An economic recession in Europe seems to be almost certain; in the US, it is still unclear, but an economic downturn cannot be excluded for 2023. The question I want to elaborate on in this opinion blog is whether an economic recession can cause something severer than a downturn? Can this be the trigger to a financial crisis?
To start with, we must define what we are trying to speak of. A financial crisis is an excessive vulnerability - may it be fundamental, policy-induced, or institutional - together with a crisis trigger. The harm done by a financial crisis can be observed in the Great Financial Crisis (GFC) of 2007 to 2009 and indeed, no one wants to live through it again. Nevertheless, somehow the similarities to the last big financial crisis are currently of a great extent: the housing markets globally turn south, partly due to a previous overvaluation, partly due to discount rate factor increases seen over the last months. One of the big names in the banking sector - Credit Suisse - seems to be in severe troubles as can be observed by credit default swaps prices. And yes, leading indicators are signalling that the global economy is in a slowdown, in some countries a recession even seems to be imminent.
Often, it is the other way around: a financial crisis causes an economic downturn, but can an economic recession cause excessive vulnerabilities to surface and be the trigger to a financial crisis? There are a variety of types of financial crisis ranging from sovereign debt defaults, over currency crises, to banking sector stress. How can this question be answered?
In crisis models, such as logistic regressions, the explanatory variables often are fundamental, policy-induced, and institutional variables as previously described. Indeed, fundamentals play an important role in crisis predictions. However, policy-induced vulnerabilities and institutional fragilities need to be present as well to make for a severe financial crisis.
With respect to the former, monetary policy is tight, some may even say too restrictive given current global challenges, and hence, policy-induced vulnerabilities should be another factor to watch. Finally, and most importantly, are institutional vulnerabilities. Institutions were described by Douglas North as the 'rules of the game' and that these rules matter is out of question today, we just must remind us about this fact.
It would be too much to discuss the variety of institutions globally, but what can be said is that in Europe, the war in Ukraine brings severe stress to the system. Emerging markets, where institutions tend to be weaker and which effects can now be observed to be swapping over to Europe, are a spot to look at closer. It should be known since the Asian financial crisis that smaller or larger emerging markets can cause severe troubles on a global scale.
To put the above differently, I would like to encourage stakeholders to look beyond fundamental variables to assess whether the current global slowdown will end in a financial crisis or even in a variety of crises. Policy-induced and institutional variables must be monitored closely and should be part of any efforts to predict and prevent financial crises.
