Economic Tsunami

What Is an Economic Tsunami?

An economic tsunami is a widespread set of economic troubles caused by a single significant event. The downstream effects of economic tsunamis generally spread to broad geographic areas, multiple industry sectors, or both.

Understanding Economic Tsunamis

Economic tsunamis take their name from natural tsunamis, which are abnormally large waves triggered by a disturbance to the ocean floor, such as an earthquake. The resulting wave causes widespread destruction once it reaches the shore and floods low-lying coastal areas, and it can even cross oceans in its effects. 

Likewise, economic tsunamis generate destructive effects beyond the geographic area or industry sector in which the triggering event takes place. These consequences can illustrate previously undetected connections between parts of the global economy that create a ripple effect only under extreme stress.

Depending on the severity of the consequences and the mechanism by which they spread, economic tsunamis can lead to new regulations as markets attempt to adapt to or prevent a future recurrence under similar conditions.

Example of an Economic Tsunami

The 2008 global financial crisis sits among the most prevalent recent examples of an economic tsunami. The subprime mortgage market in the U.S. acted as a trigger in this case, with large investment banks (IBs) miscalculating the amount of risk in certain collateralized debt instruments.

Unexpectedly high default rates led to large financial losses in portfolios with high credit ratings, which triggered massive losses for highly leveraged investments made by financial institutions (FIs) and hedge funds. The resulting liquidity crunch spread rapidly beyond the subprime mortgage market. In response, the U.S. government took over secondary mortgage market giants Fannie Mae and Freddie Mac, while Lehman Brothers filed for bankruptcy. Losses at Bear Stearns and Merrill Lynch led to acquisitions of those companies by JPMorgan Chase & Co. and Bank of America, respectively.

Foreign banks also suffered losses through investments affected by the economic crisis. Iceland's banking sector suffered a nearly complete collapse following the subprime crisis, tanking the nation's economy. Meanwhile, in the United Kingdom, the British government stepped in to bail out its banking sector.

The U.S., the U.K., and Iceland all undertook varying degrees of regulatory reform following the crisis. Iceland's economy essentially reinvented itself to rely more heavily upon tourism than on international banking. The U.S. introduced a range of regulatory controls via the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 as well as the Housing and Economic Recovery Act of 2008. Many of these regulations strengthened oversight of mortgage lending. The U.K. response included the introduction of the Financial Services Act in 2012.

Special Considerations

Globalization is one of the main reasons why an economic downturn in one part of the world can be felt on the other side of the globe. Without widespread economic interdependence between markets across the world, economic tsunamis, along with their associated costs, would essentially cease to exist. Free trade agreements (FTAs) between different countries have made companies more competitive and helped to lower the prices that consumers pay for various goods and services, but the benefits of globalization come with important caveats. 

Closer economic and financial relations also lead to increased transmission of economic shocks. The increased interconnectedness of national economies means that an economic downturn in one country can create a domino effect through its trading partners. Nations now depend on each other to stay afloat. If the economy of a key buyer or seller of goods and services experiences turbulence, this could be expected to have a knock-on effect, impacting exports and imports in other countries.

The increasing interconnectedness of global financial markets over time has also become a major factor in the propagation of economic tsunamis. This can be seen above in the example of the global financial crisis and the Great Recession as well as in other prior events such as the Asian currency crisis and the Long Term Capital Management incident.

In the first six months of 2019, the United States' biggest trade partners were, in the following order: Mexico, Canada, China, Japan, and Germany.

Trade Wars

Growing calls from some quarters to unwind globalization are also stirring up threats of economic tsunamis while possibly also mitigating the risk posed by economic tsunamis by reducing dependence on foreign supply chains. 

An example of this is the trade war between China and the United States. A bitter standoff between the world's two biggest economies is hurting companies from both countries, weighing on equity markets, investments, the labor market, and consumer spending. In 2019, the value of U.S. exports to China amounted to $106.6, down from around $120.3 billion in the previous year. A paper published by the National Bureau of Economic Research in January 2020 (and revised in August 2020) by the economists Kyle Handley, Farina Kamal, and Ryan Monarch found that one-fourth of U.S. exporters — companies that account for more than 80% of U.S. exports, by value — imported products subject to tariffs during 2019. On average, the higher costs created by these tariffs equaled $900 per worker.

Other countries have been caught in the crossfire, too. The International Monetary Fund (IMF) warned that America's trade spat with China could cost the global economy roughly $700 billion by 2020. 

On the other hand, to the extent that increasingly protectionist trade policies achieve their stated goals of increasing reliance on domestic supply chains and decreasing dependence on foreign markets, they may reduce the danger of economic tsunamis being transmitted between economies and increase the overall resilience of the domestic economy to economic shocks. 

Financial Crises

Globally connected financial markets represent a major transmission mechanism for economic tsunamis. Stocks, bonds, commodities, currencies, and derivatives are all traded across effectively global markets in the modern economy. A disruption to trading or collapse in the value of an asset in any one market can very quickly spread across the planet. Moreover, the major financial institutions, whose rise and fall has the power to move markets, are interconnected around the world with investors and governments in a complex web of financial obligations and counterparty risk. 

This increases the risk of economic tsunamis originating in or traveling through international financial networks as seen in the financial crisis of 2008 and the Great Recession. Indeed several economists, including Kenneth Rogoff and Carmen Reinhart in their 2009 book, This Time It's Different, have documented clear, persistent links between the degree of international capital mobility and financial crises.

Since the Great Recession, total global capital flows, which peaked in 2007, have fallen, according to the International Monetary Fund. However, other measures of financial globalization have steadily risen, such as foreign direct investment and foreign holdings of equity and credit instruments. In addition to conventional financial arrangements, the global shadow banking system (which was so heavily implicated in the 2008 financial crisis) has surged, increasing in total assets by 75% between 2010 and 2017, according to the international Financial Stability Board based in Basel, Switzerland. This all suggests that global financial transmission of economic tsunamis will remain a substantial risk to the world economy.