The growth of finance and looming global financial crisis

There is a growing concern in most developed and developing economies that record string of interest rate hikes to wrestle inflation under control quickly could drive up unemployment and slow down these economies more than expected. Most households in these countries have suffered cut in their real income. Rising interest rates will also cause fall in output and employment leading to squeeze on wages. Therefore, higher borrowing costs could exacerbate the squeeze on real incomes. Any increases in wages have also been mostly offset by rising prices and higher interest rates.
Higher interest rates could also be expected to encourage people to save more negatively impacting on household consumption. If that happens, the demand for labour would slow and unemployment rate is likely to rise beyond the rate required to ensure inflation returns to the target rate in a reasonable timeframe. Over a long period, one can expect that the rate of inflation to be roughly equal to the rate of hourly wage growth, minus the rate of productivity growth.
While inflation risks remain prominent, previous rate rises have larger than forecast impact on broader economy in most developed countries as reflected in the pause in interest rate hike in the US and some other developed economies. Yet, according to the IMF Blog (July 13), while global inflation seems to have peaked, and core inflation somewhat eased, in most advanced economies inflation remains well above central banks' targets.
Meanwhile, to add to the current economic woes resulting from rising inflation, the Annual Report published recently by Basel based the Bank of International Settlement (BIS), the global umbrella organisation of the world's central banks, provides a detailed gloomy picture of a global financial system wracked by deepening problems. In fact, any one of them could set off a crisis on the scale of the 2008 crash or even greater.
The report points out that the combination of high inflation and rising financial vulnerabilities, unprecedented in the post-war period, is resulting from the increase in debt, both public and private. Debt creation has been going on for decades, mostly in response to financial crises that erupted since the 1980s. It is important to note that the 1970s and early 1980s inflationary surge was not accompanied by financial instability. Also, the Global Financial Crisis (GFC) of 2008 occurred at a time of very low inflation.
The report emphasises that this "unique combination of high inflation and widespread financial vulnerabilities" is not "a bolt from the blue" nor the outcome of pandemic or the war in Ukraine. The root cause is much deeper as "debt and financial fragilities do not appear overnight: they grow over time".
The report in analysing the challenge faced by the global economy points out that "in no small measures a growth illusion born out of the unrealistic view of what macroeconomic stabilisation policies can achieve".
In fact, there is an assumption or illusion that all growth is good, and the type of growth does not matter. Also, GDP data (the statistical indicator of growth) do little to alleviate the fear about what the next decade may look like, as well as the uneven income distribution, wage and job security within the country. In other words, growth means GDP growth. This has led to the acceptance of an economic paradigm based on the single-minded pursuit of GDP growth.
The report further states that the pursuit of growth resulted in "a de facto debt fuelled growth model that has made the economic system more fragile and unable to generate robust and sustained growth". In this context it is important to point out that developing countries, in particular in Asia, have increased their borrowing in recent decades exposing themselves to risks arising out of rising interest rates and heightened volatility in financial markets.
"There are widespread macro-financial vulnerabilities in the system. Public and private debt levels are historically high", the report further adds. Therefore, the report suggests, "Interest rates may need to stay higher and for longer than financial markets are pricing in. The strains that have emerged so far reflect interest rate risk, but credit losses are still to come".
Borrowing by governments, companies and consumers and financial firms is currently well above the pre- GFC period in many countries around the world. So highly leveraged companies face much greater risk of defaulting so long monetary policy and financial conditions remain tight.
IMF managing director Kristalina Georgieva while speaking at the China Development Forum in Beijing in late March also warned that the global economy faces risks to its financial stability because of fallouts from the recent banking crises and the formation of rival economic blocs triggered by the Ukraine conflict.
Georgieva also said that 2023 would be "challenging" and the world economy was likely to see growth slowing to below 3 per cent. 'as scarring from the pandemic, the war in Ukraine and monetary tightening weigh on economic activity". She also mentioned the recent crisis in the banking sector in the US and Europe which exposed vulnerabilities in the global financial system.
She further said at the conference that "At a time of high debt levels, the rapid transition from prolonged period of low interest rates to much higher rates - necessary to fight inflation - inevitably generates stresses and vulnerabilities, as evidenced by recent developments in the banking sector in some advanced economies".
She praised policy makers' swift response to the banking crisis and collaboration by major central banks to support the global banking system by boosting the flow of US dollar around the world. She said that they "have acted decisively in response to financial stability risks". She also noted that "These actions have eased market stress to some extent, but uncertainty is high which underscores the need for vigilance".
According to the United Nations Conference on Trade and Development (UNCTAD), the international investment climate was extremely gloomy last year as cascading geopolitical and economic shocks undermined confidence around the world. UNCTAD Secretary General Rebecca Grynspan also said, "Rising inflation, fears of a recession and turbulence in financial markets put many investment plans on hold at beginning of this year".
Despite growing signs of financial instability, even a crisis and warning of a recession, indexes of the three stock exchanges in New York have risen by 70 per cent between March 2020 and March 2023 and are continuing to rise. According to data compiled by Bloomberg and released early in July, the world's richest people added US$852 billion to their fortune in the first half of 2023.
But a very different picture has emerged from a policy brief provided by the United Nations Development Programme (UNDP). The brief notes that successive economic shocks over the past three years including the Covid-19 pandemic, wars and other violence and extreme weather disasters have pushed around 165 million people into poverty around the world.
According to another UN report published prior to the UNDP brief, an additional 122 million people have been pushed into hunger worldwide since 2019 for the same reasons. The brief also mentioned that over the past decade a larger share of public revenue is going into debt service payments by developing countries, thus negatively impacting the delivery of vital social services.
But the BIS report referred to above emphasises further austerity and opined that "The priority for fiscal policy is to consolidate", pointing to the growth of government debt to historic high. The report also argues that "consolidation would provide critical support in the inflation fight. It also reduces the need for monetary policy to keep interest rates higher for longer, thereby reducing the risk of financial instability".
As billions of people on the planet face soaring living costs, declining real wages and growing destitution, Bloomberg notes "the gains (by the world's richest) coincided with a broad stock exchange rally, as investors brushed off the effects of central bank interest rate hikes". The global economy is now not only faced with a looming financial crisis but also with alarming increase in poverty rates and hunger.
Public debt has reached 120 per cent of GDP in the US and the same figure for Japan stands at 128 per cent, the UK 96 per cent and Germany 70 per cent. With such high levels of public debt/GDP ratio, a global financial crisis would plunge the world into a recession with serious economic consequences for developing countries like Bangladesh.
Over the last 30 years of so, the financial sector has become dominant in the leading advanced economies like the US and UK. This growth is apparent whether one measures the sector by its share of GDP, volume of financial asset or by employment. In the US and UK the sector accounts for 8 per cent plus and 9 per cent respectively of GDP, but in a country like Luxemburg the share is a quarter of GDP. It is estimated that the financial sector raked 30 per cent or more of profits in the US in recent years.
The BIS in a research paper (WP No. 490) concluded that the growth of a country's financial sector is a drag on productivity growth or put it another way, financial sector growth crowds out real economic growth. This also means speculative business transactions overshadow the real economy where the real production of good and provision services take place as reflected in the wealth the financial elite in the banking and shadow banking sectors relative to that of the industrial and business elites.
The financial sector has become the central force driving the economy where pricing of goods and services is not determined by the market forces alone but increasingly by movements in the value or prices of financial instruments tracking goods and services.
The sector is very loosely regulated in most advanced economies like the US and such weak financial regulation is a direct product of neo-liberal ideology that took off in the 1980s. The development of the financial sector has led to the increasing subjection of the real economy to volatile dynamics of the sector. In fact, since 1980s there have been at least 12 major financial crises including the GFC of 2008.
Therefore, in order to address the frequently occurring financial crises which appear to have become a norm and lack of market discipline in the financial system, governments, especially in the advanced economies, in particular the US must go past the neo-liberal paradigm. This will entail bringing in a tougher regulatory regime including tougher standards on financial institutions and taxing financial products like sales of stocks, bonds and derivatives as happens in the case of goods and services as well as removing special tax treatment of interest income.

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