Both the global financial crisis (GFC) of 2007-2008 and the Covid-19 pandemic caused disruptions to the world economy.
During the GFC, stock markets plummeted, and millions of people became unemployed. Business and bank failures resulted in financial pain.
Covid-19 did not cause as much economic destruction as experts predicted. So far, at least.
During this recession, bankruptcies declined during the pandemic, while prices of assets such as cryptocurrencies, stocks, and houses reached record levels. The net worth of US households increased by USD$26 trillion in 2020.
These developments are extraordinary and unusual. Usually, recessions mean severe losses rather than wealth gains. Are our current financial circumstances sustainable?
Our new report Walking the path to the next global financial crisis explains how skyrocketing public debt and monetary policy easing threaten global financial stability.
In the wake of the GFC, government bailouts of financial institutions ratcheted up public debt ratios dramatically. That was not reversed before Covid struck.
Governments and central banks in developed economies now face tough choices regarding interest rates and debt.
Raising interest rates or ending quantitative easing could destabilise asset markets and the economy. Governments, meanwhile, struggle to wind down stimulus spending and fear higher interest payments on debt.
By printing money and maintaining low-interest rates, it also fuels consumer price inflation. In New Zealand, consumer price inflation hit 4.9% – the highest level in over a decade. Inflation in the US and the EU is also approaching 6%.
The authorities are not showing a determination to return settings to more normal levels before the next economic shock occurs. They have led investors to believe that the government will underwrite high asset prices such as cryptocurrencies, stocks and housing.
It is now common to hear terms like “too big to fail” and “whatever it takes” in financial market jargon. Such beliefs are dangerous for financial stability.
For the government, it is prudent to repair the roof while the sun is still shining. Financial support packages were necessary during Covid-19. But the government should have a credible plan for reducing net debt to more sustainable levels once the pandemic is over.
The financial well-being of citizens is at greater risk when governments are less financially prudent.
As a small, globally integrated economy, New Zealand cannot prevent the next financial crisis.
We do not know when the next financial crisis will hit. But we can prepare for it when it does.