Recession or a coming financial crisis? Economists say the difference is vast

Interest rates arecreeping higher, andthe word "recession" is on everyone's lips.

But so far, only a few financial commentators are warning of something much worse thatcould abruptly change the rules of the game: The threat of a financial crisis.

On Wednesday, the Bank of Canada is preparingto announce what's expected to be another large hike in interest rates,continuingits battle against stubborn inflation.

Thebank's governor, Tiff Macklem, has repeatedly and confidentlysaid that neither the risk of a recession norfalling house priceswillstop him from getting inflation down to its target range, two per cent.

Master poker players

In a business that depends on confidence, central bankers must bemasterpoker players. They can't be seen to be sweating when they have a tricky hand.

Keeping inflation down isMacklem'sclearly stated priority, but if history is a guide, he and his U.S. counterpart, the Federal Reserve's Jerome Powell, will likely be putting plans in place for an even more important dutypreventing their own and the world's financial systems from falling into confusion.

Doubterswho needhistorical evidence can gaze back three weeks, when the Bank of England dropped everything to save the U.K. bond market and pension system.

For the general reader, the details are arcane, but after disruption of the markets by the British government's tax and borrowing plan, a kind of private sector insurance scheme by pension plans faced liquidation, "driving a potentially self-reinforcing spiral and threatening severe disruption of core funding markets and consequent widespread financial instability," according to a letter from the Bank of England deputy governor Jon Cunliffe.

After the fact, everyone played down the danger. But in the immediate aftermath, as the pound was plunging, one experienced London bond traderdescribedthe crisisas a potential"Lehman moment," harking back to that instant in September 2008 when the U.S. subprime mortgage crisis turnedinto a full-fledged banking crisis asLehman Brothers declared bankruptcy.

The authors of anarticle for the financial services company Morningstartitled "Why Are Fears of a New Financial Crisis Growing"? were careful to play down the risks. But the sudden and unexpected disruption in British markets came as a useful reminder that central bankers must be prepared for trouble.

Crisis before hitting inflation goals?

"Financial crisis is a new focus," John Canavan, lead analyst at Oxford Economics,told Morningstar. "It does appear that growing financial stability risks raises the possibility that the Fed may need to react to financial stability concerns before its goals are reached on inflation."

Economists who spoke to CBC Newssaid that beforefinancial crises happenit is hard to know for sure where and how they will appear. But central banks say they know onewhen they see one.

The peril of failing to respond to an unfoldingfinancialcrisis harks back to the 1930s, whena sudden market crash in 1929led to a cascading series of problems. Investment loans were called in andbanks ran out of money. Businesses big and small collapsed. One-quarter of employees were thrown out of work, and the Great Depression was born.

"In a financial crisis, some sectors of the financial system are failing," saidAngela Redish, an economic historian at Vancouver's University of British Columbia. "Financial crises almost always lead to recessions, but not all recessions lead to financial crises."

A fall in bond values, or house prices, or stock markets or currency markets do not by themselves create a crisis, said Redish. A crisis hits when those market changes reach extremes.

Crises are severe in a way that damages the structure of the market, leading to contagionsinother parts of the financial system. They shatter the faith andconfidence in a system that runs on faith and confidence.

Contagious crises

In the recent British example, the contagion spread from bonds to pensions to currency. In 2008a plunge in house pricesled to a failure of subprime loans creating a crisis for the banks that insured them. Money dried up because no one was willing to lend, leading toa credit crisis.

Crises also often lead to contagionto other countries, especially due to an unforeseen change that catches investors by surprise. In the late 1990s, a large U.S. investment firm, Long Term Capital Management, was shockedby financial crises in Asia and Russiathat led to a collapse of the fund's supposedly risk-free investment strategy.

Fearing a cascading effect on the entire U.S. market system, the Fed cut interest rates and convinced banks to ante up with a bailout.

Similarly, after the Lehman crash, then-Federal Reserve chair, Ben Bernanke, whose work on theGreat Depression won him a Nobel Prize this month,cut interest rates and flooded the market with cash to avoid a repeat of the 1930s systemic collapse.

One of the biggest impacts of a financial crisis, said Laura Jones, an economist and executive vice-president of the Canadian Federation of Independent Business, is the psychological impact on people and businesses that leads to fear and uncertainty.

"Small businesses are often quite a good shock absorber for recessions, particularly those triggered by a financial crisis," said Jones. "So if you look at 2008, small businesses were a lot slower to let go of employees."

Two years of small business hell

But burdened by debt and in the full knowledge they are unlikely to get another bailout package of the kind they gotfrom the federal government during the pandemic, they may not be able to provide the same kind of buffer. Uncertainty just makes that harder.

"Small businesses have just come out of two years of hell with COVID," said Jones. "And they came out of that to face supply chain challenges, inflation, interest rate hikes and labour shortages."

Others have warned that the COVID-19 bailouts did not lead to the kind of shakeout in small businesses that, while painful for individual business owners, is good for the wider economy.

WATCH | Staggering drops in home sales:

New numbers show steep decline in home sales compared with last fall

2 years ago

Duration 1:55

New numbers show Canada's housing market is continuing to cool, with home sales down 32 per cent this September compared with the same time a year ago, and prices down 6.6 per cent.

Another long-awaited shakeout happening right now is in the Canadian housing sector. As Hilliard Macbeth, an Edmonton-based financial advisor and author of the book When the Bubble Bursts, has noted, most financial crises in history were preceded by a huge surge in private sector debt.

"Canada's private sector debt is over 220 per centof GDP, one of the highest ratios in the world," said Macbeth in an email conversation on Saturday.

It is mortgage debt that pushes Canada and its banks into the danger zone, he said.

The Bank of Canada has studied whether Canada's large banks could withstand a severe economic downturn. And their conclusion is that the banks are safe.

But Macbeth said the bank stress test report assumes bank losses due to mortgage losseswill be minimal, and he fears that this time could be different if Canada and the world faces a severe recession.

"In the past Canadians have usually paid their mortgage debts with only minimal losses," said Macbeth. "In today's scenario with household debt levels and house prices much higher than ever before, we cannot know if this track record will hold."

Whether or not the Bank of Canada thinks that is likely, their job, like that of the Bank of England and the U.S. Fed, is to be prepared to try and swoop to the rescueif the worstshould happen.