Is the Next Financial Crisis Looming?

While so much of the world’s attention has been focused on the inability of the global economy to stage a strong recovery from the last financial crisis, a new financial crisis may be brewing that could derail this fragile recovery and send the global economy into another tailspin.  This time around, much of the blame for this emerging threat to the global economy has been directed towards the world’s leading central banks, as their use of extraordinary measures to revive the global economy is now raising economic risk levels around the world.  In recent years, most central banks have acted aggressively to restore economic growth. 

These aggressive measures that were aimed at boosting the global economy have instead dramatically expanded the balance sheets of most central banks while producing dangerously high debt levels.  Furthermore, the incredibly low interest rates that have remained in place in recent years have significantly weakened the financial sectors of many countries, while increasing the number of potential financial flashpoints around the world.  Worse, these policies failed to generate the levels of economic growth that were hoped for when they were enacted, thus raising risk levels while producing few rewards.

The main legacy of the measures used by central banks to boost economic growth in recent years has been the dramatic expansion of the balance sheets of these central banks.  A good example of this is in the United States, where the quantitative easing programs undertaken by the Federal Reserve resulted in the size of the Fed’s balance sheet rising from $800 billion in 2008 to more than $4.5 trillion today, the most dramatic increase in its history.  Around the world, the size of the cumulative balance sheets of the world’s leading central banks has risen from $6 trillion in 2008 to nearly $18 trillion today, with major increases in China and Japan in recent years.  These moves have been done in a bid to boost the global economy through the encouragement of risk-taking by businesses and consumers, but unfortunately, this has not had the desired impact as growth rates have remained well below target levels.

In recent years, these aggressive bond buying programs and ultra-low interest rates have sent debt levels soaring around the world, in strong and weak economies alike.  According to a recent study from the International Monetary Fund (IMF), global debt levels have risen to a record-high of 225% of global GDP, with nearly $100 trillion in debt being owed to the private sector alone.  In two key economies, these debt levels are proving to be particularly worrisome.  In China, the dramatic increase in the availability of credit has led to huge bubbles and over-capacity in many areas of the economy, threatening to lead to a major crisis in the world’s second-largest economy.  In the Eurozone, public debt levels remain dangerously high, particularly in highly vulnerable southern European economies such as Italy, Greece and Portugal.  One other risk that has emerged as a major threat is the fact that much of the world’s debt is denominated in US dollars and the recent appreciation of the US dollar is exposing more vulnerable debtors to significantly higher default risks, especially in emerging markets.

In recent years, the policy of many central banks has been to dramatically increase their level of bond buying, a move designed to boost risk-taking in order to stimulate a sluggish global economy.  However, this policy has led to the creation of an increasingly dangerous global bond market bubble.  An example of this bubble is the fact that now there are more than $12 trillion in sovereign bonds that are being trading at negative interest rates.  Moreover, this policy has led to a significant decline in credit spreads between high-risk and low-risk investments.  For example, the Italian government can now borrow at a lower interest rate than the United States government, despite the myriad of economic and financial problems facing Italy today.  As a result, there is a significant risk that the bond market bubble that has developed in recent years is getting closer to bursting, a development that would have massive repercussions for the health of the global economy.

The combination of these risks that have developed as a result of the policies pursued by the world’s leading central banks in recent years has led to the growing threat posed by a number of economic and financial flashpoints around the world.  Three of these flashpoints are found in Europe, a region that has struggled to generate much economic growth in recent years.  First, southern European economies (with the recent exception of Spain) have struggled to generate any growth in recent years and continue to be vulnerable to external or internal shocks.  Second, Europe’s banking system remains extremely weak, with low (or negative) interest rates severely impacting the health of most European banks.  Third, the uncertainty surrounding the United Kingdom’s impending withdrawal from the European Union is adding to the uncertainty facing Europe. 

Outside of Europe, China’s credit bubble could lead to a hard-landing for a country struggling to deal with lower rates of economic growth.  Elsewhere, Japan and the United States are also facing threats linked to their high debt levels, with much uncertainty surrounding the incoming Trump Administration’s policies in the US.  Altogether, the global financial system may be on the verge of creating yet another sharp global economic downturn as its policies have led to dangerously high levels of risk that threaten to bring an end to what has been a very anemic recovery.