Three scenarios for our financial system in 2050 – told by the fictional story of Ivo Salvini, who started his career in a fintech startup in 2018.
January 18, 2050 – an ordinary Thursday evening in the Red Lion pub in East London. “The crash was inevitable, can we at least agree on that?” Ivo had another argument with his friend from university, Lydia González. They were quarreling once again about the financial crisis of 2027 and how it should have been handled by politicians. “Yes, of course, crashes are inevitable in our financial system. But to predict them, this is the hard part. Professor Hindsight has always an easy time to explain what happened”, said Lydia, who had become a well-known professor in the field of economic history.
Nevertheless, even Lydia had to admit that the writing was on the wall. Since the turn of the millennium, various economists highlighted that financial crises usually follow well-known patterns. One “New York Times” bestseller even ironically proclaimed that “This time is different”. And although reputable institutions like the Bank of International Settlements pointed out concerning developments in finance, the people in charge did not bother to listen.
In 2027, most were taken by surprise, again.
If Lydia had to put a date on when our financial system started to fall apart, she would have picked the 1970s. Back then, the rules of the financial system were flipped upside down. Richard Nixon buried Bretton Woods.
Bretton Woods was a system of fixed exchange rates that pegged all the currencies to the dollar. The dollar in turn was linked to Gold. The collapse of this system was the beginning of a flexible exchange rate regime. It also marked the rise of a global paper-based money system without any link to a scarce commodity. It was the first time in history when all major currencies could be created out of thin air.
In 1970s, a further important development picked up speed: the digital revolution. Computers increasingly conquered the offices of the world. This also changed the banking system, because, as Lydia says: “The financial business is basically of a purely virtual nature.” No wonder, securities trading accelerated and cross-border transactions grew rapidly. The banking industry underwent a radical transformation, as IT allowed it to repack loans into complex financial innovations. A new shadow banking sector emerged in turn. In the US, this new sector was larger than the traditional banking shortly before the financial crisis of 2008.
For Lydia, the conclusion is clear: “In the second half of the 20th century, both money and credit broke free from their historical ties.” This sentence seemed familiar to Ivo – perhaps it was from Lydia’s PhD thesis? As a good friend, he once felt compelled to read at least the summary. He remembered having seen there an illustration of the unprecedented growth in global debt.
In an early phase, excessive amounts of loans were granted to households and companies. After the crash of 2008, the debt structure shifted. On the one side, the balance sheets of central banks exploded to unprecedented levels. On the other side, governments bailed out banks and supported the ailing economy. This forced them to pile up staggering amounts of government debt.
“This transformation of private into public debt seemed extraordinary to contemporary observers, but the same thing happened after many financial crises throughout the 19th and 20th century”, Lydia explained. This was one of the observations of Carmen Reinhart and Kenneth Rogoff, the two economists behind the bestseller “This time is different”. They have shown how banking crisis have often been followed by sovereign debt crisis, and that excessive levels of government debt paired with expansive monetary policy often developed into currency crises and high inflation.
Quite a few economists warned that the fundamental issues that led to the financial crisis of 2007-08 remained unsolved. “Nobody cared about the explosion of debt and leverage. Instead, those who were in charge fell into a regulatory frenzy,” Lydia told Ivo, who was just about to stand up to get another pint. Indeed, the regulatory activity following the financial crisis of 2007-08 was astonishing and unprecedented. In 2016, Thomson Reuters registered 200 regulatory changes around the globe – every single day!
The world found itself in permanent crisis management and did not bother dealing with the underlying issue of too much debt. But that did not stop those in charge to praise themselves as heroes who had successfully “fixed” the financial system. “Global debt levels were higher than ever before in history, the regulatory framework more complex than ever before in history, and U.S. banks made more money than ever before in history. And what did global regulators say in 2017? Mission accomplished: the financial industry is #safersimplerfairer” Lydia grimly said.
Ivo did not bother challenging Lydia’s criticism of “his” industry. In the end, Lydia agreed that the crash was anyway inevitable, so who cares what people said or did before? “Mistakes happened before the crisis. We cannot change that anymore. And I have a lot of work tomorrow. So let’s postpone our discussion about what the best crisis response would have been to another after work beer”. Lydia agrees. They get out on the street, say goodbye to each other, and Ivo hails a self-driving cab and is driven home.
More regulation to fix the financial system
- Assumption: No currency crisis
- Crisis Response: Another coordinated global bailout for financial institutions
- Result: Higher market concentration, higher leverage, dense regulation.
The radio alarm clock switches from “5:59” to “6:00”. The music starts, “I got you babe”. Ivo awakes. After a shower and a shave, he puts on his dark suit and a red tie. Then he takes a cab straight to the offices of the Goliath National Bank, his employer.
The Goliath National Bank was created in the aftermath of the financial crisis of 2027. The Fed and the U.S. Treasury merged three of the largest banks into one conglomerate, together with a few dozens of smaller financial institutions. These smaller financial institutions emerged during a so-called fintech boom that started shortly after the financial crisis of 2007-08.
Back in the early days, these companies proclaimed themselves as disruptors to the banking industry, but they were quickly bogged down by regulation. So they switched their approach and cooperated with the big banks. The big banks dealt with compliance and regulatory issues and provided cheap funding, while the fintech startups could make much more money with innovative business models than the banking desks that relied on traditional business models and were bound by strict regulation.
However, the financial crisis of 2027 exposed these innovative business models as a mirage. They exposed the big banks to huge risks. Later, economists found that their business models were very similar to the business models employed by the shadow banking sector before the financial crisis of 2007-08. Huge risks piled up outside of the regulators spotlight. And in 2027, the house of cards collapsed.
Once again, central banks and governments saved the day. They used all their financial firepower to prevent the system from collapsing. The megabanks and the fintech institutions, which were sponsored by these megabanks, were consolidated into even bigger banks. At the same time, smaller banks and independent fintech companies could not build on government support. Ivo still remembers the Treasury secretary explaining this course of action: “We cannot write a blank check for all financial institutions. Some degree of market discipline needs to be maintained.”
As of today, Goliath National Bank and Monstrosity Capital Group control 93% of all banking assets in the United States. Some financial experts see large economies of scale with this setup, while others are worried about the market concentration. But everyone agrees that those two mega bank conglomerates are definitely “too-big-to-fail”. Consequently, new laws were introduced. The Prank-Todd Consumer Reform and Wall Street Protection Act regulates the new mega banks. The goal was clear: Never again should another financial crisis like 2027 happen. Clearly, no easy task. So it is no surprise that Prank-Todd filled more than 320’000 pages. Some breakthroughs in AI technology made it possible that machines wrote large parts of the new law.
Ivo is in the compliance team of Goliath National Bank. He is part of a team with 40 members that monitors adherence to the new biodiversity risk regulations. He and most of his team members used to work for Fintastic. Fintastic was a Fintech startup that has been taken over by Goliath National Bank. Originally, Fintastic offered innovative credit solutions for the automotive industry.
But during the crisis, the founders realized that RegTech (Regulatory Technology) was the place to be. Hundreds of new regulations were put into force on every single day. RegTech was the only way to cope with this amount. So Fintastic completely changed its strategy. A few months later, Goliath National Bank offered a takeover deal.
Not only Fintastic changed its business model radically, also Goliath National Bank was completely reorganized after Prank-Todd was introduced. The Executive Board now consists of a Chief Regulatory Officer, a Chief Legal Officer, and a Chief Compliance Officer. The CEO reports to this so called “Triumvirate” and manages payment services, lending, and trading.
Ivos job is rather dull, but he considers himself lucky to have a job. While the collapse was avoided, the real economy suffered badly. The unemployment rate in the U.S. rose to 30% after the crisis. It fell afterwards but it is still above 15%. However, the U.S. is still in a much better position than countries in the European Union with unemployment rates still hovering close to 40%.
With rising unemployment, the political landscape has shifted, too – an effect that economists have already identified in the aftermath of previous financial crises. Many people thought that the Trumpists were done after the disastrous second term of Donald Trump. In the recent election, however, their presidential candidate won by a landslide on the promise to destroy all the robots that were not produced on American soil. Also Ivo voted for them.
Despite these radical measures, the Trumpists were unable to revive the economy. On his way home, Ivo listens to the news. The economy did not do well and GDP shrunk by 0.2% in the last quarter. Nevertheless, the economic commentator highlighted that the U.S. still performs much better than Japan or Europe: “Debt levels in the U.S. are very sustainable with a public debt to GDP ratio still below 350%, an impressive ratio compared to Japan that struggles with a ratio of over 800%.”
Blockchain and Free Banking
- Assumption: The global currency system collapses
- Crisis Response: Prevent the collapse of rule of law
- Result: The rise of cryptocurrencies and a free banking system around it
“6:00”. Ivo awakes to the sound of “I got you babe”. A new day starts. His employer is Heydaypayday (HDPD), and his first task today is a client visit. He skips breakfast and heads straight to his client, a coffee shop around the corner, which he successfully acquired a couple of weeks ago. Just before meeting the shop owner, he looks into the camera of the coffee machine and orders a soy skinny caramel latte. He checks his smartscreen and is happy to see that he was charged correctly. Until recently, they still had some issues with their updated facial recognition technology.
Facial recognition is one of the oldest innovations from HDPD. The company resulted out of the merger of various Fintech companies after the financial crisis of 2027. One of the companies was Fintastic, which developed innovative financing solutions.
When cryptocurrency emerged, Fintastic started to offer scalable payment solutions based on blockchain technology. It also developed the Fastcoin. But Fastcoin seemed to be a failure. It did not even take off during the famous cryptocurrency bubble where prices of Bitcoin and Co. skyrocketed. The Problem with Fastcoin was simple: No one was interested at that time in real-world applications of the technology. But everything changed with the financial crisis of 2027.
As in financial crisis of 2008, the Fed and the Treasury tried to control the damage. They extended huge loans to banks, organized mergers of failing banks, and created a bad bank for the most toxic assets. Initially it seemed to work. But then it happened. After announcing another round of quantitative easing. Something snapped. People lost faith in the established currencies. What started as a banking panic escalated into a full-blown currency crisis. People got rid of paper currencies and started to buy houses, precious metals, durable goods – and cryptocurrencies.
It was the first time in history when all major government sponsored currencies in the world were hit by hyperinflation at the same time. The world economy almost collapsed. Global supply chains fell apart, and entire industries could no longer uphold production. This resulted in mass unemployment. Many countries fell into severe civil unrest.
Ivo still remembers that he just started at HDPD a few months before the crisis gained pace. He initially cursed himself for joining a startup in such a difficult environment. But the management of HDPD soon realized that one of the preceding firms, Fintastic, developed Fastcoin that was operating on the most scalable blockchain solution of that time. The potential was huge, because everyone was now looking for an alternative payment system.
HDPD developed a convenient and secure interface for the Fastcoin. And with that, Fastcoin took off. HDPD was approached by companies all around the world for payment services. The crisis catapulted the startup at the top of the payment services industry. Today, it focuses on restaurants, grocery stores, and other small service providers with high transaction volumes and the need for convenient and fast payment solutions.
Ivo is not only a client relationship manager, but also responsible for monitoring developments in the cryptocurrency space. New coins are created every day, and existing coins sometimes collapse. Ivo still shudders when he remembers the “Great Hack of 2041”. Hackers exploited a security gap of the then dominating blockchain in Latin America. The tokens built upon this blockchain collapsed overnight. The next morning, Millions of people woke up to find their life savings wiped out. Even 15 years after, the entire region has yet to recover from this blow.
Of course, this triggered a discussion whether monetary policy should be re-nationalized. But economists like Lydia were adamant that such “frictions” have to accepted. Progress leads to disruption, and constraining the process of “creative destruction” of a free market economy would create bigger issues than it could potentially solve – just remember the crisis of 2027. Market participants will eventually learn their lesson without regulations. Cryptocurrency operators and exchanges invested massively into IT security, while households and companies now carefully diversify their savings across different cryptocurrencies and service providers.
However, the heterogeneity of a private money system has undeniably led to inefficiencies. Countless exchange rates with high volatilities complicate commerce. The ups and downs of the business cycle has intensified. On his way home, Ivo listens to the news. The commentator praises the exceptional economic performance from the last quarter. GDP grew by 2%. But the quarter before that, the economy contracted by 1.5%. The commentator explained: “This rebound is to be expected. The high short-term volatility in the economy is the price we pay for long-term stability.”
Cut the Debt
- Assumption: No currency crisis
- Crisis Response: A coordinated wind down of insolvent institutions
- Result: Redistribution between Debtors and Creditors
“6:00, January 17, 2050” Ivo wakes up. While showering, he sings at the top of his lungs “I Got You, Babe”. When was the last time he heard this classic from Sonny and Cher? He suddenly feels a Déjà vu. The first thing he does after arriving in the office of the Independent Financial Advisors (IFA): he searches for the tune on the Internet to listen to it again.
His employer, IFA, originated from a fintech startup called Fintastic. The company was set up to provide innovative funding solutions. The founders first focused on business clients, but they soon discovered retail customers. They realized that many retail investors were unable to cope with choosing the right crowdfunding investment opportunities.
As such, IFA tried to build a unique selling proposition around their independence, hence they changed their name from Fintastic to IFA. IFA was an advisory-only business, and this model required them to take a management fee from retail clients. As such, they had a hard time acquiring customers, despite the fast growth of crowdfunding. But the financial crisis of 2027 changed everything.
To the surprise of bankers and banking regulators, governments all around the world decided not to bail out financial institutions again. Governments were burdened by too much debt, and they were afraid that another bailout could trigger a full-blown currency crisis. To the surprise of and against the warnings of leading bankers and academics at the time, they decided to liquidate failing banks. In addition, the leading G20 nations conducted a coordinated global debt haircut for households, companies, and governments.
The global coordination paid off. The course of action prevented a complete meltdown of the financial system. The bankers warned that the world would come to an end without them, but their warnings turned out to be wrong. While trade and economic activity reduced significantly for some time, supply chains could be maintained – there were no severe civil unrest as some had expected.
The price for the debt haircut was a global redistribution of wealth from creditors to debtors and owners of real values. In particular, house owners with mortgages benefited tremendously from the financial crisis. However, as many other governments, the US enacted additional levies on real estate, in a similar fashion Germany did after the hyperinflation of the Weimar Republic.
Also owners of gold were not spared. IRS employees opened vaults around the country and taxed the holders of precious metals with an 85% “solidarity tax”.
Besides creditors, the main winners of the financial crisis of 2027 were fintech companies that did not tie their business model to banks, but instead operated an independent business model. This was the moment for IFA. After the liquidation of the banking system, the remaining financial system was completely disintermediated and decentralized. New Crowdfunding and payment service providers mushroomed. And advisory services to cope with this new world were in high demand.
The economy also recovered rapidly. Freed from the debt burden, the economy expanded at rates as it did back in the 1960s. As usual, Ivo was listening to the news on his way home. The U.S. economy grew by almost 4% during the last quarter. A commentator in Washington explained that the strong growth is very helpful in resolving the ongoing dispute about how to deal with the issues raised by the global debt haircut: “It does not come as a surprise that Republicans and Democrats have just agreed on a new compensation plan to support struggling pensioners.”
This article has originally been published in the Neue Zürcher Zeitung, the Swiss newspaper of record. Quite a few details, however, have been adapted for an international readership. You find an online version of the original text here (in German).
- The small bug that crashed our economic system: Regulators came up with a long list of contributing factors to the financial crisis of 2007-08. But what if all these factors are only symptoms of one underlying, much more fundamental issue?
- Banking regulation moves closer towards peak complexity: The global framework for banking regulation is already extremely complex. Newly presented rules will complicate matters further.
- Why Fintech needs a license to disrupt finance: Financial regulation treats banks as protected species. This prevents long overdue structural change. The way forward is a fintech license. But current proposals, such as the latest one by the Swiss government, are not comprehensive enough.
Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts.” in NBER Macroeconomics Annual 2016, volume 31, edited by Martin Eichenbaum and Jonathan A. Parker. Chicago: University of Chicago Press.
Pozsar, Zoltan & Adrian, Tobias & Ashcraft, Adam B. & Boesky, Hayley, 2013. “Shadow banking,” Federal Reserve Bank of New York Economic Policy Review, 19 (2), pages 1-16.