Similar to 2005 when I started at the FDIC, the U.S. economy is experiencing a period of prosperity. Growth in real GDP has averaged 2.2 percent in this expansion, and was right around 3 percent in the second and third quarters of 2017. Our stock market has reached new highs and real estate prices have been rising. Global economic growth appears to be picking up, with the IMF raising its growth forecasts for Japan, China and Europe.
The post-crisis economic expansion is now in its 101st month, making it the third-longest expansion in U.S. history. This coming June, it would become the second-longest expansion in our history. The current consensus is this will occur. None of the economists polled by the Blue Chip Economic Indicators foresee a recession this year or next.
This improvement in the economic outlook is a positive development for banks and bank regulators. We know, however, that economic expansions eventually come to an end. We also know that financial shocks can come from unexpected sources at any time.
Following the Savings & Loan crisis of the 1980s and the banking crisis of the late 1980s and early 1990s, we entered a 10-year economic expansion — the longest in U.S. history. Even that period was punctuated by a series of domestic and international crises that tested the effectiveness of risk managers. Banking and economic crises emerged during the 1990s and into the early 2000s in Scandinavia, Mexico, east Asia, Russia and Argentina. Domestically, severe disruptions were averted in 1998 following the collapse of Long-Term Capital Management that resulted from its use of high-risk arbitrage trading strategies. The 2001 crash in dot-com equity prices was soon followed by the sudden bankruptcies of Enron and WorldCom. Finally, the development that would ultimately trigger the recent financial crisis was the decision by financial institutions in increasing numbers, and of increasing size, to enter the business of originating or securitizing subprime and alternative mortgages.
Such experience is a reminder that, despite the good conditions we currently see, there are always challenges that could quickly change the outlook. Even though the current expansion appears more sustainable than the boom that occurred in the years leading up to the 2008 crisis, there are vulnerabilities in the system that merit our attention.
One vulnerability relates to the uncertainties associated with the transition of monetary policies — both here and abroad — from a highly expansionary to a more normal posture. Market responses to changes in monetary policy can be hard to predict. Recently, the Federal Reserve has embarked on a gradual reduction in the size of its balance sheet. Thus far, there has been no apparent market reaction. Nonetheless, higher interest rates could pose problems for industry sectors that have become more indebted during this expansion.
By many measures, stocks, bonds and real estate are richly priced. Stock price-to-earnings ratios are at high levels, traditionally a cautionary sign to investors of a potential market correction. Bond maturities have lengthened, making their values more sensitive to a change in interest rates. As measured by capitalization rates, prices for commercial real estate are at high levels relative to the revenues the properties generate, again suggesting greater vulnerability to a correction.
Taken together, these circumstances may represent a significant risk for financial market participants. While banks are now stronger and more resilient as a result of the post-crisis reforms, they are not invulnerable.
History shows that surprising and adverse developments in financial markets occur with some frequency. History also shows that the seeds of banking crises are sown by the decisions banks and bank policymakers make when they have maximum confidence that the horizon is clear. It is also worth keeping in mind that the evolution of the global financial system toward greater interconnectedness and complexity may tend to increase the frequency, severity and speed with which financial crises occur.
It would be a mistake to assume a severe downturn or crisis cannot happen again.
Martin J. Gruenberg is chairman of the Federal Deposit Insurance Corporation. This essay is an excerpt from a Nov. 14, 2017, speech he delivered to the Brookings Institution in Washington, D.C.