Home \ Blog \ Two Respected Business Voices Warn of the Coming Crash

Two Respected Business Voices Warn of the Coming Crash

With the Dow and NASDAQ off to their best start of the year since 2006, there's no denying that most of the key indicators suggest good economic times are here and appear likely to continue, at least in the near term for equity investors, owners of other financial assets and the richest of the rich.  The massive stimulus and liquidity resulting from the tax cut and repatriation bill will, by most accounts, result in huge direct and indirect windfalls to the wealthiest Americans.  That will likely significantly juice stocks and other assets.  Of course, 2006 was also the last time everyone agreed that good times were going to continue, but massive systemic risks were building unseen.

The catastrophic financial crash of 2008 - which continues to wreak havoc in the country socially, economically and politically - demonstrated beyond doubt the horrific dangers of everyone believing the same thing.

That's why everyone should think carefully about Gene Ludwig's recent Op Ed in the American Banker:  "Bankers should resolve to be more paranoid in 2018."  Mr. Ludwig is a respected business leader, former Comptroller of the Currency and founder and CEO of Promontory Financial Group (recently acquired by IBM).  Whether you agree or disagree with him on any particular issue, he is as experienced, thoughtful and knowable about our financial and regulatory system as anyone alive.  Yet, he's worried.  Very worried.............and for good reason:

"Forces are building that suggest that the next recession could be more like 2007 [financial crash] than simply an ordinary cyclical turn down.  In fact, the last 100 years of finance suggest that tail-risk events that seriously impact finance are more common than many believe - and may be more frequent.... I fear that a major tail event that will shock the financial industry is likely in the foreseeable future."

After reviewing some of the concrete risks apparent now, Mr. Ludwig discusses how financial firms should be thinking about these possibilities as indicators of an impending crash start to emerge, noting, among other things, that "we all benefit by reasonably frequent stress tests."  He concludes by observing that, "[d]espite these risks, many market observers continue to claim there is nothing but better times in sight."  You don't have to be a scholar of Hyman Minsky's work to understand that kind of thinking is almost always a certain sign that bad, if not disastrous times are coming.

Although more muted, another wildly successful, highly respected businessman has issued a similar warning:  Ray Dalio, founder and leader of the hedge fund Bridgewater Associates (and author of the recent, must-read best seller "Principles").  For lots of reasons, Mr. Dalio is worth listening to, not least of which is that his firm foresaw the 2008 financial crash coming.  As reported by Greg Ip at The Wall Street Journal in a story entitled "A Hedge-Fund Titan Puts Away the Punch Bowl," Mr. Dalio (unlike Mr. Ludwig)

"doesn't see another crisis in the offing, [but] he does see the same underlying stresses at work: Americans have accumulated far more debt than they have assets and income to support.  Not only will this drag on growth and markets, it will leave the economy acutely vulnerable to higher interest rates."

Mr. Dalio is focused on economic fundamentals (and the social and political implications of another downturn):

"The problem is that with interest rates and risk premia near all-time lows and debt and asset values near all-time highs, there's little fuel to repeat the process [the Fed used to rescue the economy in 2008-9].  Just as the Fed can't cut rates much, it can't raise them much either, or debt servicing would swamp cash flow and asset prices would sink."

We have talked about the logical implications of this for some time:  unlike 2008, the US simply does not have the fiscal or monetary capacity to respond to another cyclical downturn, much less a financial crisis, which, as Mr. Ludwig points out, is increasingly likely.

Mr. Dalio, however, didn't identify all the accelerants currently providing kindling for the fire to come.  First is the ongoing economic damage from the 2008 financial crash: wage stagnation, underwater homes, debt exceeding 2008 levels, student loan debt doubling to $1.3 trillion, under-employment, the lowest employment to population rate in history, increasing inequality and all but nonexistent economic mobility.  Second, is the equity and asset bubbles created by the Fed's post-crisis zero interest rate and QE policies, which have now been supercharged by the stimulus and liquidity of the Trump tax cuts.  Third, the likely coming cuts to social safety net programs purportedly due to the astronomically high deficits and debt created by those tax cuts.  Fourth, the loss of health care by millions of Americans and the increase in health care costs for almost everyone else.  Added to the point Mr. Dalio did make -- the increasing and unserviceable debt loads of individuals and corporations which are going from burdensome to unserviceable as the Fed increases rates (i.e., a Fed quarter increase will move an additional $1.5 billion out of the pockets of credit card holders into banks’ bonuses) – and the economic, social and political ramifications cannot be overstated.

This is precisely when countercyclical measures should be put in place by regulators, policy makers and elected officials.  However, the Trump administration is doing the exact opposite at the worst possible time (very similar to what was done in the years before the crash in 2008).  The Trump administration is attempting to remove many of the financial protection rules put in place after the last crash to prevent the next crash.  They are steadily chipping away at the rules across the financial regulatory agencies and the Treasury Department has issued comprehensive reports providing a roadmap for more. 

This has been the plan all along.  Rather than a direct frontal assault on financial reform, the industry and its allies have always wanted to cause death by 1,000 cuts, a few at each of the SEC, the CFTC, the Fed, OCC, FDIC and Treasury.  Additionally, notwithstanding all the priorities of the American people, it looks like the first bipartisan bill to come out of the US Senate will be to deregulate finance even more.  When added to the elimination of designating systemically significant nonbanks and the gutting of FSOC, which will recreate the two-tier regulatory system that incentivizes risk to migrate from the regulated banking sector to the unregulated shadow banking system, the signs could not be more ominous.  Given that the industry is enjoying record revenues, profits and bonuses (directly rebutting their baseless claims that the financial protection rules are hurting banks, lending and the economy), history is going to judge them all very harshly.

While important, Mr. Dalio is actually worried about the likely best-case outcome:

"[H]is biggest worry is that lower corporate taxes and higher stock prices do nothing for the bottom 60% of households who own almost no assets and whose stagnant wages are the mirror image of expanding profit margins, feeding resentment and political polarization.  Says Mr. Dalio: 'If we do have an economic downturn, I worry we will be at each other's throats.'"

We agree with Mr. Dalio, except it's not "if," but "when" and how bad.  The rules of economics have not been suspended today any more than they were in the years leading up to the 2008 crash, although many of the most respected and accomplished economists, policy makers, regulators, financiers and bankers thought so and argued aggressively that it was true....................until it was not.

Share This Article: