In early 2009, financial markets rallied strongly on the assumption that the worst of the post-crisis slump was over - now the talk is of a double-dip recession, writes Larry Elliott.
The activities of financial markets are often irrational. Prices go up for no apparent reason and then suddenly the mood changes.
What's worrying about the latest spasm that has convulsed bourses in Europe, Asia and North America is that the sell-off is grounded in real, and ever more pressing, concerns. Make no mistake, something serious is going on here.
The first cause for anxiety is the global economy and, in particular, that of the United States.
A survey report released last Thursday by the Philadelphia regional Federal Reserve Bank covers only a small part of the eastern US but it has a good track record for charting the ups and downs of the world's biggest economy. The Philly Fed's barometer has just plunged deep into recession territory.
There are also simultaneous slowdowns going on in the rest of the world. Europe's economy has slowed to stall speed, Britain is still operating way below its pre-recession level and activity has come off the boil in China, even though, to Western eyes, growth still looks amazingly strong in China.
Two-and-a-half years ago, financial markets rallied strongly on the assumption that the worst of the slump was over. There was relief that Great Depression II had been avoided. Now the talk is over a double-dip recession.
Concern No.1 has reignited fears about the health of the global financial system. Again, markets have been operating for the past couple of years on the assumption that large dollops of financial help from the taxpayer and a return to growth have made the global banking system immune from a fresh collapse.
This always looked questionable, and now that activity is slowing, markets suspect that some banks may go under. In the 1990s, the Japanese government prevented its financial system from collapse, but only at the expense of creating zombie banks, neither alive nor dead but kept functioning thanks to the largesse of the state.
The reason the sell-off in financial stocks has been more pronounced than the fall in sharemarkets as a whole is that investors believe Europe and North America now have their own zombie banks.
Reports that US regulators are taking a close interest in European banks, and comments from Sweden's chief financial regulator that it wouldn't take much for European interbank markets to freeze, only serve to bring back memories of the long descent from credit crunch in August 2007 to the collapse of Lehman Brothers in September 2008.
At least then, though, governments were in a position to ride to the rescue. Today, governments are seen not as the solution but as part of the problem. The debt burden accumulated by the banks was, in effect, nationalised during the crisis.
It was hoped this would prove temporary, but the persistence of weak growth means that a private-debt crisis has become a sovereign-debt crisis. What's more, the markets sense that policymakers have run out of bullets to fire.
They can't cut official interest rates, they find it hard to justify more quantitative easing when inflation is at current levels and almost every Western government is trying to cut its budget deficit.
Put it all together and you get the full Japanese package: weak growth, weak banks, weak policy response. Not a good recipe for shares. Today Tokyo's Nikkei is at less than 25 per cent of its level at the peak of the sharemarket boom in the late 1980s.
Frequently Asked Questions about this Article…
What does the term "zombie banks" mean and why do investors fear them?
The article explains "zombie banks" as banks that are neither fully alive nor dead — kept afloat only by state support or taxpayer largesse. Investors fear them because they can mask weak balance sheets, limit credit flow, and prolong a slow-growth environment similar to Japan's 1990s experience.
Why has there been a sharper sell-off in financial stocks compared with the broader market?
Financial stocks have fallen more sharply because investors suspect some banks in Europe and North America may already be functioning like zombie banks. That perception, plus signs of slowing activity and increased regulatory scrutiny, has made the banking sector appear especially vulnerable.
How are concerns about a double-dip recession feeding market anxiety?
The article notes that after an earlier rally, renewed weakness in the global economy has revived talk of a double-dip recession. Simultaneous slowdowns in the US, Europe, Britain and a cooling in China mean markets worry growth won’t rebound, increasing stress on banks and markets.
What economic signals are pointing to renewed weakness in the US and global economy?
One specific signal mentioned is the Philadelphia Fed barometer, which plunged into recession territory and has a good track record of tracking US economic ups and downs. The article also cites slowing activity across Europe, Britain operating below pre-recession levels, and China’s activity cooling.
How have governments become part of the problem rather than the solution, according to the article?
During the crisis governments effectively nationalised bank debt with large rescue packages. Now, persistent weak growth has turned a private-debt problem into a sovereign-debt crisis, leaving policymakers with fewer options — limited rate cuts, constrained room for more quantitative easing, and pressure to cut deficits.
Why do analysts compare the current situation to Japan’s lost decade?
The article draws a parallel to Japan in the 1990s, where preventing a banking collapse created long-lasting zombie banks and prolonged stagnation. It warns that weak growth, weak banks and weak policy response — the so-called "Japanese package" — is a poor outlook for sharemarkets.
What risks do strained interbank markets pose for investors?
The article highlights comments that European interbank markets could freeze with little provocation, which would recall the credit crunch that led from August 2007 to Lehman’s collapse in 2008. A freeze in interbank lending raises systemic risk and heightens uncertainty for investors.
As an everyday investor, which market developments mentioned in the article should I monitor closely?
The article suggests watching indicators of economic growth (like regional Fed surveys), signs of financial-sector stress (large relative falls in bank stocks and regulatory scrutiny), and policy capacity (room for rate cuts or more quantitative easing). These signals help show whether fears of zombie banks or broader sovereign-debt pressures are growing.
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