Los Angeles, CA (TFC) – Since the start of 2016, financial news headlines have been increasingly grim. The stock market has gradually been sliding and other markets including Europe and Asia have been increasingly volatile. Despite the fact that some of this volatility is related to political instability, there is undeniably an underlying weakness in the economy. These developments have raised concerns about the prospect of another financial meltdown or economic downturn.
The 2008 Financial Crisis is a very complex phenomenon that is well beyond the scope of this article. However, it is very comparable to the Great Depression in that they were both caused by similar financial practices. Ultimately the Great Depression and the 2008 Financial Crisis were caused when high risk investments failed. Since nearly every financial institution invested heavily in these failed investments, outrageous amounts of wealth were instantly destroyed. This threatened many banks and financial institutions with failure, which caused panic. Since many of these banks were on the brink of failure, they could not lend to the public which is essential to the functionality of the economy. This contraction in credit greatly harmed the American economy, which then through the mechanisms of globalization, greatly slowed down the global economy.
An economic catastrophe of this magnitude warrants action by the government. During the Great Depression, economics was an emerging field of study and was not understood. As a result, the government and the Federal Reserve did not know how to respond to such a crisis. However, since the Great Depression, economists have found that to recover from a situation like this, the supply of money needs to be increased so that the flow of credit can be reestablished.
The US government responded to the 2008 Financial Crisis by bailing out the banks. Many people, including myself, were morally outraged by the fact that those who caused the crisis were going to receive access to taxpayer money. However, despite its obvious moral shortcomings, the bailout undeniably prevented the failure of the banks, which would have restricted credit even further and made the crisis worse (which occurred during the Great Depression). The Federal Reserve also worked to increase the supply of money by engaging in quantitative easing, which is the purchase of toxic securities from financial institutions to increase the supply of money. The idea was that financial institutions would use this money to lend to the public while lowering the interest rate. This would, at least in theory, restore the flow of credit and end the crisis.
Sadly, quantitative easing did not have its intended effect. Instead of lending the money to the public, banks hoarded the money to collect interest. The low interest rate that quantitative easing caused also allowed financial entities to borrow money cheaply so that they could buy securities. This increased demand drove the stock market up, despite the fact that the economy was still in a poor state. As a result, many argued that the stock market was overvalued and that the economic “recovery” that has occurred since 2008 was largely superficial.
The recent volatility in the stock market started in December 2015, when the Federal Reserve announced that it was increasing interest rates and slowing down quantitative easing. Since this announcement, the stock market has decreased. At the same time, there have been many other developments that have threatened the global economy. The Chinese economy has demonstrated signs of weakness and is almost certainly slowing down. This caused panic on the Chinese stock exchange, which was performing so badly that it was actually shutdown twice within the span of a week. Europe recently reported very weak growth in the last quarter of 2015 and many believe that low oil prices are fueling political instability which is harming the global economy.
There are currently many threats that can lead to continued instability or a financial meltdown. While I am not qualified to say whether any of these can or will cause a financial meltdown, I can say that the governments are running out of options for combatting a financial crisis if it were to occur. At the World Economic Forum (the Davos Summit), an official from the Bank of International Settlements claimed that central banks were running out of tools to combat another financial crisis. This is very plausible in light of the Federal Reserve’s decision to slow down quantitative easing. In addition, many countries have expended large amounts of their foreign exchange reserves in an attempt to prop up their currency and their economy. Some countries, like Japan, have come up with creative solutions, like negative interest rates, to try to continue economic stimulus. However, the stock market reacted poorly to this announcement, which likely demonstrates the public’s skepticism towards this proposal. As a result, if something bad happens to the economy, it seems that there is little that governments can do to respond to it.
The current situation that the global economy faces is unprecedented. It seems to me that the global economy is currently on the brink and that a small push could send it over the edge into a recession or a meltdown. There are many threats that could provide this push and, if it occurs, it seems that governments have very few options for responding to it. As a result, I fear that if the economy begins to slide, there could be a domino effect that could push the world into a global recession. Only time will reveal what will happen. But for the world’s sake, I genuinely hope that my assessment is wrong and that the economy is in a much better state than it appears.