By Ali Shakil Khan
The global financial crisis of 2008 is considered to be one of the most devastating financial crises since the great depression of the 1930s. The developed and emerging countries of the world responded to the crisis with massive spending on infrastructure projects to revive the economy. They also conducted bail-outs of big financial and non-financial institutions by buying stakes and lending money. Interest rates were also reduced to ultra-low levels to spur demand and revive lending. The European Union had its own share of sovereign debt crisis in which countries like Greece, Spain and Portugal that had borrowed too much money were eventually unable to repay the debt. When fiscally disciplined countries like Germany intervened and provided conditional bail outs to countries like Greece, subject to strict austerity measures, rioting erupted in the streets of Athens.
It is not the government of Greece alone that spends beyond its means. It is a global phenomenon. According to the Geneva report, global debt accounted for 180% of global GDP in 2008 and the 2013 figure stands at 212%. The level of global debt has actually hit a new high in 2013. Sub-prime mortgages were made to unworthy buyers at low initial “teaser” rates which promised low fixed rates for the first two years and a variable rate thereafter. As interest rates rose from the fixed exceptionally low rates during the first two years to substantially higher variable rates which adjust to market rates, the mortgage payments swelled up to levels which were beyond the means of the buyers. Defaults on these mortgages were the primary cause of the 2008 global financial crisis.
Post global financial crisis, we would expect the world to be more responsible and borrow less and head towards financial discipline. On the contrary, the world has never been in more debt than it is now. In the United States for example, even though mortgage related debt has fallen in the recent years, household debt has hit a new high of US$3.2 trillion. So, the crisis in the making will not only involve public debt, but also private debt.
What is more worrying is the fact that in response to the global financial crisis, global central banks have lowered interest rates to exceptionally low levels. Lower interest rates tend to lead to sharp increases in the value of financial assets such as stocks and real estate, as it becomes cheaper to borrow at low interest rates and buy these assets. However, the party often ends in tears when market participants realize that prices are too high and liquidity (demand) essentially evaporates into thin air with no willing buyers in the market. At the moment, major stock indices such as the S&P 500, Russell 2000 and Dow Jones 30 are at record high levels. The major problem is that real income and corporate earnings in the US and the rest of the world are mostly stagnant or showing modest increases.
The fundamentals do not support the current levels in prices of assets such as stocks and real estate. The exceptionally low interest rates have made securing loans and mortgages more easy and affordable. The market should have actually seen a timely correction by now if it weren’t for the historically low interest rates. Instead, we are witnessing increasingly higher levels of stock and real estate prices due to the tendency of late comers to join in the party. The more these prices swell up the more steep and devastating the drop is going to be.
Over the last two decades, the emerging markets have shown unmatched resilience and have been drivers of the global economic engine. China has been at the forefront of driving global economic growth. Economists are quite concerned over China’s debt to the global financial crisis ratio which was 147% before the crisis and it now sits at a lofty 251%. Despite this massive debt build up, the Chinese economy is struggling to maintain high growth and economists expect it to miss the 7.5% growth target set by the government. It will be even more difficult for the government, businesses and households to pay off the massive accumulated debt in a slow growth environment. The slowdown in China is already having an impact on global commodity prices which are in a downward spiral. This in turn has implications for nations such as Australia which depend heavily on the mining industry.
Economic growth that is fuelled by debt rather than an increase in productivity and technological innovation is bound to eventually lead to a mess. At some point, the debt has to be re-paid and interest rates will not always remain so low. As interest rates increase, the cost of the debt will rise until it reaches a point where it becomes impossible to make the payments on the debt. This is precisely what we saw in the global financial crisis with the sub-prime mortgages. Even governments technically went bankrupt in the Euro Zone sovereign debt crisis. The governments have created new problems to solve existing ones. There is no easy way out of this mess.
Eventually, painful adjustments and balances will need to be made. This would mean governments would need to cut spending and households would need to curb their consumption. The focus has to be to drive real income by enhancing productivity and leading technological innovation rather than driving economic growth by piling up a mountain of debt.
Ali Shakil Khan is a lecturer with the Faculty of Business and Design at Swinburne University of Technology Sarawak Campus. He is contactable at askhan@swinburne.edu.my