In January 2020, I completed a book analyzing the financial crises that triggered the Great Depression of the 1930s and the recent Great Recession. In that book, I argued that the world’s financial system was caught in a “global doom loop” at the beginning of 2020. Bailouts and economic stimulus programs during and after the global financial crisis of 2007-09 (GFC) imposed heavy debt burdens on most governments, and leading central banks were carrying bloated balance sheets. The rescues arranged by governments and central banks during the GFC created a widely-shared expectation that they would continue to intervene to ensure the stability of major financial institutions and important financial markets. That expectation encouraged speculative risk-taking by financial institutions and investors as well as dangerous growth in private and public debts. I warned that the global doom loop was planting the seeds of the “next” financial crisis, which could overwhelm the already strained resources of governments and central banks.
The “next” global crisis began only two months later, in March 2020. The rapid spread of the Covid-19 pandemic caused governments in most developed countries to shut down large sectors of their economies and impose social distancing mandates. Many thousands of businesses closed, setting off a downward spiral in economic activity that paralyzed global financial markets. Investors, businesses, and financial institutions “scrambled for cash” and engaged in panicked “fire sales” of financial assets. Governments and central banks in the U.S. and other advanced economies adopted fiscal stimulus measures and financial rescue programs with a size, speed, and scope that far surpassed the emergency actions they took during the GFC.
Congress approved $5.2 trillion of fiscal stimulus programs between March 2020 and March 2021 – a response that was four times as large as U.S. fiscal stimulus measures during the GFC. During the same period, the U.S. and other governments around the world adopted $16 trillion of pandemic stimulus programs, which provided unprecedented support to households and businesses. Central banks established emergency lending and guarantee programs (supported in many cases by government backstops), which stabilized financial institutions and financial markets and prevented a global financial crisis. Central banks also maintained ultra-low interest rates and purchased vast quantities of government bonds, mortgage-backed securities, and other assets.
Large-scale asset purchases by the Fed, the Bank of England (BoE), Bank of Japan (BoJ), and European Central Bank (ECB) expanded their balance sheets from $15 trillion to $25 trillion between January 2020 and June 2021. During the same period, central bank balance sheets as a percentage of home country gross domestic product (GDP) increased from 19% to 34% for the Fed, 27% to 43% for the BoE, 38% to 61% for the ECB, and 104% to 131% for the BoJ.
Government fiscal stimulus programs and central bank asset purchases supported very large increases in debt levels for governments, households, businesses, and financial institutions. In December 2020, government debts in the U.S. and worldwide climbed to their highest levels since World War II as a percentage of U.S. and global GDP. During 2020, U.S. private and public debts increased by 10% to $82.7 trillion and reached 385% of U.S. GDP – breaking the previous record of 366% in 2007. Similarly, global private and public debts rose by over 12% during 2020 and set a new record of $290.6 trillion, equal to 359% of global GDP.
The pandemic financial crisis and the massive responses by governments and central banks demonstrate that policymakers have not addressed the root causes of the GFC. Major financial institutions and financial markets remain highly unstable. They continue to underwrite rapidly rising levels of private and public debts based on their shared expectation of future government bailouts. Governments and central banks have expanded their “safety nets” far beyond banks and now protect the entire financial system, including short-term wholesale credit markets, systemically important nonbanks, and the corporate bond market. As a practical matter, governments and central banks have “bankified” the financial system, thereby undermining market discipline, stimulating dangerous asset bubbles, and increasing social inequality.
The pandemic crisis has not yet forced the U.S. and other developed countries to recapitalize large financial institutions. U.S. and international bank regulators have said that the lack of failures among systemically important banks shows that big banks are “more resilient” by virtue of the stronger capital and liquidity requirements imposed since 2009. However, regulators have acknowledged that megabanks benefited greatly from the unprecedented relief programs that governments adopted during the pandemic. Governments gave crucial support to large banks and nonbank financial institutions when they rescued short-term wholesale credit markets, extended huge amounts of assistance to households and business firms, and backstopped the corporate bond market. Governments and central banks avoided the need for controversial bailouts by saving the firms and people who otherwise would have defaulted on their obligations to large financial institutions.
The global doom loop has created an infernal cycle of ever-increasing public and private debts and ever-larger bailouts. From December 2007 through March 2021 – a period that witnessed enormous government rescue programs during the GFC and the pandemic crisis – total U.S. public and private debts increased from $53.8 trillion to $83.9 trillion. The federal government’s rapidly growing debt burden accounted for over 60% of that increase, rising from $9.2 trillion (63% of U.S. GDP) to $28.1 trillion (127% of U.S. GDP). Similarly, global public and private debts expanded from $167 trillion in December 2007 to $289 trillion in March 2021. Rising worldwide government debts accounted for 40% of that increase, expanding from $34.8 trillion (60% of global GDP) to $83.4 trillion (106.5% of global GDP).
Escalating levels of private and public debts are likely to cause another systemic debt crisis comparable to 2008 and 2020, but with even worse results. During severe financial crises, as shown by Europe’s experiences during the Great Depression and Great Recession, heavily indebted governments often lack sufficient credibility to borrow the funds they need to stabilize their financial systems. In that event, private-sector financial crises become sovereign debt crises, and governments must choose between defaulting on their debts explicitly (through debt repudiations, moratoria, or restructuring) or implicitly (through currency devaluations or rapid inflation). The Eurozone barely avoided such a disastrous outcome during the Great Recession. In view of the colossal debt burdens that governments and central banks now carry, it is very doubtful whether the next major debt crisis would have an equally benign conclusion.
Our financial system must be reformed so that it no longer promotes unsustainable booms, fueled by reckless growth in private debts, followed by destructive busts that require massive bailouts and huge increases in government debts. My recent book provides a blueprint for needed reforms, including a new Glass-Steagall Act. A new Glass-Steagall Act would break up financial giants by separating banks from the capital markets and by prohibiting nonbanks from financing their operations with functional substitutes for bank deposits. A new Glass-Steagall Act would establish a financial system that is more stable, more competitive, and more responsive to the needs of consumers, communities, and business firms. Properly implemented, a new Glass-Steagall Act would provide the most direct and practical approach for breaking the global doom loop and ending the toxic boom-and-bust cycles of the past quarter century.
Arthur E. Wilmarth, Jr. is Professor Emeritus of Law at George Washington University Law School