Raphael Kaplinsky - Sustainable Futures

Contagion from the crisis in the housing market was not confined to the US economy. The International Monetary Fund calculated that only one of the thirty-three high-income OECD economies (Australia) avoided the fallout. In Iceland, the three largest banks failed. Greece, Ireland and Spain were pushed to the edge of default. Between January 2008 and January 2009, industrial output fell by 31% in Japan, 26% in Korea, 16% in Russia, 15% in Brazil, 14% in Italy and 12% in Germany. More than 20 million jobs were lost worldwide, predominantly in the construction, services and automobile sectors. Stock markets throughout the world became increasingly volatile, with values on a declining trend. In 2008, share prices fell by almost a third in Europe and the Asia-Pacific region. In wealthy European countries, an increasing number of people were living on the streets and begging for handouts, and the number of foodbanks mushroomed. The list goes on.

Recovery from the Great Recession took some time. It was only in 2016 that average real living standards in Europe returned to their pre-Recession levels. Countries such as the UK and Greece which adopted austerity policies took much longer to recover than those such as the US, where governments took active steps to revive demand and stimulate economic activity. But, as we saw earlier, the primary vehicle used to stoke recovery – Quantitative Easing – ratcheted up the very financialization of the economy which had led to the Great Recession in the first place. Moreover, despite much protestation, most of the financial sector which had engaged in irresponsible lending and non-productive speculation was left untouched. Most of the key economic architects appointed by incoming President Obama were Wall Street bankers who had been key players in the financial sector which caused the crisis in the first place. Thus, the ‘rescue’ did not address the major systemic flaws in the economic system. It was merely poor-quality sticking plaster, ready to peel off under the slightest abrasion. Quantitative Easing programmes were renewed, and by 2019 the pyramid of speculative finance which had led the financial system to collapse in 2007 had regrown to pre-Great Recession levels. Global debt is at a historically high level, and spans the spectrum of borrowers – governments, households and, despite record profits, the corporate sector as well.

Debt has spiralled across the global economy. In early 2020, before the Covid-19 pandemic, the ratio of global debt to global GDP doubled from 160 per cent in 2000 to 330 per cent. In the high-income countries, much of the undirected QE was used to underwrite debt-driven consumption. In the UK, according to the National Audit Office, in 2018 8.3 million people were unable to pay off their personal debt or to cover their household bills. In the US, household debt rose from $13.65tn in 2008 to $14.15tn in 2019. 9US corporate debt rose from $439bn in 1980 to $3.1tn in 2007, before the Great Recession. Thereafter, it mushroomed to reach $14.15tn in 2019. 10US Federal Government debt also grew rapidly, from $879bn in 1980 to $9.5tn before the Great Recession, and to $22.8tn in 2019. US Federal debt owed to international and foreign parties rose from £492bn in 1990 to $2.4tn in 2007, and to $6.9tn in 2019. 11All of this spiralling debt, of course, predated the Covid-19 epidemic which hit the global economy in 2020, exacerbating each of these growing debt piles.

These spiralling levels of household, corporate and government debt reflect the underwriting of consumption in the US, the UK and other high-income countries. For, as we saw above, the levels of investment in productive assets remained stagnant ( Figure 2.2). Growing debt thus took the place of investments in infrastructure and productive capacity in the balancing of aggregate demand with aggregate production capacity. But debt is a tax on the future – it has to be repaid. When interest rates are extremely low, as in the era of the Covid pandemic, growing debt is a relatively minor problem. But these low interest rates depend on a depressed economy. If growth were to revive, the repayment schedules would place a heavy burden on sustainable future growth.

Added to this problem of domestic debt in the US, the UK and other high-income economies, is the spectre of sovereign debt – that is, money borrowed by governments. This, too, represents a time-bomb at the base of revived economic growth. For a while, it seemed as though Greece (with sovereign debts of $353bn, equivalent to 182 per cent of its GDP in 2018) was a prime candidate for sovereign default. When the Financial Crisis struck in 2008, virtually all of this debt was owed to the commercial banking system, particularly to banks in Germany and France. Had Greece defaulted at that time, the blow to the interconnected global banking system would surely have thrown the global economy into a substantial crisis. Yiannis Varoufakis, Greece’s then Minister of Finance, has chronicled the manner in which these sovereign debts were transferred from the commercial banking system to European governments. This reduced the systemic risk of a potential default, and added muscle to the arm of Greece’s creditors. In the subsequent decade, Greece implemented a traumatic austerity programme. (Because this led to a 25 per cent fall in the size of the economy, this perversely led to an increase in its debt-to-GDP ratio.) Whilst inflicting enormous costs on its suffering population, it has (at least hitherto) saved the global financial system from a financial meltdown.

Whilst Greece’s experience illustrates the power of creditors to contain disruptive defaults, however, it would be wise not to be too sanguine about the dangers to sustained global growth arising from sovereign defaults. The Council on Economic Affairs expressed its concern about the potentially contagious impact of an Italian default. 12Italy’s debt of $3.6tn in 2018 was 131 per cent of GDP, twice the levels permitted by the EU. Italy is the third biggest economy in the EU and an Italian default would hit banks across Europe. If Italy decided to leave the euro currency and return to the lira, this would cause massive losses to investors, triggering another financial crisis.

And then there is the problem of debt in the emerging economies. Between 2000 and 2017, the value of their dollar debts trebled from less than $1tn to more than $3tn. Their Euro debts more than doubled from around €200tn to more than €550tn. The vulnerability of these emerging-economy debts is not just due to their absolute size and the share of debt in their domestic economies. It is also because much of this debt was transacted in foreign currencies and by the private sector. If a debtor economy willingly or unwillingly devalues its currency, this magnifies the burden on debtors whose earnings are in local currency. A default by a large emerging economy (say Brazil), or perhaps a default by more than one emerging economy (Brazil and Argentina and Indonesia) may have serious repercussions for the sustainability of growth in the global economy. If these debts are contracted to the commercial banking system or to the private corporate sector, these dangers will be magnified.

There are a number of structural characteristics within the financial system which have the potential to spill over into a systemic crisis. One potential source of instability in these markets is the fragility of automated trading systems. 13Automated trading is increasingly used to drive investments in stocks. Programmable buy–sell computer-driven systems allow for automated transactions based on algorithms designed by the programmers. This is referred to as ‘black box high frequency trading’. The share of automated trading transactions in the US rose from 15 per cent of total market volume in 2003 to 85 per cent in 2012. During the 2008 Financial Crisis, it was not uncommon for market prices to fall/rise by 5–10 per cent in a single day, largely driven by algorithmic trading. These algorithms have the potential to produce what is referred to as a ‘flash crash’. On 6 May 2010, the US Dow Jones Industrial Index fell by 9 per cent in the space of 15 minutes. This is widely believed to have resulted from unregulated automatic algorithmic trading. It is believed that the growing use of Artificial Intelligence in these systems may reduce the possibility of a flash-trading crash. Perhaps they will. However, the growing sophistication of these algorithms makes them less transparent to external intervention. If only one of these algorithms is incorrectly designed, the financial sector may easily tip into crisis.