The world is sensitive to US tightening and moves in the dollar
The International Monetary Fund teases us. It talks of “dangerous undercurrents” in the global system. It warns of a “sudden, sharp tightening in financial conditions” that could pop the asset bubble, without pinning down the likely mechanism.
The title of its Financial Stability Report provokes – “A Decade After the Global Financial Crisis: Are We Safer?” – yet the fund fails to answer its own question. Our fate is left dangling.
So let me try to flesh out what the IMF might think but dares not say because it is the political captive of Washington, Beijing and Europe’s monetary union.
There is the usual nod to debt in the IMF risk list. The liabilities of states, households, and companies have reached $167 trillion (£126 trillion). This is more than 250pc of world GDP, up from 210pc on the cusp of the Lehman crisis. Higher debt ratios mean the pain threshold for monetary tightening will be lower in this cycle, and forms of debt are just as gangrenous. Leveraged loan issuance has surpassed the pre-Lehman peak.
An eye-watering paragraph on Chinese “repo” market borrowing – linked to an $11 trillion nexus – says daily volumes have risen fifteenfold over the last year alone. They are now double the peak ratio in the US just before the 2008 collapse. These repos are being used “to bridge the maturity gap” between short-term debts and illiquid long-term assets. It was exactly such a mismatch that blew away Northern Rock and then Lehman when the capital markets seized up.
The IMF sketches an ugly denouement where a sudden jump in US inflation forces the US Federal Reserve to hit the brakes. The twin blast of higher US borrowing costs and a stronger dollar slams into emerging markets, already suffering from a squeeze. The Fund delicately blames US overheating on “procyclical fiscal policy”. That is a euphemism for the tax cuts and pork-barrel spending by the Trump White House and the Republican Congress, a late-cycle policy mix of criminal irresponsibility.
The Fund’s Fiscal Monitor states that US federal deficit will soar to 5pc of GDP next year and remain near there as far out as 2023, by which time gross public debt will have rocketed to 117pc. There is no economic value to such over-stimulus. The fiscal multiplier is dead at this stage of the cycle. The unemployment rate is already at a half-century low.
It is redundant extra debt and will come back to haunt US society. But for the next year or so US overheating is the world’s problem.
We are at a unique juncture in economic history where the US is no longer the hegemonic economic power. This aspect of the global system is “multi-polar”. East Asia is a bigger force. Europe is no minnow. The lion’s share of net growth over the last decade (80pc in some years) has come from emerging markets.
Yet the US does remain the global financial hegemon. China, India and their peers lack deep capital markets. The euro remains dysfunctional. The global payments nexus is dollarised. So are the international lending markets. Cross-border loans in dollars outside US jurisdiction have ballooned from $2 trillion in 2002 to $13 trillion today, or $26 trillion when equivalent derivatives are included. The world has never been more sensitive to Fed tightening or to moves in the dollar. The international system is out of kilter and extremely dangerous.
The first of the Trump/Fed impulses has flattened the weakest emerging markets, those with big deficits and low exchange reserves. Argentina and Turkey have spun into crisis. South Africa is hanging by its fingertips. Even the strong are having to retrench. This has led to a contraction in global trade volumes and caused a sudden industrial slowdown in the eurozone.
The risk now is a US inflation scare. The yield on 10-year US Treasuries has this month broken out of its long trading range and punched higher to 3.25pc. What if it now ratchets up towards 4pc, pushed by the “crowding out” effect of the US debt markets by Trumpian deficits and a net $50bn of bond sales each month by the Fed?
In the doomsday scenario, the world would then be faced with a systemic emerging-market crisis. China would be in the sights. The country cut the reserve requirement ratio for banks by 100 basis points over the weekend to shore the economy but this risks currency slide. Beijing knows from the currency drama of early 2016 how quickly devaluation can turn toxic. It had to burn through $1 trillion of foreign reserves and even that was not enough. What saved the day was a US retreat on rate rises. The Yellen Fed was willing to act as the world’s central bank. The circumstances are unrecognisable today.
The final channel of contagion is into the unreformed eurozone. As the IMF makes clear, the “doom-loop” between banks and sovereigns remains in an ineluctable feature of the EMU structure and is on vivid display in Italy. It warns a blow-up of the “sovereign-bank nexus” in Italy will not be contained. It will spread through southern Europe.
Bodies such as Jacques Delors’ Notre Europe warn that the eurozone will not survive another global recession as currently designed. Without fiscal union the prospects are hopeless. Public debt ratios are much closer to the danger line than at the outset of the last downturn.
The contagion from a full global crisis would trigger a eurozone recession. The ECB would have no monetary ammunition left to combat the shock since interest rates are already minus 0.4pc. Only a massive fiscal response could rescue Europe but this is prohibited by the “Ordoliberal” Stability Pact, and would in any case be impossible for the Club Med states acting singly.
If it reached this point, the eurozone would crash into deflation, leading to a string of sovereign bankruptcies and the devastation of Europe’s financial system. Monetary union would shatter. It would the end of the post-War European order.
Yes, the “blowback” into the US economy itself would eventually cause the Fed to change course. But the moment of danger is the interregnum when the furies escape across the world, while Washington is still in its own political universe.
The benign scenario is that US inflation ebbs in time. The Powell Fed takes the global pulse, dials down its rhetoric and abandons tightening altogether.
Let us hope. My assumption is that the Fed will continue on its set course until something breaks: the world economy.
‘The world has never been more sensitive to Fed tightening or to moves in the dollar’
Eye of the storm: Jerome Powell, chairman of the US Federal Reserve