As urgent as it is to protect the population from the coronavirus, we are approaching a global economic crisis as part of the international shutdown. The 2008 financial crisis, on the other hand, is relatively harmless. Which crash scenarios are threatening us now and why a hybrid financial system will be necessary for the future.
Corona is what the bad real estate loans were in 2007: the trigger for a new global economic crisis. A trigger that triggers financial bubbles and challenges economic stability. If the financial crisis of 2007 was a struggle by central banks, the corona crisis is a struggle by the states. The central banks have switched off the interest rate, their task is done with it. They can no longer do more than open their balance sheets for bonds and stocks.
Despite or perhaps because of the stock market rally of the past 12 years, the global economy is more fragile than ever. The risks in the system have built up so that the following crash scenarios or breakdowns can now occur in the next few weeks and months:
1. Bank collapse
Since the 2007 financial crisis, many banks, particularly Spanish, have failed to recover. German banks are also in worse shape than ever.
Not only because of the Deutsche Bank and Commerzbank share prices, but above all because the regional banks have been deprived of their livelihood: the interest. Saving banks and Volksbanks suffered for the misconduct of the large private banks due to unnecessary bureaucracy (Basel 3) and low-interest rates.
While they helped stabilize the national economy in the Lehman crash, they are now victims themselves. Especially since the small and medium-sized corporate customers have an account, i.e. those without large reserves, who are now losing their livelihood. Also, many home builders.
If the rates for the far too expensive real estate bought will fail in the next three to four months and, as expected, there is no buyer, we will experience a negative spiral here.
In short: credit institutions, practically all over the EU and in other parts of the world, are faced with a major problem: receivables fail and the granting of loans is neither attractive nor justified by the risk profile. The risk of a domino effect in which banks, due to the mutual dependencies, fall one after the other is there.
As a result, we are very likely to see massive mergers and nationalizations. The business operations of the most profitable pillar of a universal bank, namely lending, has currently come to a standstill and is now being completely taken over by the state, ergo the Kreditanstalt für Wiederaufbau (KfW). The nationalization of an entire industry has already started.
2. The Chinese shadow banking system carries unforeseen risks
The over-indebtedness of Chinese companies is already enormous. Only in contrast to Europe and the USA are the interest rates there higher and the transparency lower.
There are no reliable figures on how high the outstanding amounts of Chinese companies are. For example, regional governments in China have amassed huge credit risks without appearing on the official balance sheets.
The so-called shadow banking system allows fears that the real credit risks, which are officially known, will exceed them. In the event of a bankruptcy wave, the very same stone can start to emerge that exposes risks that were simply not priced in or secured.
At the same time, we have a heated real estate situation in major Chinese cities. This combination is deadly and can lead to a subsequent shock in the next few weeks and months, just like in crash scenario 1. The hope here is the enormous reserves of the Chinese state to counteract this with extreme measures. At the same time, fewer foreign government bonds are bought up. So less money will flow from China to foreign countries, especially American and European ones.
3. Breaking up of the euro area
The eurozone is starting to shake. The already highly valued euro is troublesome for some companies, which is particularly noticeable in the case of export failures.
If there is not a significant devaluation against the US dollar promptly, then in combination with distressed banks and soaring national debt, Southern Europe, as in 2010 for the Greek crisis, can trigger new instability in the eurozone.
This time it is not just the little Greece, but above all Italy, that threatens to fall first. Then it would be Spain, Portugal and then France. Germany could not stop this domino effect either. New European rescue packages and stability mechanisms will, therefore, be needed to keep the euro system stable.
4. State “burn rate” exploded faster access than measures
Small and medium-sized companies, in particular, without large reserves, such as restaurants, taxi drivers and roofers, can quickly fall into existential need. Without direct compensation from the state, there is a risk of bankruptcy among SMEs and thus a surge in unemployment, as around 60 percent of all employees in Europe are employed in companies with fewer than 50 employees.
While Germany has a comparatively low unemployment rate, countries like Spain and France are likely to face even more massive problems preventing or cushioning a wave of unemployment. The social security systems would collapse in the shortest possible time unless one countered directly by printing money.
The only solutions here are direct government investments and support programs, without much bureaucracy via the watering can principle. It is not possible to check hundreds of thousands of applicant companies for an exact need within a few days. Even if you reduce an examination of an application with the associated documents to two hours, KfW and Co. would be completely overwhelmed. There is a lack of automated and digitized processes to supply an entire economy with loans and financial injections within a few days.
Without immediate action in the next few days, there is a risk that weaker nations, in particular, are overwhelmed and can no longer hold their country together. The combination of a loss of tax revenue combined with a lack of reserves and soaring costs can break the neck of countries like Italy sooner rather than later. Every hour counts not only in the fight against the coronavirus through a shutdown but also in the necessary economic measures by the states and central banks.
5. Deflationary shock brings private investment down to almost zero
Start-ups in particular, which are moving from one financing round to another, are already noticing this: venture capitalists who are believed to be safe are withdrawing. Hardly anyone currently dares to invest in a project. What may be bearable for start-ups, which are now not particularly relevant in terms of GDP, applies to the entire macro level.
Everyone, regardless of whether they are a small investor or an investment fund, is holding back their money. Very few players with very deep pockets will use the cheap courses to buy more in the acute phase. The fear of a constant decline in the price of companies and real estate is causing a market to dry up.
Fortunately, we learned from the 1929 deflation crisis. Central banks and the state will do everything in their power to avoid deflation as it did back then and accept expropriation of the savers. The fact that at a certain point the rudder can also turn into hyperinflation, as happened in the 1930s, must currently be ignored.
Whether states and central banks manage to slow down this deflationary dynamic cannot be answered, as there is no historical precedent for this scale. Nobody can say exactly how much a system can withstand and how far you can take economic and monetary policy measures.
The remaining monetary stability must be sacrificed to maintain the system. Saving will be even more expensive and expropriation will be even greater than before. The process that was started by Lehman in 2007 is now entering a new phase.
6. Oil conflict exacerbates the economic situation
OPEC is also currently in a crisis mode. The oil-producing countries are fighting for market shares, especially Russia and Saudi Arabia.
Even before Corona, the price of oil slumped. As a result, practically no state can produce oil profitably. Certainly not the United States, which is dependent on fracking for significantly higher oil prices than, for example, Saudi Arabia. This is now exacerbating the crisis in the USA, as well-paid jobs in structurally weak regions are no longer available. Russia, which is significantly dependent on raw material income, is currently experiencing enormous financial losses.
This oil crisis can significantly increase the potential for conflict in the world and become a crisis accelerator for the USA and Russia. On the other hand, a low oil price also has enormous advantages in the crisis. China, which is hungry for oil, can put its industry back into operation at such a low cost.
The blockchain technology would only be further
Blockchain technology will not be able to help immediately. Nevertheless, the example of the most urgent real economic measure, the supply of credit to small and medium-sized companies, shows the backwardness of the banking infrastructure, both technically and regulatory. Credit processes that must now run through KfW are not digitized at all.
Anyone who needs a loan cannot avoid the physical paper and the manual clerk processes, as well as the middleman, called the house bank. Smart contracts would not only significantly increase the level of automation here. Digital identities on the blockchain could also help to prevent the bureaucratic impotence that threatens us. Unfortunately, the establishment of blockchain technology is not that far, even if we need it more urgently than ever.
Expand central bank measures with Central Bank Digital Currency
Digital central bank currencies can enable a higher real economic impact. This is exactly what the crisis is about now, because the middlemen between the central bank and the company/population, ergo the commercial banks, no longer work. This important transmission channel has come to a standstill, like a blocked pipe through which water no longer flows.
Therefore, new forms of distribution outside the commercial banking infrastructure are needed. The Chinese central bank plans to include non-financial institutions in its monetary policy with the digital renminbi, specifically Alibaba and Tencent. There is also the possibility of making monetary policy measures such as interest rate adjustments more flexible and automated.
Of course, no blind actionism helps here. Digital money is only as good as its smart contract infrastructures are. Before a central bank decides to issue a programmable currency, it has to think a lot beforehand.
Mixing traditional and crypto-financial systems: the hybrid financial system
The rescue that is still ahead of us through gigantic debts and central bank measures is inevitable. However, the price for this will be very high. Accordingly, we have to ask ourselves how we can maintain the centralized monetary system to stabilize our society and political order and at the same time re-establish a functioning and free market.
A solution here can be the hybridization of our financial economy. In this way, decentralized financial applications (Defi) can lead to the establishment of healthy structures again without any legacy issues and market distortion.
In particular, the interest rate as the most important information carrier in the financial industry is losing weight due to the upcoming measures. No free financial market can come into being without interest. Decentralized credit and savings systems that work independently of the commercial bank infrastructure concerned can therefore once again ensure healthy financial market mechanisms.
The small savers of the future will get their interest through staking instead of savings book interest, which already no longer exists. Other decentralized finance applications, such as lending at MakerDAO, will also create new financing ecosystems. All in all, the strained financial sector can be relieved and our system – on a decentralized basis – can be set up on several legs.