Where will the next crisis come from? Every crisis starts with a pile of debt that can't be paid back, and shady accounting to hide that debt. When one big one goes under, everybody starts to question the shady deals they've invested in, the extend-and-pretend game ends, heretofore simple rolling over of short term debt suddenly ends, and the run starts. Governments bail out. Really big crises happen when governments run out of bailout power or will and you have a sovereign debt crisis or inflation. Governments bail out by borrowing, but if people won't lend the government money to bail out, either default or inflation must follow. Reinhart and Rogoff describe a frequent "quiet period" between financial crisis and sovereign crisis. So far we have just had quiet.
So, where around the world is there a lot of debt that might not be paid back and really shady accounting? Well, duh, China, right?
So if I have to dream up a nightmare scenario it goes something like this: A pile of debt in China is found wanting. China's government takes desperate steps -- huge bailouts, sell its pile of treasuries, force people to buy worthless assets, print up lots of money, but prop up its value by stopping people from taking currency abroad, and so forth.
The next step is some sort of "contagion" to the rest of the world. Foreign businesses turn out to have invested more in China than we think (shady accounting again). Or supply chains are disrupted, we discover we're pretty darn dependent on trade and so on.
Meanwhile, the usual "information-insensitive" securities become "information-sensitive" in Gary Gorton's nice language. Italian banks are ready to go, and a hint Italy might leave the euro to bail them out might enough to get the Italy run going. Seeing China blow up might be just the hint people need to think about that. That event would be enough to put Italian and European sovereigns at risk, or force the ECB to real monetization in the trillions.
Can it spread to the US? We're usually the quality to which people fly. But Illinois and California's pensions don't look a lot better than Chinese banks really. Student loans loom. The Federal government has guaranteed a lot of debts! And the long-run cash flow forecasts for the US government aren't great. The prospects of a strong economy help demand for our debt, but a China-Europe crisis could well send us back to a recession. And in a global sovereign crisis, China and Europe will be cashing in their treasuries. Can we really borrow another $5 trillion for bailout and stimulus while foreigners are dumping $4-5 trillion or so of our treasuries?
This is absolutely not a forecast. The definition of a crisis is that it is unpredictable. It needs a lot of things to go wrong, a lot of firebreaks to fail. (Equity is one essential firebreak against asset failure turning in to liability failures.) After the event, it becomes obvious, and we hail a few lucky guessers (ignoring those guessers' may other wrong calls).
At best it is a scenario, a chain of events that could happen, with very small probability. The next crisis -- there will be one, someday, until that charmed day that the world adopts equity-financed banking and governments run fiscal surpluses -- may come from somewhere else totally. But the art of risk management is to think through improbable chains of events.
Why bring it up now? Well, in today's Wall Street Journal Lingling Wei reports that "China's banks are hiding more than $2 Trillion in loans," In the lead editorial rightly making fun of currency manipulation, the WSJ notes that China has already dumped $1 Trillion dollars of its reserves (likely US Treasuries) and facing $100 billion per quarter capital outflows. China is imposing strong limits on its citizens ability to move capital out of the country (translation: sell Chinese currency, bonds, bank accounts and get same in dollars abroad). At the start of the new year, individual Chinese will be allowed to take out their yearly allotment. I would guess they do it soon.
All these are signs of propping a currency up, not pushing it down; declining demand for currency and bonds that will be needed if China wants to do a massive bailout of bad debts. (Allow bankruptcies? Well, we in "capitalist" America don't do it, so I doubt China will do it either.)
These are signs that a run on China is already starting. Not all runs explode. Many fizzle out. But maybe this first link in the chain is closer to blowing up than we think. How are those firebreaks doing?