The trigger for the next financial crisis

We know that financial crisis are recurring. The last one was in 2008, almost 8 years ago, so it is not difficult to forecast that a new one is in the making.

The trouble for investors is that it is almost impossible to forecast when a new crisis will arrive. It may be next month, next year or in five years. Who knows?

Another annoying feature of financial crisis is that it is equally difficult to foresee which drop will spill the glass, that is, what will be blamed as its trigger.

Paul Krugman just listed two possible candidates – China and oil – in his NYT op-ed “The 8 A. M. Call”.

So, let me add another candidate – IRRBB Interest rate risk in the banking book – caused by the excessive reliance of banks on the derivatives market.

This choice may sound odd, given that the Basle Committee has been working hard on new standards for this risk which will be implemented in 2018, aimed at preventing IRRBB to materialize when interest rates normalise from historically low levels. Indeed, the notional value OTC derivatives which at end-2014 was 6.5 times larger than all outstanding debt securities has been reduced by 70 trillion USD in the first half of 2015.

It really does not matter if the crisis is triggered in these markets, or any other place like the M&A or the currency markets. The “fire” can be started anywhere, as long as the “wood” is close enough to spread it by contagion.

What matters is to know whether the “firemen” are capable of containing it.

In this regard the perspectives are frightening, given the resistance to apply the so-called Volcker rule to ring-fence commercial banking from investment banking, the exhaustion of ammunition by central banks to deal with a liquidity trap and the balance of public finances in some major economies.

Brexit: A brief history of economic disintegration

History is full of episodes of political and economic disintegration, which were often the natural culmination of experiences of forced integration. With a few exceptions, most empires ended through a process of violent and anarchic disintegration. Whether we think about the ancient empires of Alexander, Rome, the Qin Dynasty or Persia, or if we consider medieval empires like the Charlemagne Empire, the Islamic Caliphate or the Mongol Empire, or if we look at the modern empires of Britain, Ottoman, the German Reich and the Japanese Empire or the breakup of the Soviet Union and Yugoslavia, the lessons are the same. The separating regions often end up in civil war and always erect barriers to trade and investment through tariffs and instable currencies which bring economic decline.

The inevitable initial sacrifice in terms of economic and human misery is often followed by prolonged periods of underdevelopment (all too visible in Africa) in the separating regions, but there are some notable exceptions like the separation of the United States of America from Britain.

Do these lessons of history have any relevance in the case of an eventual separation of Britain from the European Union (the so-called Brexit)? If so, would the UK follow the general pattern of decadence and misery or could it replicate the US successful experience?

The first question is relevant because the European Union is a voluntary association of countries, not a forced empire. So, an eventual exit of a member state should be seen as the natural counterpart to a voluntary membership and should not be cause for war or vicious conflict. Nevertheless, we cannot ignore that Great Britain is itself an association of three nations – the English, the Welsh and the Scots – which may have quite distinct views in relation to the European Union, wish may lead some to question in which union they wish to participate - the European or the British.

Although military violence cannot be expected, social unrest may still arise in a strongly divided nation in relation to an eventual separation. Moreover, it will also depend on the attitude of the remaining member states in the European Union. Namely, whether they will be understanding and friendly or will be hostile and competitive, for example, by promoting an international financial centre to rival the City of London.

So, political attitudes in London, Brussels, Berlin and Paris would have an important bearing in the outcome of an eventual separation. Nevertheless, the answer to the question whether a separate Britain would be a failure or a success story requires an understanding of the economics of disintegration.

As a preamble to that understanding, let me just give the reader a chart depicting the experience of economic growth in Britain relative to that of France and the USA, before and after joining the European Union.

The chart is impressive. Before joining the European Union, the UK lagged France by over 30%. Since joining, it still lagged the USA by 20% until 1998, but managed to match the GDP growth in France. Since the creation of the Euro, Britain managed to overtake France by 10% and to match the growth in the US economy.

Given the success of Britain in the European Union, for outsiders it is hard to understand the decision to hold a referendum on its continuation in the Union. Is it simply local politics, or there are any fundamental reasons?