Queen Elizabeth II famously asked about the 2008 Global Financial Crisis, ‘Why did no one see it coming?’
In fact, many economists (including yours truly) had pointed out that the financial system probably would crash. But we failed to predict what would precipitate the collapse, how severe it would be and when it would happen.
This is partly a logical problem. If we knew when the crash would occur – say 30 February 2026 – then everyone would take action the day before – 29 February 2026 – which would bring the collapse-day forward, invalidating the prediction. Similarly, for the ‘how’ issue.
Consider a building which engineers think is prone to collapse. They cannot tell what the shock will be that does the damage nor when it will hit. It could be an earthquake, a fire, heavy wind gusts, a truck smashing into it …
These remarks are preliminary to the increasing references by reputable observers that various key financial markets seem shaky, including the American share market, the cryptocurrency market and the venture capital market for AI. (Currently, there is little attention being given to the Chinese financial system, but who knows?) There have been recent collapses by smaller firms, such as car-parts provider First Brands, which seem to be tied up with financing. Small collapses are integral to capitalist evolution – ‘creative destruction’ – but too many can be an indication of an impending financial crisis. There is the rule of thumb that the world has a good financial shakedown every decade or so. The last one was 17 years ago, which suggests the next might be a whopper.
Please read a lot of caution into the last paragraph. It is a time for prudence rather than hysteria.
The technical problems arise because market prices reflect subjective value – what people think assets are worth – not some objective value. Contrast the value of the house you live in with its market price. If the price were to change, your dwelling would provide exactly the same comforts as it did earlier. But you may also treat your house as a financial investment, hoping that an increase in its price will add to your wealth.
That is fine, until you start borrowing, speculating that the rise in house price will add to your wealth faster. True, but if the house price falls the opposite happens and your wealth falls faster. However, the value to you of living in the house remains the same.
It is this ‘leveraged’ borrowing which is key to understanding why financial crashes are so dramatic. Typically, the source of the loan is a financial institution which has borrowed to fund the loan. Depositing amounts to the institution borrowing from you.
The depositor does not usually know where their money is being on-lent, trusting the institution to make good decisions. Of course, it will make mistakes but the expectation is that they will be few and any losses are covered by the margin between the interest from your deposit and what they charge the lender.
It is not so simple. As we saw during the GFC, many financial institutions go into complex financing arrangements which no single person understands (including an economist), while the activities of the borrower may not be as transparent as they appear. As the Guardian article cited earlier remarks, ‘as ever in finance, it’s what investors don’t know that scares them most, and with First Brands, there appears to be plenty’.
Moreover, investors may borrow for investments with prices more volatile that their financial returns – if any. Examples are share markets where there may be dividends and cryptocurrencies where there are not.
The earlier shaky building parallel does not capture the way that financial markets develop over time. Suppose the building is continually being renovated and added to. It may not change the engineer’s basic assessment of its instability – strengthening is discussed below – but it becomes even more difficult to understand the details.
Hyman Mynsky described, in very top-down terms, the evolution of the financial system, with three phases.
During the Hedge Phase, financial institutions and borrowers are cautious. Loans are minimal so that borrowers can afford to repay both the initial principal and the interest.
The Speculative Phase emerges as confidence in the financial system recovers during the Hedge Phase. Borrowers no longer invest on the basis that they can pay both principal and interest. Instead, loans are issued for which borrowers can afford to pay only the interest. As the loan principal comes up for payment, they rely on being able to refinance (‘roll over’) their debt, borrowing the principal again.
As confidence continues to grow, investors move into the Ponzi Phase, in which they neither pay the interest on the loans nor repay the principal, relying on the capital appreciation from what they have invested to finance their investing. The asset-price appreciation that the Ponzi investors rely upon cannot go on forever, especially as it needs to accelerate. Eventually, Stein’s law takes its toll; if something cannot go on forever, it will stop. (Just before is known as the ‘Wile E Coyote moment’, when the cartoon character has run off a cliff but not yet realis
ed that there is no ground beneath him.)
Many reputable commentators think the current financial system is in its Ponzi phase, with the expectation that at some stage the bubble will pop at the ‘Minsky Moment’ after which everyone tries to get out of their investment commitments, turning them back into cash. Ponzi borrowers are forced to, because they have no cash; speculative borrowers can no longer refinance the principal even if they are able to cover interest payments. The prices of assets fall, with innocent lenders suffering as well as guilty borrowers.
We cannot predict when the Minsky Moment will occur. Nor can we prevent it, although there are some who try to prolong it – promising a bigger crash.
What we can do – in this small corner of the earth – is to take measures to mitigate what happens, just like making a building more robust to a shock. Much has done been since the GFC. The government tries to keep its debt down to give it freedom to manoeuvre. The housing market has been dampened down (although some are still trying to beat it up). The RBNZ has increased its supervision of the financial system (which may reduce your return on financial investments today, but mitigate your loss after the crash). There is the deposit compensation scheme, which shifts risk from small depositors to the public purse in return for an insurance premium. Regulation has reduced the amount of self-interested financial advice.
Much of this is like fighting the last war, adding protections we needed during the GFC. The next war will be different – who predicted the role of drones when the Ukrainian invasion started? The GFC was different from the 1928 Wall Street crash and the 1987 Stock Market (Black Monday) debacle, not only because the financial system evolved but because mitigating protections had been put in place.
As for you, the advice is surely to reduce your leveraged borrowing and your exposure to others’ leveraged borrowing. Even so, while the impact of a financial crash may differ for the prudent from the imprudent, it is not too fussy about whether one is guilty or innocent. The building comes down on everyone.