Recession And Debt Ceiling Fears Loom Large For Investors

Investor worries are on the rise, driven by the debt ceiling confrontation and the possibility of a recession. The fears are real and justified, but could either of these events cause a systemic collapse? To help answer this question, let’s start by thinking about what it would take to really rock the system. We have had only two of those events in the past couple of decades: the Great Financial Crisis (GFC) and the pandemic. So, what made those so bad?

Current Worries in Context

First, they were unexpected. For the GFC, no one—and I mean no one—saw how the U.S. housing boom, combined with the interlocking nature of financial obligations, worked against what was in retrospect grossly insufficient capital, to basically shut down the global financial system. For the pandemic, again it was completely unexpected. Nothing like this had happened since 1918, and governments worldwide struggled to figure out what to do. The shutdowns basically shut down the economy as well: the same kind of unexpected shock that we saw in the GFC, with basically the same results.

Using these two events as a template, we can therefore come up with a preliminary definition of something that might take us into another systemic crisis. It would have to be unexpected. It would have to be global. And it would have to have the potential to shut down either the economy or the financial system. Absent all three of these factors, we would just have a fairly normal event. This gives us the context to look at the current set of worries.

Time to Panic?

Let’s start with a recession, which fails the first test. Any recession this year will be the most anticipated in history. The fact that we are even discussing it means the effects have largely already been discounted.

Second, let’s look at the debt ceiling. Here, we have some history. The first time it happened, markets were indeed rattled. The second time, less so. And on to now, when markets are basically ignoring it. We know how it works, we know what to expect, and we now have the experience to largely look through even the worst case. Both of these are clearly worth watching, but they are not worth panicking about.

Beyond that, it is worth thinking more generally about systemic risks. Let’s assume something unexpected happens. By definition, we can’t predict it, but let’s assume. Next, we have to assume that whatever that is puts a significant strain on the financial system. What then?

Not Headed for a Crisis

In the GFC, what turned a housing crisis into a global banking system crisis was the lack of sufficient capital in the banking system. The good news now is that even if that were to happen again, the financial system is much better capitalized than it was during the GFC, largely due to reforms made to prevent a GFC recurrence. We know those reforms worked, too, as one of the key results of the pandemic was that the financial system was never under serious threat, despite the economic chaos. Even if we do get a shock—and what we are worrying about now won’t give us one—the system is much more robust. Beyond that, governments now have experience with two of those shocks and have learned valuable lessons.

Moving Through the Worries

So, it is certainly not time to panic. The things we are worrying about now are well known, are relatively small on a systemic level, and even if they occurred would not threaten either the economy or the financial system. They simply don’t fit the systemic crisis requirements. And even if and when something else comes up to combine with them to create a systemic crisis, we are in a much better place now than we were in either of the two previous crises.

In short, bad things can and will happen. But since our current worries are relatively known and contained, we will just move on through them—as we have always done.