Thursday, March 19, 2020

Financial Markets

All over the world, financial markets have tanked. The main US share price indexes have fallen by a third in the last week. The falls have been similar in other markets and other countries. This represents a massive loss of wealth for people who own shares and other financial instruments directly, or indirectly through their superannuation funds and insurance companies.

But there is another consequence, which is even more serious. Over the last few decades, the finance sector has grown massively, far outpacing the rest of the world economy. Banks and other businesses in the finance sector have worked together to create a huge infrastructure of debt that sits on the top of the real economy. Most of these debts have some form of collateral attached to them for the security of the lender. This collateral often consists of shares and other financial instruments.

The big fall in the financial markets significantly reduces the value of the collateral that has been posted for security. This leaves the borrower with two choices. They can either post more collateral as security (if they have it) or pay down some of their loan until it matches their collateral. Both these options can be difficult in uncertain times, but the alternative is to default on the debt, which would have a snowball effect, weakening other financial institutions that are connected to the one that fails.

A significant portion of the debt is denominated in US dollars, often using foreign exchange swaps (partly because US interest rates have been so low). The need to beef up collateral against debt may be one reason why the US dollar has strengthened so much against other currencies. It is not a sign that the US economy is strong, but that the financial system is weak.

The central banks will try to paper over the cracks in the system by creating money and making loans, but this will not resolve the underlying problems that make the modern financial system unstable in the first place.

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