There will be another financial crisis. It’s just a question of when
Financial bubbles are inevitable and their pathologies virtually identical. The only variable is timing. This is why financial crises appear so obvious in hindsight yet remain frustratingly difficult to predict.
A few years ago, the hedge fund Winton Capital produced a handsome and richly-illustrated book called The Pit and the Pendulum, chronicling many, but by no means all, of the financial crises throughout history.
Winton makes its money by using sophisticated mathematical models to detect when assets are mispriced. It shouldn’t work, according to the efficient market hypothesis, which posits that current prices fully and accurately reflect all available information. But David Harding, the founder and chief executive of Winton Capital, thinks the hypothesis is bunkum. He recently told a conference that if markets are efficient, he must be either “a lucky monkey or a fraudster”, adding that “neither of those characterisations appeals”.
Markets are, Harding argues, human constructs. As such, they are prey to every human foible. His comprehensive chronicle of speculative mania and panics was meant to hammer home the point.
The book includes well-known bubbles, such as the tulip mania that gripped 17th century Holland, and the boom in US subprime lending which resulted in the 2008 financial crisis. Along the way, it ventures from the wilds of Qajar Persia to the bazaars of Constantinople, and highlights little-known bubbles such as the Japanese rabbit mania of 1873, during which fluffy bunnies imported from Europe could fetch up to ¥600, at a time when the average monthly salary was about ¥0.6. (Apparently those with yellow ears were particularly highly prized.)
The same thing happened with diving patents in the 17th century (which were supposedly going to be used to salvage sunken Spanish gold in the Caribbean); Brazilian rubber in the 18th century; and Spanish merino sheep, mulberry trees and British railway securities in the 19th century. And so on and so on: history stuck on repeat.
Such financial crises tend to occur every two to three years on average, according to Danske Bank, which helpfully points out that the last one, the European sovereign debt crisis, ended more than three years ago. The pattern is always the same. Cheap money floods the financial system. In 19th century Japan it was compensation payments made to samurai who were disbanded in the wake of the Meiji Revolution. Since 2008 it has the been the 637 individual interest rate cuts perpetrated by global central banks and their combined purchase of more than $12 trillion in assets, according to Bank of America Merrill Lynch.
That money flows into the less risky assets and pushes their yield (which moves inversely to price) down. Investors get greedy and start looking at riskier assets. They also start borrowing money to make these investments. This drags in the banks. Leverage builds up. Bubbles start to inflate.
So where might this currently be happening? Where to begin? Emerging market debt is a good candidate, as are US high-yield bonds. The Chinese construction bubble has arguably already burst and dragged global commodity prices down. But we have still got London house prices, government bonds, energy and commodity companies (especially US shale producers) and additional Tier 1 securities issued by banks, to name but a few frothy assets.
At some point, money will become less cheap and the process will go into reverse. This is why the financial world is hanging on every word that the chairman of the US Federal Reserve, Janet Yellen, utters. It is also the reason behind the current obsession with the efficacy of negative interest rates in certain parts of the world.
In Denmark and Switzerland, banks have to pay to place money on deposit with their central banks. Some are passing this on to customers by, for example, increasing mortgage rates. And why is that important? It means that central bank monetary policy decisions that have been designed to stimulate the economy are actually resulting in a tightening of credit. This is, needless to say, far from ideal. It could be among the first, faint signs that the world’s central banks are running out of room for manoeuvre.
Are we close to the crucial point in every crisis – sometimes known as the Minsky moment – when overconfidence flips over into fear? This is what causes markets to crash, banks to start withdrawing credit and economies to plunge into recession.
Emotion plays a crucial role, because markets are not efficient. Jeffrey Currie, the senior commodity analyst at Goldman Sachs, put out a note on Monday which argued that the markets had “nothing to fear but fear itself”. But that is not so reassuring, because fear appears to be taking hold. Gold has risen by more than 14pc this year; Bank of America’s latest fund manager survey found that investors have a bigger portion of their portfolios invested in cash than at any time since 2001.
Perhaps the admittedly benign economic fundamentals outweigh the financial dislocations. But add to the latter a palpable sense of fear and the balance begins to tip.
That is why all eyes are trained on the meeting of G20 finance ministers and central bank governors in Shanghai, appropriately enough, on February 26 and 27.
Bubbles always burst. But some grow a little larger and float a touch longer on the breeze before they do. The question, therefore, is not “if” but “when”. One wrong step by the world’s central banks and that could be sooner rather than later.