As urgent as the protection of the population from the corona virus is, we are heading for a global economic crisis in the course of the international shutdown. In contrast, the financial crisis of 2008 appears comparatively harmless. What crash scenarios are threatening us now and why a hybrid financial system might be necessary in the future.
Corona is what the rotten 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 battle of central banks, the corona crisis is a battle of states. The central banks have suspended interest rates, so their task is done. They can do no more than open their balance sheets to bonds and shares.
The global economy is more fragile than ever, despite or perhaps because of the stock market rally of the last 12 years. The risks in the system have accumulated to such an extent that the following crash scenarios or collapses may now occur in the coming weeks and months:
1) Banks collapse
Since the financial crisis of 2007, many banks, especially Italian and Spanish ones, have not managed to recover. They are already on the ECB's drip. The German banks are also in a worse position than ever before. Not only because of the share prices of Deutsche Bank and Commerzbank, but above all because the regional banks have been deprived of the basis of their existence: interest. Savings banks and Volksbanks had to suffer for the misconduct of the big private banks through unnecessary bureaucracy and low interest rates. While they helped to stabilise the economy during the Lehman crash, they are now the ones who are suffering. Particularly as they are the ones where small and medium-sized corporate customers have an account, i.e. those without large reserves who are now losing their livelihood.
If the rates for the much too expensively bought properties now default 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 facing a huge problem: receivables are defaulting and lending is currently very unattractive. There is an absolute risk of a domino effect where banks fall one after the other due to their interdependence.
Consequently, the probability that we will see massive mergers and nationalizations is very high. The business operations of the most profitable pillar of a universal bank, namely lending, have currently come to a standstill and are now being completely taken over by the states. The nationalisation of an entire sector has therefore already begun.
2) Risks of the Chinese shadow banking system
The over-indebtedness of Chinese companies is enormous. Only in contrast to Europe and the USA, interest rates are higher and transparency lower there. There are no reliable figures as to exactly how high the outstanding debts of Chinese companies are. For example, regional governments in China have accumulated gigantic credit risks without them appearing on the official balance sheets. This shadow banking system gives rise to fears that the real credit risks are much higher than those officially known. In the event of a wave of bankruptcies, the very stone can start rolling that brings to light risks that were simply not taken into account.
At the same time, the real estate situation in China's major cities is heating up. This combination is downright lethal and can lead to a subsequent shock in the coming weeks and months, just like in crash scenario 1. The hope here is that the enormous reserves of the Chinese state will be able to counteract this with extreme measures. At the same time, fewer foreign government bonds will then be bought up. So less money will flow from China to foreign countries, especially American and European ones.
3) The end of the Eurozone
The euro zone is starting to wobble. The already highly valued euro is causing problems for some companies, which is particularly drastic in the case of export failures. If there is no significant devaluation against the US dollar and Co., in combination with distressed banks and soaring national debt, Southern Europe could trigger new instability in the euro zone, as happened in 2010 with the Greek crisis. This time it is not only Greece, but above all Italy, which is the first to threaten to fall. Then Spain, Portugal and then France would have their turn. Even Germany could not stop this domino effect. So new European rescue packages and stability mechanisms will be needed to keep the euro system stable. Also, every additional euro of new debt of crisis countries will have to be borne by the ECB at zero interest rates to prevent the euro from breaking up.
4) State "burn rate" is developing too rapidly, measures have no chance of success
Especially the small and medium-sized enterprises without large reserves, such as restaurants, taxi drivers and roofers, can fall into existential distress in a very short time. Without direct compensation from the state, there is a threat of a wave of bankruptcies among SMEs and thus a rapid increase in unemployment, since around 60 percent of all employees in Europe are employed in companies with less than 50 employees. While Germany has a comparatively low unemployment rate, countries like Spain and France are likely to face even more massive problems in preventing a wave of unemployment. The social security systems would be on the verge of collapse within a very short time, unless one took immediate countermeasures by printing money.
The only solutions here are direct state investments and support programmes, without a lot of bureaucracy via the watering can principle. It is not possible to check hundreds of thousands of applicant companies for exact need within a few days. Even if one were to reduce the examination of an application with the relevant documents to two hours, KfW and Co. would be completely overtaxed. There is a lack of automated and digitalised processes to supply an entire economy with loans and financial injections within a few days.
Without immediate action, there is a danger that weaker nations in particular will be overburdened and unable to keep their country together. The combination of a loss of tax revenues with a simultaneous lack of reserves and soaring costs can quickly break the backs of countries like Italy. Every hour counts, not only in the fight against the coronavirus through a shutdown, but also in the necessary economic measures of the states and central banks.
5) Deflation causes investments to slow down
Start-ups in particular, which are moving from one financing round to the next, have already noticed that investors who thought they were safe are withdrawing. Hardly anyone dares to invest in a project at the moment. What may be understandable for start-ups, which are not so relevant in terms of GDP, applies to the entire macro level. Everyone, from small investors to investment funds, is holding back their money for now. Only very few players with very deep pockets will take advantage of the favourable prices to buy later in the acute phase. The fear of a never-ending fall in prices is causing the markets to dry up.
Fortunately, we have learned from the deflation crisis of 1929. Central banks and the state will do everything in their power to avoid deflation and will accept the expropriation of savers in return. The fact that the rudder can also change into hyperinflation at a certain point, as happened in the 1930s, must be ignored at present.
However, whether states and central banks will succeed in slowing down this deflationary dynamic cannot be answered, as there is no historical precedent for this magnitude. No one can say exactly how much a system can withstand and how far one can push the economic and monetary policy measures. The remaining monetary stability must be sacrificed to preserve the system. Saving will be even more expensive and expropriation even more so than before. The process set in motion by Lehman in 2007 is now entering a new hot phase.
6) A new oil crisis
Currently, OPEC is also in a crisis mode. The oil-producing countries are fighting for market shares, especially Russia and Saudi Arabia. Even before Corona, the oil price has collapsed. As a result, practically no state can produce oil profitably any more. Especially not the USA, which is dependent on significantly higher oil prices than Saudi Arabia, for example, due to fracking. This circumstance is now exacerbating the crisis in the USA, as well-paid jobs in structurally weak regions are disappearing. Russia, which is dependent on commodity revenues, is also currently suffering 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. Especially the oil-hungry China, can get its industry up and running again at low cost.
Hope for the World: Blockchain Technology
Blockchain technology will not be able to help directly. Nevertheless, the example of the most urgent measure in the real economy, the supply of credit to small and medium-sized enterprises, shows the backwardness of the banking infrastructure, both technically and in terms of regulation. Credit processes, which now have to run via the KfW, have not been digitalised at all. Anyone who needs a loan cannot avoid the physical paper and manual processes and the middleman called the house bank. Smart Contracts would not only significantly increase the level of automation here.
Digital identities on the block chain could also help to prevent the impotence of bureaucracy that threatens us. Unfortunately, the establishment of block chain technology has not yet reached that stage, even though we need it now more urgently than ever. Nobody can currently answer how individual case handlers are supposed to handle as many cases in a few days as would otherwise not be possible in a whole year.
Central Bank Digital Currency will expand central bank measures
Digital central bank currencies can enable a higher real economic impact. This is exactly what the crisis is all about now, since the commercial banks are no longer functioning. This important transmission channel has come to a standstill, like a clogged pipe.
New forms of distribution outside the commercial banking infrastructure are therefore needed. For example, in the digital renminbi, the Chinese central bank plans to include non-financial institutions in its monetary policy, specifically Alibaba and Tencent. It is also possible to make monetary policy measures such as interest rate adjustments more flexible and automated.
Of course, blind actionism will not help here. Digital money is only as good as its smart contract infrastructures. Before a central bank decides to issue a programmable currency, it has to think a lot about it.
A hybrid financial system
The rescue that is still in store for us in the form of gigantic debts and central bank measures is inevitable. However, the price will be very high. Accordingly, we must ask ourselves questions about how we can keep the centralised monetary system to stabilise our society and political order and at the same time re-establish a functioning and free market.
One solution may lie in the hybridisation of our financial economy. In this way, decentralised financial applications (DeFi) can lead to the re-establishment of healthy structures without any inherited burdens or market distortions. In particular, interest rates as the most important information carrier in the financial economy will lose weight as a result of the upcoming measures. Without interest, no free financial market can come into being. Decentralised credit and savings systems that function independently of the affected commercial banking infrastructure can therefore restore healthy financial market mechanisms.
The small investor of the future will get his interest through staking instead of savings account interest, which already today no longer exists. Other decentralized finance applications, such as lending, will also create new financing ecosystems. All in all, this will relieve the burden on the ailing financial sector and allow our system to be restructured and decentralised.