Is the global economy heading for a Minsky moment?

Now the global economy is experiencing the best period of economic growth since the Global Financial Crisis (GFC) of 2007-08 which caused greatest economic meltdown since the Great Depression of 1929-33. The International Monetary Fund (IMF) in its latest World Economic Outlook report (October 2017) also upgraded its forecast for global growth. It predicts that global growth in 2017 would be 3.6 per cent, and 3.7 per cent in 2018. According to IMF chief economist Maurice Obstfeld the current acceleration is notable because it is broad-based and offers an opportunity for developing policies to raise economic resilience in the future. Such an optimistic outlook is also supported by the Organisation for Economic Cooperation and Development (OECD). A recent report published by the OCED noted that the global economy is now growing at its fastest pace since 2010, and this acceleration in economic activity is increasingly becoming synchronised across countries.
Such an economic upturn following a major downturn like the GFC normally leads to increased investment leading to both output and employment growth with rising wages. But IMF report clearly indicated wages growth remained low. In effect, real wages growth has displayed a secular declining trend.
As the global economy is showing signs of strengthening, foreign trade is also exhibiting a rising recovery trends. We are also witnessing strong performance in stock prices in all leading advanced economies, in particular all three major US stock indexes have recoded high in 2017 and continuing as 2018 begins. In the wake of the passage of Trump's tax cut bill in the US Senate, the Dow-Jones Index hit a new record high. As stock and housing markets in major developed economies are continuing to rise, there is growing weariness that a new financial crisis may be in the making.
The Bank for International Settlement (BIS), popularly known as the central bankers' bank, issued a warning in its latest quarterly review of financial conditions that the current situation bore similarities to that prevailed in the lead up to the Global Financial Crisis (GFC) of 2008. A huge volume of investment has now once again started to flow into speculative investments in property and futures trading including in the cryptocurrency bitcoin. Now the global economy is possibly going through a phase of very high levels of asset prices, indeed it is very high even in the historical context.
The current surge in speculative investment has its root in the broader development in the global financial system following the GFC, where all leading central banks went for bailing out collapsing banks and then pump priming trillions of dollars into US and global financial markets along with setting historically very low interest rates. The outcome has been rising asset, stock and house prices to new highs. The record low interest rates encouraged even large corporations to invest in high return investments and also repurchasing their shares on a very large scale instead making new investment in productive activity. Former US Treasury Secretary Lawrence Summers indicated that economic growth in the USA 2017 had been driven by a stock market rally resulting in an increase of more than US$6 trillion in household wealth which went to a very rich segment in the country
There is no built-in automatic mechanism in the global financial system to correct high global asset valuation. Eugene Fama's "efficient market hypothesis'' tries to provide a framework how efficiently financial markets operate. His hypothesis postulates that the prices in financial markets reflect all available information, thereby, by using them investors exploit all profit opportunities. So there is no room for earning economic rent by speculative means, therefore, financial markets are able to channel money around the economy efficiently. As it turned out during the GFC, people were not fully informed and financial markets are far from being efficient. In effect Fama's hypothesis is now totally discredited.
One would naturally expect to rein in, in a short period what the former Federal Reserve chief Alan Greenspan described as "irrational exuberance'' by exercising vigilance and prudential supervision of financial institutions. Instead during the Clinton administration, the Glass-Stegall Act of 1933 was abolished. The Act was designed exactly to prevent a recurrence of the rampant speculation that preceded the Great Depression of 1929-33. Wall Street had been pushing for the abolition of this act since the 1980s and also to weaken federal supervision of financial institutions. In effect, a carte blanche was given to banks what they could do.
With rising asset prices fuelled by cheap money, the world is more indebted now than it was before the GFC. While asset prices remain high there is always a risk of a sudden correction which could destabilise a financial system and the global economy. The appetite for risk taking is now fuelling a "speculative euphoria'' which can only lead to Minsky having his moment again.
The idea of "Minsky moment'' is derived from the work of economist Hyman Minsky. The term found its first expression during the Asian Financial Crisis of 1997 and a revival after the GFC. The term implies when asset prices experience a long period of growth fuelled by leverage can collapse if pressures are introduced. During the 1997 Asian Financial crisis (in effect it was an exchange rate crisis), when speculators put an increasing pressure on dollar-pegged currencies causing eventual collapse of those currencies. The root cause of the GFC of 2007-08 (this was primarily a banking crisis), was securitised mortgages which enabled banks to provide without worrying about if they would be ever paid. The risk was shifted to investors who bought those securities, most often even without fully comprehending what those securities contained because they were so fangled. No wonder the GFC was heralded by the collapse of two Bear Stearns hedge funds which had invested heavily in mortgage securities, then the collapse of Lehman Brothers leading to breakdown in the global financial system. Rest are now history.
Minsky clearly identified that banks create money by making loans and that powers the economy - and eventually that leads into a crisis. In an upward spiralling asset markets, banks loan out money assuming asset prices to go up further (e.g., house prices).Now lenders and borrowers are creating a self-fulfilling upward spiral - which ends as a bubble and all bubbles eventually burst followed by a recession. Now comes the "Minsky moment'' where lenders get cold feet and ask for loan repayment and banks stop lending money to risky borrowers and asset prices ( e.g., houses) tumble. Minsky said innovation in financial markets (e.g., securitisation) help cause speculative finance. He observed that the root cause of financial crises and recessions are financed-based capitalism.
Deutsche Bank published its annual long-term assets survey entitled "The Next Financial Crisis". In it the bank identified rather a long list of trigger points which could lead to a financial crisis. They include a recession, a disorganised central bank unwind, deflation; an asset market crash; and a collapse in market liquidity. Triggers could also come from countries such as China, Japan, Italy or Britain. The Deutsche Bank experts are pretty sanguine the next crisis is on its way but they are not yet sure when it will unfold and where it will hit first.
There is a surge in "speculative euphoria'' in financial markets now and they are disregarding the warning signals. That being so, it is now increasingly becoming evident that it will be almost impossible to avert a Minsky moment-style collapse. If that happens, we will be out of ammunitions to tackle the situation given that most advanced economies have already negative to near zero interest rates and very high levels of public debt.
The writer is an independent economic and political analyst.
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