I am writing this article in Tokyo. Judging from my walks around the city during the past week, and despite the fact everyone is wearing face masks, it's like Covid has vanished. Subways and trains are jam-packed and shopping areas are full of people. However, the pandemic has left some scars. Many shops have gone under, including my favourite 50-year-old sushi restaurant.
The return to “business as usual” for Japan didn’t stem from tourist spending but rather from the financial strength of domestic consumers. Even before Covid first emerged, tourism income accounted for just 2% of Japan’s GDP. Moreover, 81% of that was derived from domestic tourists. Foreign visitors played a relatively insignificant role in helping revive Japan’s economy.
The quick return to normalcy is due to the Bank of Japan’s (BoJ) ultra-easy monetary policy. The price to pay is, of course, the rising rate of inflation, which is the highest now in 33 years. People who live on pensions are complaining about their weakening purchasing power. Soon, the BoJ will have to strike a balance between maintaining economic momentum (an economic issue) and the livelihoods of people with fixed incomes (a social issue).
What is happening in Japan does not represent the real picture of the world economy. In my view, it shows the pent-up demand after a long period of Covid-related fear. With new cases dropping from a high of 220,000 per day to below 30,000 a day early last month, the Japanese are ready to spend and get their lives back. I am afraid this might be a short-term blip as the global economy is slowing down faster than many expected. In the United States, home prices are falling faster than in 2006, which led to the housing loan crisis in 2008. Personal computer shipments are projected to fall 10-20% this year, while smartphone sales are tipped to decline 10%.
Many experts say this economic slowdown will be furious but fast, as the Fed has front-loaded its interest-rate hiking strategy. Historically, the US central bank would raise rates by 25 basis points (bps) at a time, but for a year or two. However this year, Fed Chairman Jerome Powell has adopted a new strategy of front-loading rate hikes to bring down inflation as fast as possible.
As such, hikes of 75bps have become the new standard, and we could see a repeat of this at the Fed’s upcoming meeting. By the time this article is published, the Fed Funds rate could already have been raised to 4.0%. Unfortunately, a by-product of this bold strategy will likely be a sharp contraction of the global economy in the first half of 2023. There is a 100% consensus among analysts that the US economy will enter a recession next year.
This “almost certain” global economic slowdown could signal a death blow for the already ailing world financial system, which is loaded with problems and on the brink of going under. We could see the collapse of commercial and investment banks, which could trigger a financial crisis similar to the Great Depression of the 1930s or the subprime debt crisis of 2008.
The main feature of a financial crisis is of course the collapse of the financial system. Without a functioning one, businesses and consumers will not have enough access to liquidity which, in turn, would cause bankruptcies and massive lay-offs. US unemployment rates were 25% during the Great Depression and 9.25% in 2009.
The initial cause of the former was a stock market crash, which saw the Dow Jones index drop nearly 13% in a day. The crash led to the insolvency of the US banking system, with 40% or about 9,000 banks out of business by 1933. The worst thing about this crisis was that the associated economic policy, especially then-president Franklin D Roosevelt’s New Deal programmes, was unable to resolve the problem of chronic unemployment. The crisis was ultimately ended by World War II.
The world faced more financial upheaval in 2008 after Lehman Brothers filed for bankruptcy due to investment losses related to its subprime mortgage debt in September 2008. That debt was estimated at US$600 billion. Fortunately, this crisis was relatively well managed by the Fed. Only 489 banks went under. The Fed immediately injected $600 billion to offset the liquidity loss from the subprime mortgage bad debt. Even with such immediate and bold measure, however, the US economy still shrank 2.6% while the jobless rate had risen to 9.25% in 2009. And it wasn’t only the US economy that suffered. Global GDP growth also contracted 1.3% in 2009.
The current financial crisis, if it pans out as feared, will be totally different from those two examples. It will be on a much larger scale and comprise a multitude of financial problems. However, we wouldn’t expect spectacular market crashes or surprise bankruptcies. Things will happen more gradually, with small problems popping up around the world. It’s more like the story of the four boiling frogs: we won’t know the water is too hot until we are suddenly boiled alive.
The first frog is the downturn in the cryptocurrency market. It peaked in November 2021 with a market cap of $3.048 trillion. By the end of this September, it had been clipped to $0.972 trillion. This $2.076 trillion investment loss (as of now) is 3.5 times higher than all the subprime debt write-offs. Luckily, this loss has been spread over many investors, rather than a single investor like Lehman Brothers. So there is no big bang, but rather a slow, painful effect on millions of investors.
The second frog would be Russia’s foreign debt of $450 billion. As most of Russia’s foreign reserves of $540 billion have been frozen, it has been forced to default. Again, the banks claim they only hold $120 billion of Russian debt and can tolerate the loss.
The third frog is ballooning private debt, estimated by the International Monetary Fund at 156% of global GDP. Before the 2008 financial crisis, the ratio was 139%. This could lead to widespread defaults.
The fourth and largest frog to be boiled is the global bond market, with an estimated value of $124 trillion, making it three times larger than global stock markets. At present, bonds have lost an average of 10.2% of their value, causing net sales of $175.5 billion in the first nine months of this year. Sooner or later, the bond market will run into major problems.
Are banks heading to bankruptcy? Not immediately, but they’re on the right track. Shares of many major banks are trading well below their book values. Deutsche Bank and the Bank of China are being traded at 29% of their book values, while Credit Suisse (CS) is faring worse at 23% and is in desperate need of capital. Goldman Sachs estimates CS will need a capital injection of $8 billion before 2024 to survive.
It really doesn’t matter which big banks fall first because the rest will follow suit like a pack of dominoes — just as they did the last two times.