The market slump seen over recent weeks is of similar magnitude to the one seen during the global financial crisis of 2008 with more than a fifth of value knocked off shares, but the reasons are very different.
What causes a crash is as important as the fact that the market crashed, if not more so, because it gives us clues about what may lie ahead.
In 2008 the crisis peaked with the September collapse of US investment bank, Lehman Brothers. Events had been building to this crescendo for over a year beforehand, with other lenders going bust before such as Bear Stearns and Northern Rock here in Britain.
The market slump seen over recent weeks is of similar magnitude to the global financial crisis
What brought all these institutions down, and subsequently caused a stock market crash and recession was a fundamental problem in the world’s financial system.
Namely, that banks had become massively over-leveraged, with their books almost entirely consisting of borrowing and lending, with very little cash actually being held for a rainy day.
As they all became more aware of this and the risks it implied they stopped lending to each other and to businesses, threatening how the whole world works, economically speaking.
The current crisis, at this stage at least, has been sparked by very different things.
It is largely a sentiment driven crisis, caused by fear generated by a so-called ‘black swan’ event – the novel coronavirus outbreak and its impact on economic activity, as well as the fallout between Russia and Saudi Arabia over oil production levels.
Given that – at this stage – the reasons for the share price crash are not as fundamental and don’t threaten the working of the banking system as in 2008, why have the falls been of similar size?
It is partly a consequence of markets being pushed so high for so long by central banks’ low interest rates and money printing. The ‘bigger they are, the harder they fall’ principle applies here.
For many months, perhaps a couple of years, markets have been itching for a big sell-off.
Widespread stock market corrections are inevitable, and its always a matter of when not if so investors are always on the lookout for a reason to sell.
Many have been ready with their fingers on the button, waiting for a reason to push it. The virus outbreak gave them that reason.
One other factor behind the magnitude of the falls often mooted is the prevalence of automated algorithmic trading, which many believe can exacerbate sell-offs in a way that was not the case in 2008.
For months markets have been itching for a big sell-off and found a reason to press ‘sell’
A descent into a much more serious crisis can never be ruled out, but these differences mean there is room for optimism that the slowdown caused by the virus can be managed, even if it gets as far as recession territory.
Aside from the inevitable handful of doom-mongers, few people see the outbreak as a threat to the world’s financial system at this stage.
Something to be wary of is that big investors who have shorted the market will try and spread fear to push it further down, and profit from that.
Largely as a consequence of the 2008 crisis, banks have been forced to hold a lot more cash in reserve to cope with economic slowdowns, so big banks going bust if we do see a recession is far less likely.
Nobody knows for sure how the Covid-19 outbreak will play out in the weeks and months ahead, but data suggest China has put the brakes on the outbreak and infection numbers have started to fall there.
It’s not just the official government numbers of infections that are improving there are indications of people returning to work and economic activity resuming.
Covid-19 infection numbers have started to fall in China, which is encouraging
If the origin and worst hit country can bring the crisis to heel, other parts of the world should be able to as well in time.
Central banks have learnt some big lessons from 2008 as well, and stand ready to act to support the world economy. While they don’t have much room to cut rates, they always have the option of quantitative easing.
Fiscal stimulus – cutting taxes or increasing public spending – is available to governments and we can expect to see this put into action tomorrow in the Budget.
An economic slowdown or recession has far reaching consequences for prosperity and peoples’ jobs of course, but the entire financial system is not in peril, as it was in 2008.
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