Ten years ago this weekend, the failure of Lehman Brothers brought the international financial system close to collapse. The shock triggered a global recession that narrowly avoided becoming a depression. It caused banking crises in two dozen counties and brought in its wake the eurozone debt crisis, austerity and stagnation. Millions lost their jobs and homes. A decade later, the banking system is better storm-proofed, though risks have spread elsewhere. Growth has returned, animal spirits in advanced economies are rising. But some deeper consequences of the crash are only now being felt.
They include a backlash against liberal democracy, free markets and globalization, for which the crisis was not solely responsible but was a catalyst. Rising nationalist populism and protectionism not only risk undermining progress on financial crisis prevention. They pose a threat to the western political and economic system few foresaw in September 2008. When it comes to strengthening the core global banking system, policy makers can congratulate themselves on a job pretty well done. Banks in most major economies are today backed by as much as 10 times more equity capital thanadecade ago, and carry for more liquid funding. Detailed “living will” plans submitted to regulators can be implemented in a crisis. “Bail-in bonds” have been introduced, designed to permit the orderly wind-down of any failing institution.
Yet while banks have been strengthened, the next financial crisis might originate from elsewhere. Tightening bank oversight has shifted risk – notably to the shadow banking sector, or non-bank financial institutions doing the business of banks, from lending to market making. Asset managers, hedge funds and insurance companies also now carry the kind of risk that used to be the preserve of banks. Technology companies are becoming systemic financial players, too. Policymakers have not held any of these challenges to the same regulatory standards as the banks.
The severity of the hit to investors from any market shock is also likely to be greater. Regulatory changes have made banks less willing to hold or buy large volumes of securities in a way that might function as a shock absorber in a falling market. Machine-driven algorithmic trading and the dramatic growth of passive funds that track indices regardless of performance could magnify the effect of market falls. If banks do ever succumb, moreover, they may pose an even greater risk than in 2008.
Following crises-era acquisitions and a decade of growth, many “too big to fail” institutions are today even bigger. If HSBC, JP Morgan or one of the Chinese big four banks were to get into trouble, the fallout would be unprecedented. By some measures- we can confirm from our experience – the next crisis already looks overdue. A principal cause of the 2007-08 meltdown – an excess of debt – has become worse.
Despite governments’ austerity policies, particularly in Europe, global debt now totals to about 250 trillion US-Dollar, 75% more than when Lehman failed. Ultra-loose monetary policy and quantitative easing were undoubtedly justified to help repair bank balance sheets and stimulate economic activity. But they magnified the debt problem. Using low interest rates to encourage investors into higher-yielding assets has inflated new bubbles. Equity markets are near record highs. Property prices in key global cities are at record multiples of inhabitants’ earnings. Without careful handling by central banks, the overdue normalization of monetary policy-unwinding QE and rising interest rates – risks puncturing those bubbles. Worries over a crisis in emerging markets, where debt has expanded sharply, are increasing. The trigger could be more expensive dollar funding, or a US China trade war. The architecture of Europe’s single currency, moreover, remains far from complete.
The nationalist populism that has spread across western countries, personified above all by US president Donald Trump, points to the wider long-term consequences of the crisis. The Lehman collapse dealt a severe blow to trust in political and business elites, unprepared for what happened. Policymakers and financial leaders earned little popular credit for averting depression. Voters perceived those who caused the crisis as having ensured they dodged the consequences, their bulging pay packets intact. Instead, ordinary people felt the costs had fallen on them. Years of rising inequality had already created groups of “left behind” citizens. Joined by victims of the crash and its aftermath, they formed a critical mass of disaffected voters. That discontent is now felt as an “us versus them” insurgency against political and business elites. The system of liberal democracy and free market economics is seen by a sizeable minority in advanced economies as one run for the benefit of well-connected insiders. The flood of refugees into Europe from the Middle East in 2015 provided further, convenient, scapegoats. Here lie the roots of Mr. Trump’s US, Brexit Britain, Viktor Orbán’s Hungary and rising populism from Slovenia to Sweden. This throws up dangers. Nationalism and protectionism are, ironically, chipping away at the very system of international co-operation that helped contain the previous financial crisis. That could make the next one worse.
The flight to extremism, moreover, threatens to undermine the market-based democracy that, while its pitfalls were brutally exposed in 2008, delivered peace and rising overall prosperity in the west of six decades. Centrist parties must now find effective ways to address voter concerns.
That means not just redoubling efforts to rein in financial risks. “Mainstream” parties need to take inequality seriously, and address the causes of disenchantment. Governments should ensure the rich are taxed fairly, and curb excesses such as runaway executive pay and corporate tax avoidance. They should invest more in services and infrastructure, and in equipping citizens with skills to cope with globalization and technological change in connection with the 4th Industrial Revolution.
If mainstream politicians can show their policies work, unlike the quack remedies peddled by political insurgents, they have a chance of wooing voters back. If not, they will be eclipsed by today’s populists – or worse one waiting in the wings. This is the central political battle of our time. The danger is that the next financial calamity may strike before that battle has even begun to be won.