posted December 17, 2017
A Theory of System Fragility (Chapter 16 of ‘Systemic Fragility in the Global Economy’, Clarity Press, 2016

One of the central themes of this book is that the global economic crisis that erupted in 2007-08 did not end in 2009. It simply shifted in 2010, both in geographic location and form: from the USA and UK to the Eurozone and its periphery and to Japan. The crisis began to shift again, a second time, in late 2013, to Emerging Market Economies and then China. That most recent phase continues to unfold and intensify in mid-2015. In terms of ‘form’, the shift has been from mortgage bonds, derivatives, and equity markets in 2007-09, to sovereign debt markets in 2010-12, and, since 2014, increasingly to forms of private corporate debt, commodities and oil futures, Chinese and emerging markets equities, and currency exchange markets.

The Historical Context

In 2007-09 virtually the entire global economy was affected by the financial crash and then experienced a subsequent deep contraction of the real economy on a global scale as well. Certainly the financial crash of 2007-09 at minimum precipitated the deep real economic contraction that followed, sometimes known as the ‘Great Recession’. It obviously enabled that contraction in a host of ways. And it was most likely also fundamental to the contraction in important ways as well. This generalized financial and real crisis of 2007-09 was clearly the first such event since the late 1920s-early 1930s in which financial cycles and real cycles clearly converged and then mutually amplified each other in various negative ways. It will not be the last.

Financial crises and recessions from the 1960s up to 2007 have been localized geographically and/or limited to specific financial asset markets. There was little convergence and amplification. During that period real economic contractions—i.e. recessions—were localized and were the outcome in most cases of supply or demand ‘shocks’, or else were conscious government policy-induced recessions, rather than financial crisis precipitated contractions. They were what might be called ‘normal’ recessions. They were therefore relatively short and shallow in terms of their contraction, and were thus relatively responsive to traditional fiscal-monetary recovery policies introduced by governments and central banks. Such normal recessions are almost never precipitated by major financial instability events, although moderate financial instability may have followed the real contractions. But financial instability was almost always limited and contained to a particular financial market, type of financial security, or an occasional financial institution default.

This localized financial instability and short and shallow recessions began to change in the 1990s, however. The first notable case was Japan’s financial crash and subsequent ‘epic’ real recession that followed, a combined financial-real event from which its economy still has not fully recovered a quarter century later.

However, even Japan’s recession in the early 1990s was not yet a generalized global financial crash or a consequent global real contraction event. That kind of generalized, combined financial and real crisis would not come until 2007-09. The 2007-09 event would prove not only quantitatively more severe than prior financial and real crises, but qualitatively different as well. So too would the trajectory of the global economy post-2009—i.e. a faltering global recovery that proved both quantitatively and qualitatively different from prior recoveries from normal recessions.

Like the 2007-09 crash and the ‘great’ (epic) recession itself, the post-2009 period thus represents something quite new. If the 2007-09 crash and deep contraction was an event diverting the global economy in a new direction, then the 2010-13 period represents the initial stage or phase—itself giving way to a subsequent second phase that has been emerging since late 2013.

In the 2010-13 first phase of global ‘recovery’ following the crash of 2007-09, the core Advanced Economies (AEs)—the USA and United Kingdom—were able to stabilize their banking systems with massive liquidity injections by their central banks. This achieved, however, only a partial and a historically weak recovery of their real economies. The other two major sectors of the AEs—Europe and Japan—neither restored financial stability quickly nor were able to achieve sustainable real economic growth. The Japanese and European real economies stagnated at best and fell into double-dip recessions once again while experiencing renewed financial instability in certain sectors and/or regions of their financial systems. In sharp contrast to the AE experience, during the same 2010-13 period China and the Emerging Market Economies (EMEs) experienced a rapid recovery in both financial and real economic terms. Both Chinese and EME economies boomed during this initial 2010-13 phase, China’s growing at a rate of 10%-12% and other key EMEs nearly as fast. Money capital from the AEs flowed in at record rates and financial and commodity markets rose to record levels.

What then explains this dramatic difference between the AEs and China-EMEs during the first recovery phase of 2010-13? Real economic conditions? Financial conditions? Major differences in policy choices compared to the AEs? Indeed, what explains the notable differences within the AE regions during this period—US and UK stabilizing (albeit partially and incompletely) while Europe-Japan regressed economically and financially again? Was it just a matter of policy responses or something more fundamental?
This unbalanced global scenario of AEs compared to China-EMEs, during the first 2010-13 recovery phase, began to change by late 2013. The uneven and unbalanced conditions between AEs vs. China-EMEs did not correct; they simply shifted: The rapid real growth in China and the EMEs, which characterized the 2010-13 period, began to slow significantly starting 2013. By late 2015 China’s real growth rate was reduced by half, and a growing number of key EME economies had slipped into recession by 2014. Global oil and other commodity markets began to deflate rapidly beginning mid-2014. Financial bubbles and instability began to emerge, especially in China. The global money capital flows into China-EMEs began to reverse, this time away from China-EMEs toward the AEs. Currency volatility rose worldwide. To forestall renewed financial market instability, both Japan and Europe introduced quantitative easing (QE) policies and accelerated their central bank money-liquidity injections—while the US and UK discontinued theirs. Both central bank and fiscal austerity policies became more congruent across all the AE regions, as the US and UK followed Europe and Japan in the direction of fiscal austerity starting 2011 and as Japan and Europe followed US and UK central bank quantitative easing policies, starting in 2013 in Japan and 2015 in Europe. What were thus previously divergences in monetary and fiscal policies between the AE core regions and the Europe-Japan regions now began to converge by 2013-14.

AEs as a group thus settled into slow to stagnant real growth by 2015, just as both real growth slowed rapidly and financial instability rose in China-EMEs. The US economy experienced repeated, single quarter negative GDP relapses in 2014 and 2015 and the UK’s induced property investment brief recovery of 2013-14 came to an end by 2015 and it stagnated once again. Japanese and European growth stagnated as well, in the 0%-1% annual range.

Although the second phase of 2013-2015 is still evolving, a comparison of it and the preceding first phase, 2010-13, shows the following main characteristics:

The AEs stabilized their banking systems in the first phase but failed to generate sustained recovery in their real economies during that period. Never having really recovered in real terms since 2009, both Japan and Europe continue to stagnate by mid-2015, as the US and UK economies also show growing signs of renewed weakness in their real economies as well. More than six years after the officially declared end of the recession in mid-2009, the AE economies appear weaker in real terms today despite having stabilized their banking systems. China and the EMEs, moreover, appear decidedly weaker in 2015 than in 2010—both in terms of financial instability and real economic performance. In both AEs and China-EMEs, total debt—business, financial, household, government, central bank—has continued to rise as real income sources are undergoing growing pressure. Should financial and real economic events occur that produce a significant contraction of real incomes in one or several of these sectors—even if temporary—systemic fragility could easily and quickly deteriorate further as the feedback effects between financial, consumption, and government balance sheet fragility exacerbate each other. Coming off a much weaker economy today compared to 2007, another financial instability event and a potentially worse ‘great recession’, will find both central bank and government policymakers even less prepared or able to confront the next crisis. All sectors—households, corporate-financial, and government are more fragile—except for the big banks and big multinational corporations, and the top 10% wealthiest consumer households, who have been able to reduce their fragility as a consequence of record recent income gains. But the vast majority of businesses, households, and local and regional governments have not been able to build a liquid income cushion. And even for those narrow sectors with sufficient income cushion, in the event of another financial implosion, and subsequent real economic contraction, those income gains will be quickly offset by the collapse of financial asset wealth—thus leaving the excessive debt levels to be serviced from insufficient income and on unattractive debt refinancing terms.

In other words, systemic fragility on a global scale is worse, not better, after more than six years of so-called ‘recovery’ from the official ending of the previous financial crash and severe economic contraction in mid-2009.

Some Queries from History

The preceding short scenario raises important theoretical questions: why was the crisis that erupted in 2007-08 on a global scale a generalized event? Why was it clearly precipitated by a financial crash? How did the financial crisis enable the extraordinary deep and rapid contraction of the real economy, and prevent a normal recovery of it for more than six years? How are financial conditions and variables ‘fundamental’ to the general crisis? In other words, how does one distinguish causes that were merely precipitating and enabling from causes more fundamental—both real and financial? Were the financial forces and conditions that have been responsible for growing fragility fundamental to the ‘great recession’ and weak global recovery that followed—or just precipitating and perhaps enabling? How do financial conditions and events drive real economic contractions—i.e. ‘great recession’ or worse, depressions? Why are financial instability events over the last four decades apparently becoming more frequent and severe, and what is happening in the real economy that may be making it more sensitive to the growing frequency and severity of financial instability events in recent decades?

These queries lead to another set of related critical questions: why have government policies since 2009—i.e. more than $20 trillion in central bank liquidity injections, trillions more in business-investor tax cuts, and still hundreds of billions more in direct and indirect non-bank business subsidies and bailouts—proven largely ineffective in generating a sustained global recovery and been unable to prevent a return of financial asset bubbles that continue to grow and expand and have now begun to unravel again?
Not least, what are the fundamental changes in the 21st century global capitalist economy that are responsible for the new, more intense interactions between the financial and real sectors of the economy? Or, put another way, how and why are financial cycles exerting a relatively greater effect on real cycles today than in the past? And why will they continue to do so?

Thus far, contemporary mainstream economic analysis has been unable to convincingly answer these questions. As a major theme of this book argues, that inability is due in large part to its outmoded conceptual framework.

The material origins of systemic fragility were addressed in the 9 major trends addressed in chapters 7 to 15 of this book. They represent the historical markers or forces, i.e. the fundamental determinants that are developing, evolving, and in the process raising global systemic fragility and leading to a generalized financial instability once again, as in 2007-09. The 9 trends were described separately in chapters 7-15. But what’s needed for analysis is an explanation of their interactions and how they combine to contribute to the development of systemic fragility.

What follows in the remainder of this chapter is a literary summary of the main ideas associated with systemic fragility. For data and evidence in support of the ideas, the reader is encouraged to reference back to chapters 7-15.

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