The seeds of the next debt crisis

It should be noted that with debt levels already at a record level, there are those who consider that the coronavirus increases the risk of a credit crisis in a world of low-interest rates.

Undoubtedly, the shock caused by the coronavirus in markets around the world coincides with a dangerous financial backdrop marked by the spiral of global debt. In fact, according to the Institute of International Finance, a trade group, the ratio of global debt to gross domestic product reached a record high of over 322 percent in the third quarter of 2019, with total debt close to $ 253bn. In this way, it could be said that the implication, if the virus continues to spread, is that any fragility in the financial system has the potential to trigger a new debt crisis.

Likewise, it is understood that in the short term, the behavior of credit markets will be critical. Despite declining bond yields and borrowing costs since the markets panicked, financial conditions have tightened for weaker corporate borrowers. Their access to bond markets has become more difficult.

Search for an answer

Notably, policymakers in advanced countries have made clear last week their willingness to seek an active fiscal and monetary response to the disruption caused by the virus. Despite this, this political activism carries a longer-term risk of entrenching the dysfunctional monetary policy that contributed to the original financial crisis, as well as exacerbating the dangerous over-indebtedness now facing the global economy.

Certainly, risks have been accumulating in the financial system for decades. And it is that since the late 1980s, central banks, and especially the Fed, carried out what was known as “asymmetric monetary policy”, through which they supported the markets when they sank, but failed to buffer them when were prone to bubbles. Excessive banking risk was a natural consequence.

Likewise, the quantitative easing of central banks since the crisis, which involves the purchase of government bonds and other assets, is, in effect, a continuation of this asymmetric approach. The resulting safety net placed under the banking system is unprecedented in scale and duration. The lax and continuous policy has led to debt-financed private spending, thus lengthening an already long cycle in which extraordinary low or negative interest rates seem to be less and less effective in stimulating demand.

A comparison of current circumstances with the period prior to the financial crisis is instructive. In addition to a large increase in post-crisis public debt, an important difference now is that the focus of debt in the private sector is not on mortgage and property loans, but on loans to the corporate sector.

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Source: John Plender | Financial Times