When the global financial system wobbles, it always seems to happen in August.
Maybe it is because so many traders are on vacation, making for less liquid markets and wilder swings. Maybe it's just coincidence. But some of the most turbulent events in financial markets in recent times have arrived in the late summer, including the Augusts of 1989, 1998, 2007, 2011 and 2015.
And so it is again in 2019, as a trade and currency war between the United States and China, as well as a slowing European economy and geopolitical strains worldwide, have sent markets spinning. The pattern continued with a steep global sell-off Monday.
To make sense of this latest turbulence, and what it portends for the global economy, two past episodes of August volatility are particularly worth studying. In fact, the outlook for the economy in 2020 depends in large part on which historical moment proves to be the better comparison: August 1998, or August 2007.
In both years, there were problems similar to, though not exactly alike, those afflicting the global economy and markets today. But in 1999 the United States economy ultimately continued booming, whereas the events of 2007 led straight into the deepest recession in modern times.
August 1998: An emerging markets crisis after Russia defaults
Several East Asian nations had been in financial crisis for about a year, but in August 1998, a full-blown crisis in the debt of emerging nations enveloped global markets.
The immediate cause was Russia's decision to default on its debt obligations, which sparked fears that other nations might do the same. Money flooded into safe assets, particularly government debt of the United States and Germany. The value of the dollar rose on exchange markets, worsening the situation for emerging nations that owed money in dollars. Commodity prices fell, reflecting a slowing world economy and adding to the strain on nations that relied on oil and similar exports.
The US economy was in the midst of a boom at the time — the unemployment rate was 4.5 per cent in August 1998. But American policymakers worried that the international turbulence would tighten the flow of credit in the United States and put the expansion at risk.
"Let me just go a step further and point out the one thing that I find particularly bothersome: It is that this element of disengagement, fear, uncertainty and the like is really pervasive around the world, and it is occurring in the same time frame," said Alan Greenspan, the Fed chairman at the time, on a confidential conference call with the central bank's policy committee in September 1998 (a transcript was released after a long lag).
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Greenspan and his colleagues acknowledged that the domestic economy still appeared strong, but cut interest rates that month to forestall damage that might come from overseas.
"While we have yet to see this in the real variables of the US economy, except at the margins, it is very hard if history is any guide to believe that growth above 3 per cent is possible in the context of the types of decisions that are being made for capital investment and inventories," Greenspan said at that meeting.
The Fed would ultimately cut interest rates three times that fall.
The results: It turned out he was too pessimistic. The US economy grew a stunning 4.8 per cent in 1999, and the jobless rate kept falling. The emerging markets panic subsided, and the combination of the dot-com boom and the Fed's rate cuts turbocharged the stock market.
If anything, the economy might have been running too hot in 1999, in the sense that the eventual popping of the stock market bubble and resulting drop in corporate investment in 2001 caused a recession (albeit a mild one).
The parallels: As in 1998, the danger in 2019 comes from a slumping world economy, reflected in falling commodity prices, a rising dollar and money gushing toward Treasury bonds and other safe assets. And as in 1998, the Fed is in an interest-rate-cutting mode to try to offset the damage to the United States.
The differences: But there are important differences, too. Trade tensions are at the core of the current bout of volatility, and in this case policy in the United States is driving the uncertainty — witness the Trump administration's plans to apply additional tariffs on China on September 1 and its declaring the country a currency manipulator last week.
Additionally, the economic damage to the United States in 1998 was limited not only thanks to the Fed's actions, but also because the real crisis was taking place far away — it was not striking at the heart of the supply chains and export markets of America's biggest companies.
The lesson: The episode is a reminder that financial contagion, though real, is not inevitable.
August 2007: Beginnings of the global financial panic
Throughout 2007, more and more American homeowners were defaulting on their home mortgages. As a result, the supposedly safe securities backed by these mortgages — especially subprime mortgages — were falling in value.
That generated losses, especially among the European banks that were heavy holders of those securities, and led them to hoard cash and become reluctant to lend to one another.
A dangerous cycle was taking hold: A slowing housing market in the United States was causing a slowdown in the economy and losses in the financial system around the world. The breakdown in the financial system in turn was tightening the availability of credit, which made the housing situation worse.
The European banking system was freezing up, and on August 9, the European Central Bank injected €95 billion ($165.1b) to try to ensure the free flow of money and avoid a credit crunch. It was the first in a long series of aggressive actions by central banks around the world.
By September, the Fed was cutting interest rates in hopes of preventing a recession, and the government ultimately engineered a series of huge bailouts of the financial sector. But the vicious cycle was too powerful: The United States entered a recession in December 2007, and the downturn became severe in the fall of 2008 after the collapse of Lehman Bros.
The results: The global financial crisis was a transformative event, inflicting enormous pain on billions of people and undermining the credibility of centrist politics and elite institutions worldwide.
As in August 2007, the forces unleashed in global markets this month reflect complex, intertwined forces across different oceans and markets.
This time, instead of the US mortgage sector, the problems are rooted in a rapidly escalating trade war between the United States and China, and in longer-term problems in Europe. Those forces are combining to drag down global growth and commodity prices, putting a damper on investment spending by American companies, despite a generally solid economy.
Bond markets are increasingly pricing in lower growth and inflation in the years ahead, and more rate cuts from the Fed are expected, suggesting investors believe that a meaningful downturn is on the way and a recession is a significant risk.
The differences: But there are also major differences between 2007 and today, which give reason to think things won't be nearly as bad as they were then.
First, one of the key drivers of today's economic troubles — the trade war — is within the power of policymakers to end. If President Donald Trump starts to see evidence that it is about to cause a recession in an election year, he will presumably look for ways to de-escalate the tension and calm things.
Second, global banks are significantly better capitalised than they were in 2007 — they have bigger cushions that allow them to suffer losses without becoming insolvent. That means there's less potential for a similar vicious cycle that does more damage than policymakers can control.
Or, at a minimum, if those kinds of financial contagions and dangerous feedback loops were to re-emerge, they would probably come from somewhere different than they did in that crisis. High corporate debt levels, for example, could be such a source of risk.
The lesson: In trying to figure out whether this month's financial turbulence will turn into a major disruption to the economy itself, the contrast of 1998 and 2007 gives some guidance.
Is the disruption driven primarily by events in other countries, or are domestic and international problems interrelated? Are there key nodes through which risk can metastasise, as occurred in the global banking system in 2007? Do policymakers have the tools and the will to try to contain the damage?
The lesson for policymakers may be this: Pray for this to be more like August 1998; plan in case it turns out to be more like August 2007.
Written by: Neil Irwin
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