The U.S. stock market is nearing its all-time highs. This appears to be very good news, but it also reminds us of what happened the last time the markets reached these dizzying heights. The recession of 2008 not only devastated the U.S. economy, it sent markets around the world into a tail spin. So this might be a good time to examine what exactly caused the Great Recession of 2008. What factors were important in creating such a disaster and do those factors exist today?
When considering the origins of the crash, most people immediately think of the United States. Most fingers would gravitate toward Wall Street and the American financial sector. The first factor that might come to mind is the unlimited greed of American financiers. Financial institutions of all types coupled with the connivance, incompetence or corruption of the rating agencies, allowed incredibly risky behavior. In 1947, the U.S. financial sector represented only 2.5% of our gross domestic product. By 2006, it had risen to 8%. In the first decade of the 21st century, it managed to gobble up 41% of all of the profits earned by businesses in the U.S. Directors in U.S. financial firms were earning million and in some cased billion dollar bonuses. The average bonus on Wall Street was half a million dollars a year. These hefty pay packets pushed the United States to have an even more unequal distribution of income as the richest 1% took an ever larger share of the national income.
These outsized profits were often earned by a second factor, financial innovation. Financial wizardry created novel financial products that sliced and diced debt into new and different ways. Once repackaged, this debt could be sold on as riskless investments all over the world. Much of this debt was considered safe because it had rock solid collateral: U.S. real estate. Housing prices in the United States had been rising steadily for 50 years. The last time housing prices declined was during the Great Depression in the 1930s. So no one ever considered that a decline was even remotely possible.
This seemingly riskless financial innovation was hailed as one of the triumphs of capitalism, a third factor. Most people believed that financial innovation actually made the markets and the banking system safer by spreading the risk far beyond banks.
This faith in capitalism was actively supported by the government. The Federal Reserve provided a fourth factor: loose monetary policy and light supervision. Subsidized government agencies like Fannie Mae and Freddie Mac provided the implicit government guarantees that freed investors from concern and allowed even riskier behavior. So the government's oversight not only failed miserably to reign in the abuses, it actively participated.
Most of these problems do not exist currently in the U.S., Europe and Japan. It is well known that these countries may be running large and perhaps unsustainable sovereign debts, but they do not seem to have other major credit issues. But there might be another country that is showing a similar pattern: China.
China has a powerful elite who, like the financiers, are a law unto themselves. For the privileged, it can mean vast fortunes. It is one of the few places that can give Wall Street some lessons on greed. Just before he stepped down it was revealed that the family of premier Wen Jiabao had amassed a fortune of $2.7 billion dollars. China's Gini coefficient, an index measuring income inequality, was 0.61. This makes China one of the most unequal societies in the world. The inequality of wealth equals or surpasses countries in Latin America like Brazil, long famous for the gap between rich and poor.
China may not be leading the world in new financial innovations, but its financial system has been evolving rapidly. Many of the products are not new, but they are new to China. As little as two years ago, the Chinese financial system was firmly in the hands of the state-owned banks. State-owned banks had captive depositors, who could not object to the interest rates paid on their accounts. There were no alternatives. Bad debts and defaults could be absorbed, hidden and socialized in the mandated spread. The system may have been unfair, but it was stable.
But recently there has been an explosion of the shadow banking system. This is a system of investments like Wealth Management Products (WMPs) that provides an alternative to the regular banking system. The system now has 12 trillion yuan ($1.9 trillion) under management, almost 13% of the banking system. It has grown over five times since 2009. It has also led to an explosion of credit growth. In 2012, credit in the amount of RMB 15.6 trillion was formed. But it did not create an equivalent amount of growth. Nominal GDP grew by only RMB 4.6 trillion. So every RMB of credit generated in 2012 created only RMB 0.30 of economic growth. The controls available in the state banking system are absent in the shadow banking system. So it is neither transparent nor stable.
The shadow banking system was not so much created as allowed. Last year, the government in an attempt to tame inflation and housing prices slowed credit creation through the banks. They were probably a bit too successful. In a year of leadership change, a sudden collapse might not be appropriate, so the regulators were far more lenient on this sector.
Like the poor regulation in the U.S., the regulation in China is far behind the financiers. Banks used to funnel money through trust companies to borrowers that otherwise couldn't receive bank loans like over indebted local governments. In 2010, the China Banking Regulatory Commission put limits on the practice. So instead of trust companies, banks cooperated with Chinese brokerages. Last year, the assets managed by these firms soared from 280 billion yuan to over 1.2 trillion yuan ($193 billion). Most of this money, between, 80 to 90%, came from banks shifting assets off their balance sheets in order to circumvent lending restrictions. Of course where this money eventually goes is also beyond the regulator's knowledge.
China is far from a truly capitalist society, but that does not mean that its system does not have apostles. Quite the contrary, China has managed spectacular growth for the past 15 years. While most of the developed world barely manages slow growth, when they manage growth at all, China booms ahead. The decline of its growth below 8% is considered a major change. CEOs and economists throughout the world give enormous credit to the Chinese technocrats. It has long been an article of faith that the government can and will do everything possible to keep the economy growing. Like comments made during the "Great Moderation," people believe that in China recessions, let alone crashes, simply cannot happen.
Finally, like the Federal Reserve before the crash, monetary policy of the Chinese monetary authorities has been exceptionally loose. In 2008, before the crash, the number of loans was only Rmb 3.5 trillion yuan a year. Since then it has averaged Rmb 7.5 trillion ($2 trillion) or a total of Rmb 37 trillion yuan ($6 trillion) over the past four years. This January it hit a record high of Rmb of 2.5 trillion ($400 billion) in one month alone - more than double the rate of a year ago.
In the U.S., the equity and housing markets just before the crash were hailed as the product of a healthy, well managed economy. The increased wealth of most people through the rise in the value of their assets was considered evidence of the ability of the financial system and the policy makers. When the crisis finally occurred it seemed to come as a complete surprise, a black swan. The reality was that the elements were always there for all to see.