posted February 27, 2016
Systemic Fragility in the Global Economy, Part 2 (Financial Shift, Debt, and Next Financial Crisis)

December 27, 2015

To understand why the global economy has failed to fully recover after the 2008-09 crash—and why it is now steadily slowing and on a trajectory toward renewed financial instability once again—it is important to realize how the global economy in the 21st century has changed fundamentally. That change is reflected in the following key trends:

• A steady slowing of investment in real assets like machinery, plant and equipment, building structures, and other forms of what is called capital investment that result in the production of real goods and services;

• A corresponding drift toward deflation in the prices of those goods and services;

• A contrasting acceleration in financial asset investment in financial securities like stocks, bonds, derivatives of all kinds, real estate, foreign currencies, etc.;

• Inflation in financial assets and securities, creating financial asset bubbles that eventually burst, leading in turn to subsequent financial asset deflation.

The fundamental question then becomes, Why is real asset investment and prices of real goods and services slowing, and drifting toward zero growth and deflation, while financial investment is accelerating and prices of financial securities escalating? Is the inverse relationship between the two forms of investment—real asset and financial asset—somehow related? That is, is the slowing of real investment somehow causing the acceleration in financial investing and speculation? Or is the rise in financial investing causing the slowing of real investment? In turn, is the drift toward deflation in goods and services, on the one hand, and inflation in financial assets like stocks, bonds, derivatives, etc., on the other, also somehow related?

These questions are central to understanding why the global economy in recent decades has been becoming increasingly unstable, and thus more prone to financial and banking crises, and why that global economy appears to be experiencing more frequent recessions that go deeper, last longer, and are more difficult to recover from—i.e. what are sometimes referred to as great recessions.

The contrast between real vs. financial investment, and between goods and services deflation vs. financial securities inflation, has further consequences as well: it explains, in large part, why income inequality is growing, why full-time permanent jobs with decent pay and benefits are being replaced with part time, temp, contract and so-called sharing economy jobs that generate less wage income and therefore consumption, and why traditional measures of fiscal and monetary policies are having a declining effect on government efforts to stabilize the economy.

Slowing Real Investment & Drift To Deflation

Economies around the world are in different stages of slowing real investment and deflation in goods and services. Real investment in both Japan and Europe has been slowing, and slowing even more rapidly in a growing number of emerging market economies, including China. Capital expenditures have been slowing globally since 2000, according to research by Standard & Poor’s.

Negative during 2008-10, it recovered weakly in 2011-12, and then has declined every year since 2013—despite record profits since 2010 and corporations surveyed sitting on $4.4 trillion in cash. As of 2014, real investment globally was no larger than it was nearly a decade ago in 2006. In other words, no net increase in almost a decade. Capital spending growth in the U.S. began to slow significantly in 2014 as well, and has so far declined by 3.8 percent through the first ten months of 2015. And the U.S. economy is supposed to be the strongest and healthiest of the global economies, according to many mainstream economists. But clearly it too is not immune from the slowing real investment trend.

Real investment is what results in jobs, productivity gains, and the potential at least for wage income gains. As it has declined, however, what we see is sub-normal job creation in the form of mostly part time, temp, contract, and so-called sharing jobs in all the advanced economies of U.S., Europe, and Japan. Virtually no gains in productivity; U.S. productivity, for example, has averaged a mere 0.5 percent lately. And wage incomes have grown only for the better-off 10 percent high-end households. Low wage income growth results in low demand for real goods and services which then eventually dis-inflate (slow in growth rate) and then drift toward deflation.

Today, Japan is again experiencing deflation in goods and services. The Eurozone has been slipping in and out of deflation for some time, as has the UK as well as other European economies in Scandinavia and East Europe. China has also begun experiencing a significant slowing in its consumer prices. In just the past year, consumer prices in China have declined from 2.5 percent to around 1 percent annually. And for the first 9 months of 2015, U.S. consumer prices have been around 1 percent or less. How then do these trends translate into systemic fragility throughout the global economy, as well as an increase the likelihood of another financial crisis and subsequent great recession, or worse?

The answer to that lies in understanding the other major trends—i.e. the escalation in investing in financial assets and securities with the consequent rise in inflation in financial assets and securities. For the forces and causes behind these trends are the same that are behind the simultaneous slowing in real investment and goods deflation. The shift to financial investing in recent decades explains the slowing of real investment, deflation, poor job creation, inadequate wage income growth, sluggish consumption in turn and the anemic recovery of real economies globally.

The shift to financial investing is crowding out and displacing real investment and is causing accelerating inflation in financial securities prices—in stock markets, bond values, financial derivatives speculation and prices, currency exchange speculation, real estate values, and so on.
This apparent anomaly of real investment and real goods prices falling while financial investment and financial asset prices escalate, create bubbles and then crash with increasing frequency, has been of little interest to mainstream economists. For mainstream economists, the two sets of inverse trends—real and financial—aren’t, apparently, related. But they are. And their failure to address the inverse relationship between the two forms of investment is key to understanding why their forecasts and predictions for the global economy in the 21st century have repeatedly missed the mark since 2000.

What changes in the global structure of finance have enabled this shift? And who are the actual agents of the shift—i.e. who are the new finance capital elite driving this?

Why the Shift to Financial Investing?

At the most fundamental level, the shift from investing in real assets to financial asset investing occurs because the structure of the global economy today incentivizes financial asset investment more than real asset investment. Financial markets have multiplied manifold globally, are closely integrated and instantaneously connected, and are more liquid. Investors can move their capital in and out of more liquid financial markets more quickly —thus avoiding losses and taking quick advantage of price appreciation capital gains. The creation of financial securities has exploded, thereby creating more financial products to sell and raising the volume of potential financial asset investment.

Technology has accelerated the turnover rate at which financial securities can be bought and sold, thus increasing the opportunities for potential financial investment. The internet, super-fast computing of trades and software algorithms, massive storage of transactions, fast trading, dark pools, spoofing and other fraud-like financial sales techniques all serve to accelerate the pace of financial asset investing and therefore its eventual volume and magnitude. Because markets for financial securities are highly liquid, long-run risk and uncertainty is less compared to real asset investment. That too makes financial asset investing potentially more profitable compared to investing in either discrete, physical consumer or producer goods.

Physical goods also have a cost of goods associated with their production. But financial securities typically have little, if any, cost of production that may reduce profitability or raise risks and uncertainty that may be involved in obtaining and ensuring availability of inputs for production. Supply costs as well as potentially costly supply constraints are thus minimized for financial assets. Prices of financial asset securities are determined instead by demand for those assets, not by their cost of production.

Another important enabler for the financial investment shift is the structural change in financial institutions in recent decades—in the form of shadow banks—that have increasingly re-directed excess liquidity, credit and debt that has been created by central banks, like the Federal Reserve, toward financial asset investment. A closely related change to the accelerating growth of shadow banks enabling the shift has been the rise of a new global finance capital elite, consisting of inside agents who manage shadow banking operations and investing, as well as their client investors who function as outside agents. Without this institutional structure of shadow banks and agents, the excess liquidity, credit and debt that has been another key characteristic of recent decades, would not be redirected in as great a volume as it has to financial asset investing.

All the foregoing, and other, causes of the shift, result in profits from financial asset investing being greater than profits from investing in real things—in goods and even services. Profits from financial investing are simply realized more quickly, with less relative risk and uncertainty, can be turned over and redirected to other financial markets faster and more easily. Capital gains from financial investing may also be realized from deflating financial asset prices, just as from rising prices. Real investment and goods profits cannot similarly be realized from falling goods prices.

Finally, the shift to financial investing tends to be greater since financial profits are taxed as capital gains and therefore often at a much lower rate than profits from sale of goods or services. That also raises their relative profitability compared to real goods. There are virtually no financial securities taxes of any consequence in any economy today. Because financial securities are also moveable globally in an instant, their profits can also be diverted instantaneously in order to avoid taxation. Tax avoidance and fraud is thus immensely easier.

What, then, is the evidence that there has been a relative shift to financial investing, but hasn’t, as available credit is re-directed to financial investment? The magnitude and dimensions of the shift is evident in the explosion of values in financial securities across the board, and globally, since 2007, as indicated in table 1.

The data shows that financial asset markets have expanded rapidly, from less than $100 trillion in 2007 to more than $200 trillion in just the past 8 years. That expansion could not have been possible, however, without the most fundamental cause of the shift: the explosion in liquidity, credit and the extreme leveraging of debt over the course of preceding decades that has enabled financial asset price values to escalate to such phenomenal levels. The crash of 2008-09 has not slowed or tamed the shift and the speculation in financial asset prices that has accompanied the liquidity-debt explosion. If anything, the aftermath of conditions and policies since 2008 has in fact accelerated it.

The explosion of liquidity—i.e. money and money-like assets available to lending by banks and shadow banks to investors—is the product of two fundamental causes. First, the continual and massive injection of money into the global economy by central banks globally, especially the U.S. central bank, the Federal Reserve. This liquidity injection, accelerating over recent decades, dates back to the post-1945 period and the creation of the Bretton Woods international monetary system in 1944, but especially after the collapse of that system in 1972-73, after which central banks, like the ancient Greek monster the Kraken, was released from its chains to inject liquidity into the global economy without restriction or limitation. Since 1973 that liquidity injection has occurred unabated due to various causes.

The second cause of the historic liquidity injections has been due to the accelerating rise of what is called inside credit since the 1980s. inside credit, in brief, refers to the ability—due to technological change in banking and deregulation of finance by governments—to extend credit to financial investors and speculators without the necessity even of liquidity in the form of money from central banks.

Together, central bank credit and inside credit have enabled a massive and growing volume of total credit available for banks and shadow banks to lend—most of which has then been loaned to investors to finance investment in financial securities of all types. The borrowing of that credit becomes the debt, the explosion of which has accompanied, and enabled, the accelerating investing in financial securities in recent decades. Total debt is comprised of government debt, household debt, and private corporate and business debt. But it is corporate debt that is the greatest contributor to the accelerating rise of total debt, especially since the early 1980s. It is also corporate debt that is the great destabilizing force in the global economy, contrary to the media-promoted notion that government debt is the problem or that profligate spending by consumer households based on debt is the cause of growing economic instability. Corporate bank debt was the prime causal factor behind the banking crisis of 2008-09. And it is the rise of corporate debt once again that is the primary source of growing global financial instability since 2008-09.

This time, however, it is not bank debt in the U.S., UK and advanced economies that will likely prove the next big financial destabilizer, but non-bank corporate debt in emerging market economies.

Table 2 shows data from the Bank of International Settlements in Geneva, Switzerland, shows how total debt has rose from 2007 just through 2013 by an additional $40 trillion dollars—and how the lion’s share of that is attributable to non-financial corporate debt and in particular such debt in emerging market economies and shows, the greatest source of debt expansion since 2007 has been the emerging market economies, especially non-financial corporations in those economies, as those economies borrowed heavily and expanded between 2010-2013 based on the massive liquidity injections by central banks in the U.S., Europe, and Japan that flowed out of their own economies into emerging markets, including China. The second major source of debt accumulation was governments in the advanced economies of U.S., Europe and Japan, which reflects the costs of bail outs of corporate interests and the costs associated with the anemic economic recoveries in those economies after 2009. What’s also interesting is that household debt has not deleveraged (declined) in the global economy at all since 2008.

Table 2 shows the debt acceleration only through 2013. The trends have continued in the past two years, 2014-2015. According to the private McKinsey Institute, total global debt has risen through mid-2014 by $57 trillion—i.e. significantly more than the $40 trillion estimated by the Bank of International Settlements. Of that, global corporate debt rose in 2014 alone by an additional $3.5 trillion, or about $22 trillion since 2007. Estimates are another $3 to $5 trillion will be issued in 2015.

That’s about $25 trillion in additional corporate debt issued since 2007 and the last global crisis. China alone has added $10 trillion of the $25 trillion in corporate debt since 2007, and other emerging markets another $8 trillion. The likelihood is therefore high that the next financial crisis will be located in corporate debt in emerging markets and China.

Contrary to other works published in recent years, it is not total debt that is essential to understanding the next financial and global economic crisis. What matters is where this debt is concentrated to begin with. Household debt may slow consumption. Government debt may result in austerity policies that also slow consumption and government spending, and thus hold back economic recovery. But it is excessive corporate debt that is the source of financial crashes and crises. And that debt has been escalating once again since 2010, as it had before that up to the crash of 2008.

Furthermore, systemic fragility and inevitable financial instability that follows, is not simply a question of even magnitudes of corporate debt. What matters is how well corporations and businesses are able to service—i.e. pay for—that debt, especially when the crisis occurs and sources of business income quickly decline and disappear. Debt does not disappear. It must be paid regardless of economic conditions. So the key becomes how able corporations are to make payments on debt. That, in turn, depends not only on their cash flow and other near cash sources of income, but on the terms and conditions under which payments must be made when the debt was incurred. So there are three key sources involved: level of debt, income to service the debt, and conditions influencing payments of the debt. Systemic fragility is a function of the interaction of all three sources.

When any of the three sources deteriorate, then corporations are faced with the prospect of defaulting on payments of their debt. Default, and even the prospects of such, quickly translate into rapid deflation of financial assets and securities. And that’s the stuff of financial and banking crashes.

What are the prospects of corporate-business default given the recent explosion of private corporate debt? Not good. Today 62 percent of all companies have twice as much debt as cash flow to make payments on the debt. And that’s just the U.S. economy. The ratio is much worse elsewhere, especially in emerging markets, and even Europe, Japan and China. The potential for corporate defaults is perhaps best indicated in the magnitude of non-performing bank loans made to corporations. Non-performing means payments of debt have been missed, in whole or part. Today, there are about $1.5 trillion in non-performing loans in Europe, more than $2.5 trillion in China, probably at least another $1 trillion in U.S. and Japan combined, and an unknown amount in other emerging markets.

It is not surprising, therefore, that in the closing months of 2015 warnings of imminent, serious corporate defaults are rising. In October, the giant Deutsche Bank declared that “pre-requisites for the next default cycle are now in place.” The UBS bank warned “It is likely that emerging markets hard currency debt will come under increasing pressure.” Strategists at Bank of America Merrill Lynch call U.S. corporate junk bond debt a “slow moving train wreck” whose “fundamentals are as poor as we have seen them.”

While central banks and their recent decades of massive liquidity injection and technological changes enabling a corresponding explosion of inside credit, have been ultimately responsible for enabling the massive debt buildup, the question still remains: How has that massive liquidity been translated into the corporate and total debt that once again threatens to destabilize the global system creating another financial crash? Who are the intermediaries between the central banks and the excessive corporate debt buildup?

The answer to that will be addressed in Part 3 of this article (coming in the March issue ) on systemic fragility to follow, when the role of shadow banks and the rise of the new global finance capital elite is addressed.

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