The risk is in financial contagion. The economy can handle individual firms going bankrupt - they'll just get replaced by other firms. The problem is when creditors start taking haircuts and going bankrupt themselves. At that point, things that people thought were secure assets (like, say, their bank accounts) suddenly get called into question, and markets lock up because of panic.
In 2008 we thought that the problem was contained to the subprime housing market, and once the Fed started supporting that market people breathed a sigh of relief and there was a rally and recovery from March-May. It wasn't until first Bear Stearns and then Lehman Brothers failed that people realized we were in a crisis. These were centuries-old, multi-hundred-billion-dollars institutions. The idea that they could cease to exist was unthinkable to anyone not actively looking at their balance sheet and doing the math, which is why there was such a panic when they did cease to exist.
> At that point, things that people thought were secure assets (like, say, their bank accounts)
what possible justification is there to be worried about their FDIC-insured bank accounts? even sticking that in as an off-hand comment is spreading FUD.
This is describing what happened in 2008. The FDIC limit was only $100,000 but many people assumed they had no reason to worry about the security of higher balances in excess of the FDIC limits. So when big stable banks started to fail or were at risk of failing that caught folks by surprise.
As a result:
> The Emergency Economic Stabilization Act of 2008 is signed on Oct. 3, 2008. This temporarily raises the basic limit of federal deposit insurance coverage from $100,000 to $250,000 per depositor.
The limit was subsequently permanently raised. So with a limit of $250,000 there’s less reason to worry about bank accounts today. But the important point remains, what causes panic is when things that everyone assumes to be safe turn out to no longer be so safe after all.
People who want to head off a financial panic. A compounding panic makes it difficult to address the underlying cause of financial issues that triggered the panic in the first place.
> The problem is when creditors start taking haircuts and going bankrupt themselves.
But this isn't really a risk to the broader market, because the government has already made it plain that it's going to backstop the liquidity to prevent any liquidity crisis, from buying commercial debt, to even buying equity. ...so if the gov't is the lender of last resort, then your argument doesn't make sense because.
Lehman Brothers going under is something the Fed has said it will not let happen again. Particularly in this scenario where bad debt is due to a pure externality.
...not to mention that people's bank accounts are protected by FDIC, and equity/retirement accounts are protected by a similar program.
Not that it really matters, because the banks are all much better capitalized than they were in 2008.
The real danger here is the potential for snap-back inflation (in a stagflation scenario), which I'd argue actually makes equities MORE attractive, not less - since stocks are inherently inflation protected.
I'd agree that inflation is probably a bigger risk right now than a 2008-style liquidity crunch. This is not necessarily mutually exclusive to a financial panic though.
Stocks tend to perform chaotically during major inflationary episodes. Over the long run corporate earnings are inflation-protected. The problem is that inflation hits unevenly, depending on where relative shortages are, and some businesses can raise prices much more than other businesses can. That can make some businesses non-competitive (= insolvent) during an episode of high inflation, while also pooling profits within a small number of survivors. You often see a big consolidation of winners, great companies of the next era born, and then a lot of bankruptcies. Mainstream investors are often not very good at predicting the winners, so you get panic and malaise in the short term.
A very likely outcome of inflation is for the indexes to underperform and gains to be concentrated in a few big winners (like, say, FAANG stocks). The big winners from inflation are generally chokepoints in the economy, companies that have monopoly pricing power over their industry, so by definition the majority of companies will be losers. Index fund investors are effectively subsidizing individual investors of the winners: the savvy individual investor gets in (looking at the competitive position of the company), their profits rise, the less-savvy individual investor gets in (looking at the new P/E ratios), the indexes rebalance to include more of stocks with higher market caps, and then the index rebalance forces index fund investors to buy in, raising the prices further for shareholders who already bought.
To some extent, this is already happening: the S&P 500 is down about 15%, but stocks like Amazon, Zoom, and Beyond Meat are skyrocketing.
Right, "savvy investors", mostly professionals, compete with each other to be first to set the market prices at their truer values. The index investor just goes along for the ride.
> then the index rebalance forces index fund investors to buy in
That's not really how it works for cap weighted whole market indices. They remain cap weighted as prices change, there's no need to "buy more" of a winning stock, you already had the stock, it won, now you have more of it (in USD terms).
Governments and central banks will certainly attempt to prevent contagion by buying assets and handing out bailout cash.
Does that fix the problem and then we go back to normal? Does it result in Weimar-style hyperinflation? Does it cause negative rates on long-term bonds?
I can only think of two historical precedents for guidance on how this might play out. First, Japan's "Lost Decade" (which was really more like 25 years). And second, the 2008 financial collapse.
Not sure either of these are directly comparable to the current predicament, though.
In 2008 we thought that the problem was contained to the subprime housing market, and once the Fed started supporting that market people breathed a sigh of relief and there was a rally and recovery from March-May. It wasn't until first Bear Stearns and then Lehman Brothers failed that people realized we were in a crisis. These were centuries-old, multi-hundred-billion-dollars institutions. The idea that they could cease to exist was unthinkable to anyone not actively looking at their balance sheet and doing the math, which is why there was such a panic when they did cease to exist.