Global Stock Selloff: Is another financial crisis coming?

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It’s like déjà vu all over again. Or is it?

That’s the question everyone on Wall Street will be asking as they enter their somber offices this morning. Thursday’s bloodletting on U.S. stock markets followed time zones around the globe as investors engaged in a panic-driven global selloff. Tokyo and Seoul were both down 3.7%, and Hong Kong 4.3%. European markets didn’t fare much better. And while Friday on Wall Street wasn’t nearly as bad as the day before, the mood is still tense. With the sense of timing only a rating agency could possess, Standard & Poor’s downgraded the U.S. credit rating on Friday. I personally believe the downgrade is ridiculous, but whatever I might think, it gives investors yet another reason to be nervous when markets reopen on Monday. 

The global market hysteria might seem like a flashback to the horrifying days of September 2008, when Lehman Brothers collapsed, a financial crisis gripped the world and we landed in the Great Recession. Does the turmoil today mean we’re heading for a similar global crash?

Before we look at where we might be going, let’s take a glance at where we’ve come from. Why are markets tanking? In my opinion, the only thing surprising about the selloff is that some people seem to be surprised by it. The ascent of stock prices earlier this year, especially in the U.S., was detached from the reality of the world economy. Investors seemed to be simply ignoring the constant drumbeat of bad news. Growth in the U.S. has been weaker than expected, unemployment remains stubbornly high and the housing crisis is far from over. The euro zone debt debacle is intensifying, with giants Italy and Spain increasingly under pressure. Inflation has forced emerging markets like China and India to slow down their overheating economies. Oil and food prices, while no longer rising rapidly, are still at elevated levels, eating into consumption spending around the world. The optimism at the beginning of the year about the strength of the recovery was way overblown. We are still suffering from the fallout from the Great Recession. Investors were in denial about the obvious risks. Not anymore. Stock markets are supposed to be forward indicators; today investors are just playing catch up.

Now that the global investor community has woken from their greed-induced coma, where might the global economy be headed? If I could answer that question with any certainty, I’d be typing out this post from the heights of Mt. Olympus, not the much-less-lofty environs of a crowded Starbucks in Hong Kong. An economic slowdown is not enough to cause a full-on financial crisis. So in order to start thinking about the possible answer we have to play a financial version of Where’s Waldo – we have to figure out if there is a ticking time bomb waiting to explode somewhere in the global economy and launch us into another worldwide crisis.

It’s likely not hiding out in the U.S. Yes, growth is slow, and Washington’s recent debt ceiling agreement is disappointing, and then you’ve got this S&P downgrade. But, so far at least, the world does not appear overly concerned about the state of American finances. Nervous investors continue to flee into Treasuries, not out of them. I’m not sure the downgrade will, in the short term, change that very much. Nor does there seem to be a big, unacknowledged hole in the guts of the American financial system – the cause of the 2008 crisis. The housing-bubble-backed subprime mortgage fiasco has already inflicted its damage; that bubble burst and Wall Street has taken its knocks. In other words, the U.S. time bomb may have already detonated.

Out here in Asia, things are still relatively buoyant. China and India may be slowing down, but not disastrously so. There are some worries about the level of debt in the Chinese economy, as well as what seems to be a percolating housing bubble, but that potential time bomb may not be ticking yet. If Asia ends up in a financial crisis, it will likely be dragged in from elsewhere.

But then there is Europe. I argued recently that Greece is not Lehman, and its debt crisis wouldn’t have the same impact on the global economy. I still believe that. But as the euro zone debt crisis grows in size, we should be asking if European sovereign debt is the ticking time bomb. Greece may not be Lehman but crises in Greece, Portugal, Ireland, Spain and Italy could add up to something just as scary as the 2008 Wall Street meltdown, with sovereign bonds playing the lethal role of subprime securities. Borrowing costs for Spain and Italy have been rising closer to levels at which the other PIIGS were forced to seek bailouts. The problem is that the EU may not have the capability to rescue both Spain and Italy. So the sovereign debt problem in Europe could explode, freezing credit and undermining banks in Europe, and spreading chaos through globalized financial and banking markets around the world from there. In the Financial Times today, Gillian Tett outlines how recent events in Europe resemble those in the U.S. leading up to the Lehman collapse:

Viewed from New York, the manner in which this eurozone story is playing out feels unnervingly similar to the pattern behind the American financial turmoil of late 2008…So will this now be followed, as it was in 2008, will a full-scale financial meltdown? Will panic spread when investors suddenly stumble on some overlooked interconnection risks? Just remember what happened, say, when it transpired after Lehman collapsed that hedge funds assets were not ringfenced in London; the legal fine print of opaque financial contracts can sometimes matter enormously but have unpredictable consequences.

The point I’d like to highlight in Tett’s fine analysis is the role of denial. American policymakers ignored the signs of crisis ahead of the Lehman flame-out; now Europe’s leaders have picked up the torch and have buried their heads in the sand just as deeply. The euro debt crisis has never been a liquidity crisis, though it has always been treated that way. The euro zone chieftains have routinely been slow to act, and when they do, the result is underwhelming.

Now I don’t want to add to the panic driving global markets downward. The recent selloff could be no more than a correction, a gravity-induced return to reality. Markets in Asia recovered from their early lows by the end of the day. But at the same time, the global stock selloff is a result of the inability of the West’s political leaders to tackle their serious economic problems. I’d like to hope that the recent turmoil is not the start of a renewed crisis, but a warning for politicians in Berlin, Brussels and Washington, that it’s finally time to get their collective acts together. Otherwise we can’t dismiss the possibility that the next ticking time bomb could well explode, and another Great Recession could loom somewhere on the horizon.