William White, the former chief economist at the Bank for International Settlements (BIS), says the hunt for yield is leading investors into high-risk instruments, and it looks like 2007 all over again.
Mr White says the current search for yield is a phenomenon reminiscent of the exuberance prior to the global financial crisis, which began in 2007-08. It comes at the same time as the US Federal Reserve prepares to start tapering its quantitative easing program, withdrawing liquidity from the global markets and could go "badly wrong".
"All the previous imbalances are still there. Total public and private debt levels are 30 per cent higher as a share of GDP in the advanced economies than they were then, and we have added a whole new problem with bubbles in emerging markets that are ending in a boom-bust cycle," said Mr White. He added that the world had become addicted to easy money, with interest rates dropping at each crisis, leaving little in reserve for central banks to use, should another crisis unfold.
Australia managed to escape the effects of the first global financial crisis thanks to a strong resources sector, limited exposure by our major banks to the US and Europe, and steps taken by the RBA to limit the damage. But we may not be so lucky the next time.
In the five years since Lehman Brothers collapsed, global banks are bigger and financial systems more closely intertwined. A shock in one part of the system is now much more likely to transfer into other areas. We could see credit markets close, as they did during the GFC, which would cause issues for Australia's major banks, including ANZ Bank (ASX:ANZ), Commonwealth Bank (ASX:CBA), National Australia Bank (ASX:NAB) and Westpac Banking Corporation (ASX:WBC). Without access to credit markets, banks could be forced to stop lending locally and call in loans to be repaid, which has serious implications for our economy.
Foolish takeaway
While that might be the 'doom and gloom' view, Mr White is famous for highlighting the wild behaviour in debt markets before the global financial crisis hit in 2008. In a worst case scenario, we could see the RBA forced to bail out one or more of the banks, most likely leaving shareholders with nothing.
Looking for a dividend-paying stock outside of the banks? Discover The Motley Fool's favourite income idea for 2013-2014 in our brand-new, FREE research report, including a full investment analysis! Simply click here for your FREE copy of "The Motley Fool's Top Dividend Stock for 2013-2014."
More reading
- Is Australia facing a housing bubble?
- Advisers and funds managers given the thumbs down
- Betting on a bank share price crash
- Aussie banks misunderstood
Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned.
