Wall Street

The next crash: correction or recession?

2017 marks 30 years since the ‘Black Monday’ stock market crash. With global markets continuing to surge, wary observers are asking when the next crash might come.

The US president is quick to remind the public that markets are rallying under his watch, a phenomenon for which, he insists, he does not receive due credit. For example, on 11 October, Donald Trump tweeted: “It would be really nice if the Fake News Media would report the virtually unprecedented Stock Market growth since the election. Need tax cuts”.

A couple of weeks later, Trump tweeted: “Stock Market hits another all time high on Friday. 5.3 trillion dollars up since Election. Fake News doesn’t spent [sic] much time on this!”

Are we in the middle of a rally or are we heading for a fall? More important, do we have the tools to predict the next crash?

Following the 2008 financial crisis, many people were understandably sceptical about economists’ usefulness. After all, what good are experts if nobody warned us the world economy was on the verge of melting down?

In a recent post, economist Paul Krugman defends the profession. Far from needing a new kind of economics, economists understand the causes of panics perfectly well. Rather, the problem in 2008 was the limited data available, which prevented economists from properly perceiving the risks. “The reason nobody saw this coming was an empirical failure – few realised that the rise of shadow banking had done an end run around Depression-era bank safeguards.”

If we accept Krugman’s explanation, we are still left with question. Some observers did warn of the systemic risks that were accumulating throughout the financial system, even if not all of them had a sense of the scale of shadow money. And a few notable experts queried the methodology by which risk was assessed. Why were these voices largely ignored?

Dark money

A more urgent question: are we able to see the risks that were formerly hidden?  

Just as hedging techniques that were supposed to protect investors actually exacerbated the 2008 crisis, a technique designed to protect against market volatility, known as portfolio insurance, is often cited as one of the causes of Black Monday.

Post-2008 regulations have made investing more transparent, but it may not be enough. As economist Hayne Leland told the Financial Times, regulators may not focus sufficiently on systemic risks rather than just the soundness of individual banks. “Regulators are focused on whether individual banks are OK, rather than their collective impact on the market,” Hayne told the paper, warning that if banks all hedge in the same direction that could increase market turbulence.

In China, attempts to rein in reckless lending have also, ironically, made finance more opaque and, arguably, increased risk. The rise of shadow banking and the failure to reduce the supply of easy money has some commentators worried about a looming Chinese crash; an outcome that would ripple across global markets.

Unknown unknowns

The real cause for anxiety might be less about any obvious danger signals than our inability to predict the sources of danger.

As per Krugman’s warning, the best economic theory in the world can’t help us if we don’t have a good grasp of the day-to-day facts.

Are seemingly benign investment products simply an affordable way for any to invest in the stock market or could they trigger a crash? Are the tools we put into place to stabilise world markets helping to sustain long-term growth or do they mask a fundamental lack of recovery? Have our techniques for measuring risk substantially improved?

Getting to grips with these questions is important because it can also help us think more seriously about the causes and scale of the next crash. Markets can’t rally forever, and nobody expects them to. But it is important to look at the fundamental conditions underlying market success. After all, Black Monday didn’t produce an enduring crisis on the scale of the events of 2008. Will the next downturn be a correction or something worse?