We are facing another financial meltdown
A brief history of the financial landscape after WW2; what went wrong, and why we are repeating the same mistakes.
After World War 2, the Allied nations created the Bretton Woods agreement, which was the system of monetary management. It established the rules for commercial and financial relations among the United States, Canada, Western European countries, Australia, and Japan. Under the agreement, countries promised that their central banks would maintain fixed exchange rates between their currencies and the dollar.
Since Richard Nixon dismissed the Bretton Woods agreement in 1971 (and took USD off the gold standard), globalization became a powerful economic driver. Neoliberal economic policy deregulated the financial industry, entered into free‐trade agreements, and significantly cut taxes for corporate and the wealthy. The promise of the »trickle-down effect« by the Ronald Reagan administration (by which average Joe should benefit from reduced taxes for the wealthy), turned out to be a (deliberate) illusion.
Because of globalization and neoliberalism, Global Financial Assets have risen dramatically, and according to Bain and McKinsey Global Institute, they peaked at 10‐12x Global GDP. The Financial Sector has grown to become the largest sector in the US with over 21% of GDP. Share of Manufacturing has shrunk from over 27% to 11% in the last 30 years, and this fall as a share of GDP coincides with the increase in Financial Sector.
The Financial Sector now represents approximately half of non‐farm corporate profits. Financial Sector directly receives more of the surplus than the Production and Retailing part of the real economy combined. The financial sector is supposed to facilitate transactions in the real economy but has received a considerable surplus. This is the direct result of the Financial Assets and debt growing rapidly. On top of that, cumulative investment income, interest compounding, and taxes in this sector are being reduced.
Increasing (over)supply
There is an abundant supply of labor, assets, and capital, and although there are also demand issues, we have created a situation with massive oversupply. The oversupply of labor and assets, in particular, has eroded jobs and real wages in the developed economies.
Oversupply of labor
Due to globalization, 1.1 billion workers have entered into non‐farm jobs in emerging economies over the last 30 years. This caused a lack of jobs that the US labor force has experienced over the past decade. More than 600 million more workers will be added to the workforce in emerging countries over the next 20 years, according to McKinsey.
The result is that manufacturing jobs have disappeared from the US and replaced it in the Financial industry. In reality, the US has let go of the jobs and replaced manufacturing with the financial sector, where there are far fewer jobs. What will make this even worse is that the developing countries are also facing a demographic challenge, as labor force growth will in some countries turn negative as the baby‐boomers retire.
Oversupply of Assets
Aggregate investment (CapEx — Capital expenditures are funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment) level and employment is strongly correlated. The reduction in jobs is also caused by underinvestment in developed vs. developing countries.
While China and India have steadily increased their investments as a percentage of GDP (China close to 50% CAPEX/GDP), the developed countries have reduced their investments as a percentage of GDP. As outsourcing of manufacturing to low‐cost countries has accelerated as globalization increased, it is logical that investments will occur in developing countries and not the developed countries.
However, the massive investment level has created abundant manufacturing assets and infrastructure in the developing world, while assets have been closed or reduced in the developed world.
Oversupply of Capital
In developed economies, we are witnessing Current Account deficits but surpluses on the Financial Account. As most of this money is created through increased credit and government deficit spending, there has been an increasing inflow of USD seeking return. Imported negative inflation and increase in USD seeking investments caused the interest rate to fall (after the dotcom bust and further after GFC and the current worldwide pandemic)
All these different events from 1971 till today make this party on financial markets even bigger and unsustainable. The increasing supply of capital, which has become ridiculously cheaper, is pushing the whole financial system to risks that have never been seen before.
Debt financing
The banks create deposits through their lending process, and the result is the creation of money. This money adds to aggregate demand, which has or should have a positive impact on both GDP growth and asset values.
The increasing debt level has maintained growth in purchasing power, although the consumers have been facing stagnating jobs and wages. Debt becomes the »plug« in the picture of increasing supply and what should have been falling demand.
In almost all developed economies, debt levels quadrupled in the last 40 years, and with the way the world economies are dealing with a pandemic (enormous stimulus packages, QE…), the debt levels will rise even further. It’s easy to see that this is unsustainable.
As an increase in debt has added to the aggregate demand in the economy, the deleveraging (or if debt stops increasing) will subtract from the aggregate demand in the economy. The US economy pulled out of recession when credit increased again (as predicted), but for how long will this continue before deleveraging occurs again?
Conclusion
As identified above, we face stagnation in the developing world, as we have had an increasing supply of low-cost labor and assets in the developing world. This has caused labor participation rates and real median wages to decline, and the middle class comprising the lion’s share of the consumption is facing reduced purchasing power. For some time, this has been compensated by rising debt, but the debt level is currently at or above what is long-term sustainable.
Globalization has brought an increased supply of cheap labor and assets. While the corporate and financial sector has enjoyed the benefits from this through lower costs and increased market access, the effect on the domestic labor force and the middle class has been dramatic due to fewer jobs and lower wages. Had it not been for the increase in debt level in the household sector, the effects would have been seen in the real economy much earlier. There would have been a lot more severe economic downturns than we actually faced in reality.
This one‐time debt increase appears to come to a natural end as the debt level has become unbearable for a large part of the population. Also, GDP growth going forward will be negative for the US and most developing countries. We will continue to enter in and out of recessions in the developing countries going forward, mainly dependent on whether we are going through phases of deleveraging or positive credit growth
Possible solutions
Therefore we need to build a new, more flexible, and more just financial system. We believe that the current financial system is not sustainable and favors specific market participants. Therefore it needs to be replaced. The pandemic and the way our governments are dealing with it are leading us to another financial meltdown. Maybe this time it will mean the end of the financial world as we know it.
Maybe there is a real chance of introducing UBI (Universal Basic Income) and a fully implemented blockchain framework in our economies, especially in financial markets. This could help reduce imbalances and practices of privileged participants in financial markets and get rid of an unnecessary middle man in everyday transactions.
DISCLAIMER: This article is for informational and discussion purposes only and does not constitute a marketing message, an investment survey, an investment recommendation, or investment advice. The article was prepared exclusively for a better understanding of market dynamics.
