Amid all the noise coming out of Washington these days, it seems that the remarkable run of Western stock markets in 2017 has come to be taken for granted by the average investor. Historic highs come and go every few months; consumers note them for a moment and then go about their lives. Yet, in this ten-year anniversary of the Great Depression, one has to wonder whether we are looking at a sound economy roaring ahead into prosperity or another superficial wave of optimism that seems to have forgotten the lessons of past financial disasters. This exact question is the focus of a recent Project Syndicate “long read” analysis by Benjamin Cohen (Professor of International Political Economy at the University of California, Santa Barbara, and the author of Currency Power: Understanding Monetary Rivalry).
Early in his article, Professor Cohen presents a succinct summary of what we have been through since the global economy escaped its worst-case scenario a decade ago:
Once it became clear that another Great Depression had been averted, policymakers shifted their attention to the financial sector, where, as Antonio Foglia of the Institute of New Economic Thinking points out, “around half of the 101 banks with balance sheets larger than $100 billion as of 2006” had failed. The ensuing reforms, Simon Johnson of MIT Sloan explains, focused primarily on financial institutions that “were so large relative to the economy that they were ‘systemically important’ and could not be allowed to go bankrupt.”
To a surprising degree, notes Howard Davies, the Chairman of the Royal Bank of Scotland, “Governments that had been suspicious of international interference” were suddenly “eager for tougher global rules to prevent banking crises from spilling across borders and infecting others.” Those rules would come from global standard-setters such as the Basel Committee and the Financial Stability Board (FSB), which was established in April 2009 as an expanded version of the old Financial Stability Forum. The Basel Committee, operating under the aegis of the Bank for International Settlements, issued a broad set of post-crisis banking rules, known as Basel III, in 2010-2011. And the FSB regularly convenes central bankers and financial regulators from more than two dozen countries to monitor global risks and coordinate supervision.
As a result of these efforts, banks in advanced economies are now required to bolster their risk-absorbing capital reserves, clean up murky balance sheets, increase liquidity, improve transparency, narrow the scope of high-risk activities, and realign internal incentives to discourage reckless behavior. Moreover, governments now conduct regular “stress tests” to assess financial institutions’ solvency. And, under the 2010 Dodd-Frank Act, the biggest US banks are obliged to develop “living wills” to ensure an orderly bankruptcy.
Aside from the fact that most of the people who caused the Great Depression escaped with their fortunes and careers intact, for the most part regulators in the West have tried to take concrete measures to avoid a recurrence of the speculative over-leveraging that led the world to the brink of economic collapse. However, given the economic, political and social realities, it’s clear to anyone who looks that (a) we have serious systemic risks still in place and (b) that there is really no less chance of another collapse in 2018 as there was in 2007. Indeed, Prof. Cohen lays out several of those risk dimensions in his analysis, each of which alone would be cause for serious concern:
…Mark Roe of Harvard Law School identifies “a serious weakness in the global financial system’s architecture” that still has not been addressed: “the trillion-dollar overnight repo market in housing mortgages.” According to Roe, reforms to this area of the financial sector fall short, “largely because they depend on the authorities and the banks to complete a complex and untested repayment process within 48 hours of a bank’s collapse.” If an “economy-wide financial event” occasions the “simultaneous collapse of multiple financial firms,” he warns, this process would be “extremely difficult,” if not impossible, to complete. Roe worries that when the US housing market retreats, as it eventually must, “financial stability could be threatened” once again.
…Johnson contends that, despite Dodd-Frank’s living-will proviso, “there has been almost no progress in terms of ensuring that large financial firms actually can go bankrupt.” American legislators have effectively reached a stalemate over how best to “finish this important piece of Dodd-Frank business.” And as New York University’s Nouriel Roubini reminds us, banks are confronting a number of new challenges, such as “the rise of financial technology that threatens to disrupt their already-challenged business models.”
Another problem is that US and eurozone regulators disagree on the role that a bank’s internal models should play in measuring its assets. Because US and European financial institutions have different lending practices and asset portfolios, negotiations over this issue have dragged on for years. Given these hurdles, a degree of caution seems warranted. The defenses in place today are certainly better than they were before. But no one can account for every possible contingency that might befall the banking sector. Shiller is right to warn that unforeseen events “may once again reveal chinks in our financial armor.” Bankers and regulators alike should heed the Boy Scout motto: Be prepared.
And then there are the dangers that we have not yet detected, what former US Secretary of Defense Donald Rumsfeld famously called “unknown unknowns – the ones we don’t know we don’t know.” Somewhere in the complex recesses of global finance, there are almost certainly unknown unknowns that could trigger a new crisis. “[I]t would be premature,” El-Erian rightly warns, “to assert that we have put all the risks confronting the financial system behind us.”
I see a few serious potential contenders to take over the “TBD” category in the next few years. The first of these are the so-called “dark pools,” where institutional traders can buy and sell off-exchange. I wrote about dark pools back in 2013, noting that:
Dark pools were invented to solve a real problem…the need for buyers and sellers to trade large blocks of stock without moving the market during the course of the trade. In other words, if I want to sell 1 million shares of Apple, and start to sell them in 10,000 share increments, today’s High Frequency Trading (HFT) algorithms will identify my strategy and act accordingly, which may not be what I want to happen. Institutional traders wanting to avoid this market signaling naturally turn to Dark Pools to avoid alerting the markets of their moves during strategy execution.
Dark pools operate, as their name suggests, outside of the strict regulatory oversight mechanisms that were put into place after the Great Recession, and therefore could be sowing the seeds of the next crisis. Indeed, as a July Bloomberg Markets piece noted:
It’s quite clear that the caps are going to kill off dark trading in a lot of stocks, but we might see systematic internalizers and other ad hoc ways of trading starting to flourish,” said Niki Beattie, a consultant who runs Market Structure Partners in London. “The world is evolving into something different, and we do not know what it is.
According to one analysis, dark pool volumes were about 14.5% of volume in 2016. That’s certainly enough volume to affect the overall markets. Moreover, that same analysis noted that “dark pool volumes have historically tended to be inversely correlated with volatility.” If that historical trends still hols, then that 14.5% figure could be even higher now. Indeed, more than one Wall Street watcher has speculated that some major banks are using their own dark pools to keep the equity price spike in place. This quote from the Wall Street on Parade web site is typical:
As we contemplated a more rational basis for the heady uplift in Wall Street bank stock prices this year, we were forced to consider the fact that the Wall Street banks run their own Dark Pools — which are effectively unregulated stock exchanges. That’s right. In addition to owning FDIC-insured banks holding Mom and Pop deposits; in addition to parking trillions of dollars of squirrely derivatives on the books of the FDIC banks; in addition to using those demand deposits to make wild, speculative gambles in the markets; in addition to being charged by regulators around the globe, including the U.S. Justice Department, with an insidious disregard for rigging and colluding in markets, the very same banks are allowed to operate quasi stock exchanges in the dark bowels of their own trading houses.
The other issue in the unknowns category is the risk of distributed ledger trading and investing. If the pools noted above are “dark” from a regulatory perspective, then DL trading is completely opaque. There is no really no oversight of what is happening in this corner of the global economy. While the overall volume seems small to date, we know that technical breakthroughs could change that situation rapidly enough that regulatory safety mechanism would not be able to keep up. Indeed, one might wonder if recent moves by some governments in Asia to ban Initial Coin Offerings (“ICOs”) are in fear of just such a scenario.
Returning to Cohen, he highlights two further causes for concern. One is the current, historically-low, interest rates:
… Roubini worries that, with the benchmark rate at 1-1.25% today, “even if the Fed can get the equilibrium rate back to 3% before the next recession hits, it still will not have enough room to maneuver effectively.” In the case of another downturn, he warns, “[i]nterest-rate cuts will run into the zero lower bound before they can have a meaningful impact on the economy.” Echoing this point, Gerlach argues that “the tools available to central banks to prevent deflation and a collapse of the real economy are severely constrained.” That means that “if a financial crisis were to occur today, its consequences for the real economy might be even more severe than in the past.”
The other, more amorphous, force that concerns him is the view of regulation of the current administration:
…almost immediately upon taking office, Harvard University’s Jeffrey Frankel writes, “Trump issued an executive order directing a comprehensive review of the Dodd-Frank financial-reform legislation,” with the goal of scaling back “significantly the regulatory system put in place in response to the 2008 financial crisis.” Then, in June, the US Treasury Department published a 150-page paper detailing the Trump administration’s proposals to deregulate large financial institutions. The plan prompted an immediate public rebuke from both Fed Chair Janet Yellen and her vice chair, Stanley Fischer, among many others.
Cohen does not mention income inequality in his piece, but the reality is that the over-concentration of wealth in .001% of the population means that risk has also been over-concentrated. This is because bad decisions by a smaller set of people are now enough to put the overall economy at greater risk.
Overall, a decade after the Great Depression, there is no doubt that some serious steps have been taken to avoid a repeat of 2007. However, financial crises are a strange breed of disasters. In 2013, I also reviewed a book called This Time Is Different by Carmen Reinhart and Kenneth Rogof, in which the authors tried to find commonalities across centuries of financial crises. Their conclusion was something to recall at this moment:
The lesson of history, then, is that even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well-regulated it seems to be.
As we look out at Wall Street’s ever-higher peaks, and the ever-accumulating wealth of the few, we have to wonder what’s brewing beneath the surface this time and what moment, unforeseen and unexpected, will bring it into the glaring light of economic inevitability.