Understanding financial crises: How to spot the bubbles about to burst

Understanding the impact of geopolitical tensions on the economic landscape is a challenging task, however, it is crucial in today’s operating environment. How can you spot the early signs of a crash (caused by any disruption)? Linda Yueh, Fellow in Economics at Oxford University, shares her framework and explores the challenges, vulnerabilities, and opportunities on the horizon. (Read the transcript below.)

Let’s go ahead and start off with your book: “The Great Crashes”. In this book, you talk about a three-step framework that helps people understand and recognise early signs of trauma and in some instances mitigate those threats. Could you talk a little about that framework?

Absolutely, and the first thing I should say, the book is called “The Great Crashes”. When economists say great, they mean the opposite. Unfortunately, we've had a regular – I would say – repeat of a lot of financial crises, so what I hope to do with the book is to help at least spot the signs and try to ameliorate the crisis, so they don't become global meltdowns.

So how do we do that? Every crisis starts with a bubble, and bubbles repeat themselves mostly because of FOMO – fear of missing out. Think technology, or back in the 17th century or 16th century, it could be anything like tulips. Basically, you get exuberant about prices, prices go up. And the real danger is if you pile in because of FOMO, but you do it with debt.

Then when the bubble bursts, that's the second phase – the resolution. That's really challenging because it depends on having credible policies and credible policymakers. For instance, the International Monetary Fund (IMF) says, the first eight months of a crash are vital. And I write about Japan's real estate crash in the early 1990s; it took them eight years, and it resulted in lost decades of growth. The final phase is just that, the aftermath. What determines the aftermath?

• How much you are leveraging, which is the repayment of debt.
• And how credible were the policies that were used to resolve the crisis.

In Japan's case, it was pretty stagnant for a long period of time. If you think about the global financial crisis from 2008, that was also pretty miserable. However, the dot-com bubble, when it burst in the early 2000s, resulted in a short recession – pretty mild. So therefore, the aftermath is very dependent on how a crisis is resolved, but most importantly, how much debt was initially involved.

As you look at the current environment, what do you see?

One of the bits of advice I was given is that you should predict the event or the timing, but never both. I don't know what the next crisis will be, but if I look at areas where you see a lot of debt build up, I would probably single out China, which has had a property bust already. They have taken about two to three years, and they still haven't resolved the issues with the property developers. This is already going beyond that time frame that I mentioned the IMF suggests.

The reason I would look at China is also because not a lot of crises would have a systemic global impact, but China is the biggest lender in the world. It lends to 175 out of 185 jurisdictions, so it would have a pretty widespread impact.

But anything could be the next crisis. Shadow banking is something that the Bank for International Settlements, which is known as the “central bank for central bank”, are very worried about. Shadow banks are just institutions that don't have a banking license, but they lend money. It could be insurance companies, it could be private credit, anything like that. Right now, half of the credit in the world comes from shadow banks, and they're not as regulated as conventional banks. So that could be another source of crisis – really, it could be any number of things.

When the NASDAQ crashed in November 2021, the NASDAQ recovered, but private tech markets continue to struggle. Then Silicon Valley Bank and those regional banks have failed. Luckily, they’re not great crashes, but unfortunately there’s regular occurrence of these kinds of crashes.

Some of the things that people think about right now, in terms of potential challenges, are the geopolitical situation in Europe and Asia and other places, as well as the high interest rate environment. Are there aspects of the financial services industry that are more vulnerable or less vulnerable to shocks from either of those sources?

It's a great question because I mentioned [in my presentation] how inflation could stay high for longer because of geoeconomic shock. For instance, the Middle East tensions are still ongoing. The Russia-Ukraine war is still ongoing. Both of those regions are commodity rich and there has been disruption of shipping lanes. Things like that can mean that central banks are hesitant to cut rates quickly because rates are restrictive, but once central banks have begun to cut, what they don't want is to reverse course – they're more likely to hold.

The impact on financial services is that you now have a higher cost of capital for your clients, higher cost of borrowing – which in one sense, for lending institutions, net interest margins look better because you have high rates. But higher rates also mean you could have, for instance, more credit impairments. Your customers will struggle to borrow commerce or just be a bit slower. There is that direct implication.

The indirect implication is what happens to your customers. Working in a globalised financial system, your customers could be anywhere in the world. They want to move their money to somewhere else; they want their investments to be global. But in a world where there are investment restrictions, in a world in which operating companies face supply chain uncertainty, distribution networks could be disrupted. I think all of those things just dampen business.

The role for financial institutions, I think, is obviously to be nimble to help your customers adjust and be aware of everything that's happening. And then, I think, there is a scope to provide advisory services, because financial institutions work with a lot of companies. You have a sense of what could be… risk diversification or mitigation strategies. There's a lot of challenges, but for financial institutions, there's also a lot of opportunities.

One of the things I thought was an interesting concept in your book was the idea of the rise of big tech vis-a-vis even nation states. Could some of these big techs actually replace the role of banks? Could Amazon start becoming our bank? How do you see the relationship between some of these giant growing technology companies, especially as technology is moving at the pace that it is, relative to nation states that, as you mentioned, sometimes are very slow to make adjustments?

I think one of the big challenges to national financial systems is the rise of DeFi – decentralised finance. This would be utilising technologies like blockchain, where you could have peer to peer financial transactions. For a lot of central banks of national governments, this is a big challenge because if you have a lot of private money, it makes it harder for them to do monetary policy, which is about manipulating the price of the quantity of money.

Also, when you look at the growth of fintech generally, the area that has already directly impacted a lot of the established banking system is around payments. That's probably one of the fastest growing areas. If you, for instance, look at Kenya, which has a payment system called M-PESA, where people have mobile wallets (even people who don't have bank accounts), it increases financial inclusion, but it's come about through private actors. You’d normally think it's actually the government's role to make sure people are included in the formal financial system. But actually, it's happening via private providers who find it to be lucrative. The ultimate impact of M-PESA is that it's actually raised Kenya's productivity, which means it's raised Kenya's growth rate, which is what you want to see happen with financial inclusion – the translation of savings into investment is very productive.

So I think there's a lot of ways in which technology can actually help bolster growth standards of living. But as with everything, the challenge is around very powerful big companies that could stifle competition. In my book “The Great Economist” – yes, all my recent books have “great” in their title – I write about Joseph Schumpeter who came up with the idea of creative destruction.

He said the most important thing to ensure you have an innovative ecosystem is to have competition and financing for startups. You allow the big tech companies. (He was writing in the early 20th century, so these are not big tech companies, but they were big companies like U.S. Steel.) You can have them, and you need to have a system where entrepreneurs and startups compete. They could get bought by the big companies, but they challenge the big companies. It's this process of creative destruction that's really good for competition and for growth.

We are currently in an era of very big tech companies, but we also have a flourishing set of startups, especially in fintech, I would say. And I think that combination is just like what Mark Twain said: “History doesn't repeat itself, but it does rhyme.” We just have to make sure that we have this ecosystem and competition framework where competition continues to be healthy. Even though we tend to look at big tech companies and how dominant they are, like the Magnificent Seven in the United States, the rate of churn (a big company’s stay in the S&P 500) has never been faster. There is a very quick process of competition and creative destruction.

So to me, the early 20^th century led to the period of what we call the golden age of economic growth in the media post-war period, and I'm hopeful this current era does the same.

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