More accurately called PCPs (Personal Contract Purchase), it is how much of the auto industry gets its business in the West. Unusually it is a game that the consumer need not lose. For if at the end of a three year lease period their lovely diesel saloon is suddenly worth next to nothing, then they can simply walk away from the deal, rather than pay the “guaranteed sum” the car company is offering to sell them the car for – that is when it is above the market value. In that case, the manufacturer has to take on its overvalued metal and dispose of it as best it can. That means a loss on very many cars sold, especially in the diesel sector, responsible for about a half of new car sales in Britain.

Most car makers set up affiliates or subsidiaries to organise finance deals, and these were and are basically banks, and sometimes joint ventures with banks. As with the old mortgage backed securities, these car loans can be packaged up, diced and spliced into tranches of similarly collateralised debt obligations. Now as then, some of the clients, and some of the car models, will become problems, defaulting and devaluing along the way.

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The losses might once have been the responsibility of the car makers’ finance arms, but now will find their way around the financial system to any investment fund, pension pot or other bank that bought a bundle of them because they offered a temptingly higher return in a low interest rate era – what was called the “search for yield” in the old days.

As with mortgage backed securities, no one knows who’s got the dud stuff, and in such circumstances the suspicion may become pervasive enough to destroy confidence in the system. Not good, and, being relatively expensive items, car finance is second only to home finance in its size and dangerousness to the wider economy. That is how a consumer could get run over by the great car loans crash, turbo-charged by the devaluation of the residual values of diesel engine variants after the VW emissions scandal.

Pension freedoms lost

We can’t be at all sure how this one will pan out, but on top of the inevitable losses to scammers and idiotic get rich quick schemes, there is a more sober version that will see people take funds out of their pension pots, sensibly, spend the cash, or give it to kids and grandkids, and then, living longer than they ever dreamed, finding themselves with nothing left and forced to throw themselves on the “mercy” of the state. Given the sums involved and the ageing population, this too threatens a slow erosion of the public finances that is already bad enough because of the residential care crisis and the state pension “triple lock”. The economic effect lies in the impact on the UK's structural public finances, i.e. it makes them still less sustainable than they are now.

A Corbyn government, by the way, would simply add to the pressure on public finances, the UK's credit ratings and ossify Britain’s flexible labour market, one of its few remaining competitive advantages. I admit Theresa May’s government is messing up in its own ways, mind you, and actually shares some of Labour’s utopianism about workers’ rights.

The Living Wage

Ever increasing minimum wage levels sound nice, but eventually they will take their toll on business and employment. This is via two main channels. First, eventually legislation will set wages at so high a level that some sectors of the economy simply become unviable – hotels, restaurants, car workers and many others. Eventually jobs and business will be lost.

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Second, more systemically, eventually minimum wages will eventually be set so high – in an era of general stagnant wage growth – that they erode “differentials” with more skilled or responsible workers, and you will then see demands from successive tiers of workers to redress the balance between their salaries and those lower down the scale. Such pressure on wage bills will push inflation higher, potentially creating a wage-price spiral not seen for decades, and in due course destroy businesses, investment and jobs. The idea – shared in Tory and Labour circles – that we can become richer just by Parliament passing a law that says so is possibly the most stupid to emerge from the current intellectual poverty of the political classes.

Rising interest rates

The Bank of England is unwilling to raise them, but events outside of its control may force its hand. If so, then the effects on business confidence, household budgets (with huge mortgage bills) and investment will be dire.

A housing crash

These only ever arrive when people go around saying that they are impossible because of demographic factors, or shortage of supply or that rising prices are just a fact of life like the seasons or Aston Villa losing away. Yet a British housing crash in far from unprecedented, could arise from any number of obvious factors: a general slowdown in household incomes; higher interest rates; a disinvestment by foreign interests; the magic factor of confidence evaporating; oversupply in some sectors as the house builders finally start building just in time for the downturn, or a combination of all of these. It would be good news for first time buyers if they could get a job.

Brexit

Even those in favour of it should admit that the short-term pain will be substantial, and the economy will take many years to adjust. That adjustment will be made all the more difficult – and even politically impossible – if some or all of these other factors are taking effect.

A eurozone crisis

Anyone who thinks that it’s all gone quiet over there and that everything’s now ok misunderstands the inherent structural weakness in our largest trading partner – the eurozone nations. Italian banks and the Greek state are old favourite weak spots, but a slowdown in German exports or the failure of Macron’s proposed reforms France could lock much of Europe into long-term stagnation, and a short term existential crisis if the German taxpayer is either unable or unwilling to pick up everyone else’s bills.

All of the above

National economies, industrial sectors, the financial system – all are intimately interlinked in a globalised world. Individual banks, at least outside parts of Europe, are probably stronger than they were a decade ago, if only because the central banks and governments insist as usual on “fighting the last war”.

There are plenty of areas where things are worse than they were in the 2000s; the US-China economic imbalances are fundamentally the same; the eurozone is still a series of accidents waiting to happen; Britain is still a victim of its failure to be more productive and export, preferring to borrow to consume imports, the funds underwritten by the taxpayer. Any one thing could go wrong and we’d able to cope because we’ve used up so much “headroom” to borrow and print money getting out of the last crash. If it all starts unravelling again then the stock of ammo at the hands of ministers and central banks is running low.

The next crash could make the last one look like a tea party.