Fed up

The world is sen­si­tive to US tight­en­ing and moves in the dol­lar

The Daily Telegraph - Business - - Front Page - Am­brose Evans-Pritchard

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

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