BTL 2022

Global financial asset deflation: Prelude to next ‘great recession’?

Economic Crisis

Traders and floor officials at the New York Stock Exchange on Monday, March 9. The Dow closed down by 2,000 points for the first time ever. Photo from Flickr.

Yesterday morning, on March 9, financial asset markets imploded. US stocks are now further collapsing by 7 percent. The same can be said for Asian and European stock markets which have slid by 6 percent.

Markets were already declining sharply last week due to COVID-19-induced supply chain shocks (reducing production) and expanding demand shocks (consumer spending contraction in select industries like travel, hotels, entertainment), all of which are being forecast by investors to whack corporate earnings in the second quarter of 2020. But imposed on the equities market crash of the past two weeks now is the acceleration of the global oil price deflation that erupted yesterday as Saudi Arabia’s deal with Russia last year to cut production and prop up prices fell apart. Collapsing oil and commodities futures prices are now feeding back up equities and other financial asset prices. Financial price deflation is now spreading, including to currency exchange rates, and money capital is fleeing everywhere into ‘safe havens’ (gold, treasuries, yen).

Will the financial asset markets deflation soon spill over to the credit system—especially corporate bonds—and accelerate the decline of real economies worldwide in turn? Are traditional monetary and fiscal policy tools now less effective compared to 2008-09? If so, why? Is the global economy on the precipice of another ‘great recession’?

Financial asset markets imploding

So we have oil futures market prices, another financial asset marketm, collapsing now and impacting the stock markets. In other words, a feedback contagion underway on stocks market prices in turn. Feedback is occurring as well on other industrial commodity futures prices that are following oil futures prices downward in tandem. But that’s not all the financial contagion and deflation underway.

The freefall in financial assets (stocks, oil, commodities) is also translating into currency exchange price deflation, particuarly in emerging market economies in Latin America, Africa and Asia, which are highly dependent on commodity sales with which to earn needed foreign exchange to finance past debt. Just take the case of Argentina, whose negotiations with the International Monetary Fund (IMF) on how to restructure their debt will now break down, I predict.

Currency exchange rates are in sharp decline everywhere as a result. For emerging market economies that means money capital is more rapidly flowing outward, toward safe havens globally like the US dollar, US Treasury bonds, gold, and the Japanese yen currency.

In short, stocks, oil-commodity futures, and foreign exchange currency markets are all imploding and increasingly feeding back on one other in a deflating downward spiral. This is a classic ‘cross-contagion effect’ that occurs in financial asset market crashes. And crashing financial markets eventually have the effect of contracting the real economy by freezing up what is called the credit markets. Businesses cannot roll over their loans and refinance their corporate bonds. Banks stop lending. The rest of the real economy then contracts sharply. It starts in the financial markets, spreads to credit markets (corporate junk bonds, BBB-rated corporate bonds, then top grade bonds).

Coronavirus effect as precipitating cause

All of this, however, began even earlier amidst a slowing real US and global economy which preceded the recent crash. The global economy was already weakening seriously in 2019, along with the US economy which was propped up mainly by household consumption. Business investment had already contracted nine months in a row in 2019 and inventories built up too much. And, of course, the Trump trade war took its toll throughout 2018-19.

Then came the COVID-19 virus which shut down supply chains in China, and then in South Korea and later Japan. Later, this began impacting Europe, already weakened by ongoing trade wars (especially Germany) and concerns surrounding Brexit. The economic impact of the virus on supply chains developed into a consumer demand crisis as well, highlighted by dramatically reduced travel spending.

Both supply chain (production cutbacks) and demand (consumption cutbacks) are interpreted by investors as leading soon to a big fall in corporate earnings, which translates into the stock price collapse we see now underway. Investors have decided the 11-year growth cycle is over. They are cashing in and taking their money and running to the sidelines, moving it from stocks to cash or Treasuries or gold or other near liquid financial assets.

In all, the COVID-19 epidemic was the ‘precipitating cause’ of the current markets crash, but the underlying, structural weaknesses in the US and global economies were already there. The virus merely accelerated and exacerbated the process.

Mutual feedback effects: Real and financial economies

Of course, financial crashes have the effect of feeding back into the real economy, causing it to contract further. What starts as a weakening of the real economy then translates into the crash of financial markets, exacerbating the crisis. Mainstream economists don’t understand this ‘mutual feedback effect’, and they often misunderstand the various causal relationships between financial asset cycles and real investment cycles. Financial crashes accelerate and deepen the contraction of the real economy, and recessions turn into ‘Great Recessions’ as in 2008-09.

Are corporate bonds and credit markets next?

The feedback effect of the current financial asset price deflation—now underway in stocks, commodity futures, foreign exchange, and derivatives—on the real economy will soon emerge as the financial markets deflation affects the various credit markets. The key credit market is the corporate bond market. Bond markets are far more important to capitalism than equity-stock markets. The credit markets to watch now are the corporate junk bonds (sometimes called high yield corporates).

Junk bonds are debt issued to companies that have been performing poorly for years. They are kept alive by banks helping them issue their bonds at high interest rates. Investors demand a high rate because the companies may not survive. In good times they do. But when markets and economies turn down, companies overloaded with junk financing typically default. The investors that bought their risky bonds are then left holding their debt that becomes near-worthless.

The US junk bond market today is ‘worth’ more than $2 trillion. At least a third of that is oil and energy (fracking) companies. A large part of their bonds must be rolled over, refinanced, in 2021. But many of them will not be able to refinance. Why? Because global oil prices have just collapsed to $30 a barrel, perhaps falling further to $20 a barrel. At that price, the oil-energy junk bond laden companies will not be able to refinance. They will default. That will spread fear and contagion to other sectors of the $2 trillion junk bond sector, especially big-box and other retail companies that also loaded up on junk financing in recent years. Investors will disgorge themselves of junk bonds in general.

Is another ‘great recession’ on the horizon?

Japan is already in recession as of late last year. Now it is contracting, reportedly, by 7 percent or more. Europe was stagnant at best, with Italy and Germany slipping into recession before the virus hit. What’s more, Korea and Australia are in recession now, as are other economies in Asia and Latin America which are also contracting. China’s economy reportedly will come to a halt in terms of GDP this quarter, or even contract, according to some sources. Meanwhile, Goldman Sachs forecasts the US economy growth will stall to 0 percent in the second quarter 2020.

So a collapse in risky corporate bonds will occur overlaid on this already weak real economic scenario. Should that happen, then a recession could easily morph into another ‘great recession’ as in 2008-09; maybe even worse if the banking system freezes up and central banks cannot bail them out quickly enough. Or if banks in a major economy elsewhere experience a crash—as in India or even Europe or Japan where more than $10 trillion in non-performing bank loans exist—and the contagion spreads rapidly to banking systems elsewhere

Failed monetary and fiscal policies, 2009-2019

Which leads us to the following question: can central banks now do so? After the 2008-09 crash, the Fed bailed out the US banks by 2010, but it kept interest rates near zero under Obama for six more years. Banks could still get free money from the Fed at 0.15 percent interest. The Fed bailed out other financial companies to the tune of $5 trillion more as it bought up bad loans from investors at above then market rates. That is, it subsidized them, and did so for six more years. All this free money flowed, mostly into financial markets in the US and worldwide, creating the stock bubbles that are now imploding. So the Fed and other central banks went on a binge subsidizing banks for years, and in the process broke their own interest rate tool needed for instances like the present crisis. The Fed tried desperately to raise interest rates in 2017-18 so it could have a cushion for times like this. But it then capitulated to Trump and began reducing interest rates again in 2019, as it had under Obama for six years.

The free money from the Fed artificially boosted stock prices. On top of this Trump added a further subsidization of banks and non-bank corporations, businesses, and investors with his $4.5 trillion 10-year tax cuts passed in January, 2018. Most of that went as a windfall to corporate-business bottom lines. 23 percent of the 27 percent rise in corporate profits in 2018 is attributable to the windfall tax cuts. And where did that go? It too was redirected to stock and other financial markets, further inflating the bubbles. Here is the channel and proof: Fortune 500 corporations in the US alone spent $1.2 trillion in both 2018 and 2019 in stock buybacks and dividend payouts to their shareholders. The stock buybacks inflated the stock markets, and most of the dividend payouts did as well (buybacks and dividends under Obama were nearly as generous, averaging more than $800 billion a year for six years).

In other words, the 25 percent run up in US stock markets in 2017-19 under Trump was totally artificial, driven by the tax cuts and by the Fed capitulating to Trump and lowering rates again in 2019. Very little of the annual $1.2 trillion went into the real US economy. For the past year real investment in physical infrastrcutrue and equipment actually contracted for nine months in 2019, and is now contracting even faster in 2020.

Just as the Fed has busted its own interest rate monetary tool as it continually subsidized banks and businesses with low interest rates for years, the chronic corporate-investor tax cutting has busted fiscal policy responses to recession.

Since 2001 the US has provided $15 trillion in tax cuts, the vast majority of which have gone to corporations, banks, and wealthy investors. That has led to government deficits averaging more than $1 trillion a year since 2008, accelerating the US federal debt to more than $22 trillion. Fiscal policy is now seriously constrained by the deficits and debt, just as monetary policy is now constrained by virtually all Treasury bond rates below 1 percent in the US and negative rates in Europe and Japan. Interest rate policy responses to today’s emerging crisis are therefore dead in the water (as I predicted they would be in my 2016 book Central Bankers at the End of Their Rope: Monetary Policy and the Coming Depression).

After years of monetary policy being used as a tool to subsidize banks, it is now ineffective as a means to stabilize the economy. The same goes for fiscal policy as tax policy. Used by Obama and even more so by Trump to subsidize corporations, stock buybacks, and financial markets, it is confronted by massive annual US budget deficits and accelerating national debt.

The likely responses by politicians and policy makers to the current emerging financial crisis and recessions in the real economy will be to cut taxes even further for businesses. It will have little effect, however, but it will exacerbate levels of deficit and debt. That means the follow-up will be to attack and reduce government spending, especially targeting social security, medicare, healthcare and education in 2021. Trump has already publicly indicated his intent to do so.

On the Fed side, expect more injection of money directly into the economy and failing businesses by means of another major round of quantitative easing (QE). That’s coming soon. Ditto for Europe and Japan where negative rates already exist. Watch China, too, should its economy contract for the first time in 30 years. And watch India, where its banking system is already fracturing due to causes totally separate from the virus effect. A banking crash in India is also on the agenda. It could result in yet another financial blow to the global economy, adding to the current Saudi-produced oil price shock and the virus effect on supply chains and demand.

Summary and conclusions

In summary, the global capitalist economy is unraveling financially, and soon further in real terms. Massive job layoffs in coming months in the US are a growing possibility. That will drive the US economy deep in contraction as household consumption—the only area holding up the US economy—now joins the contraction. It remains to be seen how US monetary and fiscal policy can restore economic stability given its self-destruction by politicians since 2008. Trump’s policies have been no different than Obama’s; just more generous to corporate America and investors. Trump’s policies are best described as ‘Neoliberalism 2.0’ or ‘Neoliberalism on steroids’ (for more on this, see my new book, The Scourge of Neoliberalism: US Economic Policy from Reagan to Trump).

The US and global economies are well on their way to a repeat of the ‘great recession’ (or worse) of 2008-09. Only this time traditional monetary-fiscal policy is much less effective. More radical policy responses will likely be developed to try to stabilize the capitalist economies both in USA and elsewhere (where problems are even more severe).

Watch closely as the crisis on the financial side moves on from equity (stocks), commodities, and foreign exchange financial markets into derivatives markets and credit markets, especially junk bond and other corporate bond markets. Watch as the Fed tries desperately to provide liquidity to business and markets via its repo channel and QE since its traditional rate channels are now ineffective. And watch as US and global capitalist advanced economies try to coordinate new fiscal policy responses to the general dual crisis in financial and real economic sectors of global capital.

Dr. Jack Rasmus is the author of several books on the USA and global economy. He hosts the weekly New York radio show, Alternative Visions, on the Progressive Radio network, and is shadow Federal Reserve Bank chair of the ‘Green Shadow Cabinet’. He also served as an economic advisor to the USA Green Party’s presidential candidate, Jill Stein, in 2016. He writes bi-weekly for Latin America’s teleSUR TV, for Z magazine, Znet, and other print and digital publications.


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