The mak­ings of a 2020 re­ces­sion and fi­nan­cial cri­sis

Financial Nigeria Magazine - - Contents -

Although the global econ­omy has been un­der­go­ing a sus­tained pe­riod of syn­chro­nized growth, it will in­evitably lose steam as un­sus­tain­able fis­cal poli­cies in the US start to phase out. Come 2020, the stage will be set for an­other down­turn – and, un­like in 2008, gov­ern­ments will lack the pol­icy tools to man­age it.

As we mark the de­cen­nial of the col­lapse of Lehman Brothers, there are still on­go­ing de­bates about the causes and con­se­quences of the fi­nan­cial cri­sis, and whether the les­sons needed to pre­pare for the next one have been ab­sorbed. But look­ing ahead, the more rel­e­vant ques­tion is what ac­tu­ally will trig­ger the next global re­ces­sion and cri­sis, and when.

The cur­rent global ex­pan­sion will likely con­tinue into next year, given that the US is run­ning large fis­cal deficits, China is pur­su­ing loose fis­cal and credit poli­cies, and Europe re­mains on a re­cov­ery path. But by 2020, the con­di­tions will be ripe for a fi­nan­cial cri­sis, fol­lowed by a global re­ces­sion.

There are 10 rea­sons for this. First, the fis­cal-stim­u­lus poli­cies that are cur­rently push­ing the an­nual US growth rate above its 2% po­ten­tial are un­sus­tain­able. By 2020, the stim­u­lus will run out, and a mod­est fis­cal drag will pull growth from 3% to slightly be­low 2%.

Se­cond, be­cause the stim­u­lus was poorly timed, the US econ­omy is now over­heat­ing, and in­fla­tion is ris­ing above tar­get. The US Fed­eral Re­serve will thus con­tinue to raise the fed­eral funds rate from its cur­rent 2% to at least 3.5% by 2020, and that will likely push up short- and long-term in­ter­est rates as well as the US dol­lar.

Mean­while, in­fla­tion is also in­creas­ing in other key economies, and ris­ing oil prices are con­tribut­ing ad­di­tional in­fla­tion­ary pres­sures. That means the other ma­jor cen­tral banks will fol­low the Fed to­ward mone­tary-pol­icy nor­mal­iza­tion, which will re­duce global liq­uid­ity and put up­ward pres­sure on in­ter­est rates.

Third, the Trump ad­min­is­tra­tion’s trade dis­putes with China, Europe, Mex­ico, Canada, and oth­ers will al­most cer­tainly es­ca­late, lead­ing to slower growth and higher in­fla­tion.

Fourth, other US poli­cies will con­tinue to add stagfla­tion­ary pres­sure, prompt­ing the Fed to raise in­ter­est rates higher still. The ad­min­is­tra­tion is re­strict­ing in­ward/out­ward in­vest­ment and tech­nol­ogy trans­fers, which will dis­rupt sup­ply chains. It is re­strict­ing the im­mi­grants who are needed to main­tain growth as the US pop­u­la­tion ages. It is dis­cour­ag­ing in­vest­ments in the green econ­omy. And it has no in­fra­struc­ture pol­icy to ad­dress sup­ply-side bot­tle­necks.

Fifth, growth in the rest of the world will likely slow down – more so as other coun­tries will see fit to re­tal­i­ate against US pro­tec­tion­ism. China must slow its growth to deal with over­ca­pac­ity and ex­ces­sive lever­age; oth­er­wise a hard land­ing will be trig­gered. And al­ready-frag­ile emerg­ing mar­kets will con­tinue to feel the pinch from pro­tec­tion­ism and tight­en­ing mone­tary con­di­tions in the US.

Sixth, Europe, too, will ex­pe­ri­ence slower growth, ow­ing to mone­tary-pol­icy tight­en­ing and trade fric­tions. More­over, pop­ulist poli­cies in coun­tries such as Italy may lead to an un­sus­tain­able debt dy­namic within the eu­ro­zone. The still-un­re­solved “doom loop” be­tween gov­ern­ments and banks hold­ing pub­lic debt will am­plify the ex­is­ten­tial prob­lems of an in­com­plete mone­tary union with in­ad­e­quate riskshar­ing. Un­der these con­di­tions, an­other global down­turn could prompt Italy and other coun­tries to exit the eu­ro­zone al­to­gether.

Sev­enth, US and global eq­uity mar­kets are frothy. Price-to-earn­ings ra­tios in the US are 50% above the his­toric aver­age, pri­vate-eq­uity val­u­a­tions have be­come ex­ces­sive, and gov­ern­ment bonds are too ex­pen­sive, given their low yields and neg­a­tive term pre­mia. And high-yield credit is also be­com­ing in­creas­ingly ex­pen­sive now that the US cor­po­rate-lever­age rate has reached his­toric highs.

More­over, the lever­age in many emerg­ing mar­kets and some ad­vanced economies is clearly ex­ces­sive. Com­mer­cial and res­i­den­tial real es­tate is far too ex­pen­sive in many parts of the world. The emerg­ing-mar­ket cor­rec­tion in eq­ui­ties, com­modi­ties, and fixed-in­come hold­ings will con­tinue as global storm clouds gather. And as for­ward-look­ing in­vestors start an­tic­i­pat­ing a growth slow­down in 2020, mar­kets will reprice risky as­sets by 2019.

Eighth, once a cor­rec­tion oc­curs, the risk of illiq­uid­ity and fire sales/un­der­shoot­ing will be­come more se­vere. There are re­duced mar­ket-mak­ing and ware­hous­ing ac­tiv­i­ties by bro­ker-deal­ers. Ex­ces­sive high­fre­quency/al­go­rith­mic trad­ing will raise the like­li­hood of “flash crashes.” And fixed­in­come in­stru­ments have be­come more con­cen­trated in open-ended ex­change­traded and ded­i­cated credit funds.

In the case of a risk-off, emerg­ing mar­kets and ad­vanced-econ­omy fi­nan­cial sec­tors with mas­sive dol­lar-de­nom­i­nated li­a­bil­i­ties will no longer have ac­cess to the Fed as a lender of last re­sort. With in­fla­tion ris­ing and pol­icy nor­mal­iza­tion un­der­way, the back­stop that cen­tral banks pro­vided dur­ing the post-cri­sis years can no longer be counted on.

Ninth, Trump was al­ready at­tack­ing the Fed when the growth rate was re­cently 4%. Just think about how he will be­have in the 2020 elec­tion year, when growth likely will have fallen be­low 1% and job losses emerge. The temp­ta­tion for Trump to “wag the dog” by man­u­fac­tur­ing a for­eign-pol­icy cri­sis will be high, es­pe­cially if the Democrats re­take the House of Rep­re­sen­ta­tives this year.

Since Trump has al­ready started a trade war with China and wouldn’t dare at­tack nu­clear-armed North Ko­rea, his last best tar­get would be Iran. By pro­vok­ing a mil­i­tary con­fronta­tion with that coun­try, he would trig­ger a stagfla­tion­ary geopo­lit­i­cal shock not un­like the oil-price spikes of 1973, 1979, and 1990. Need­less to say, that would make the on­com­ing global re­ces­sion even more se­vere.

Fi­nally, once the per­fect storm out­lined above oc­curs, the pol­icy tools for ad­dress­ing it will be sorely lack­ing. The space for fis­cal stim­u­lus is al­ready lim­ited by mas­sive pub­lic debt. The pos­si­bil­ity for more un­con­ven­tional mone­tary poli­cies will be lim­ited by bloated bal­ance sheets and the lack of head­room to cut pol­icy rates. And fi­nan­cial-sec­tor bailouts will be in­tol­er­a­ble in coun­tries with resur­gent pop­ulist move­ments and near-in­sol­vent gov­ern­ments.

In the US specif­i­cally, law­mak­ers have constrained the abil­ity of the Fed to pro­vide liq­uid­ity to non-bank and for­eign fi­nan­cial in­sti­tu­tions with dol­lar-de­nom­i­nated li­a­bil­i­ties. And in Europe, the rise of pop­ulist par­ties is mak­ing it harder to pur­sue EU-level re­forms and cre­ate the in­sti­tu­tions nec­es­sary to com­bat the next fi­nan­cial cri­sis and down­turn.

Un­like in 2008, when gov­ern­ments had the pol­icy tools needed to pre­vent a free fall, the pol­i­cy­mak­ers who must con­front the next down­turn will have their hands tied while over­all debt lev­els are higher than dur­ing the pre­vi­ous cri­sis. When it comes, the next cri­sis and re­ces­sion could be even more se­vere and pro­longed than the last.

Nouriel Roubini, a pro­fes­sor at NYU’s Stern School of Busi­ness and CEO of Roubini Macro As­so­ci­ates, was Se­nior Econ­o­mist for In­ter­na­tional Af­fairs in the White House's Coun­cil of Eco­nomic Ad­vis­ers dur­ing the Clin­ton Ad­min­is­tra­tion. He has worked for the In­ter­na­tional Mone­tary Fund, the US Fed­eral Re­serve, and the World Bank.

Brunello Rosa is co-founder and CEO at Rosa & Roubini As­so­ci­ates, and a re­search as­so­ciate at the Sys­temic Risk Cen­tre at the Lon­don School of Eco­nomics. Copy­right: Project Syn­di­cate

Un­like in 2008, when gov­ern­ments had the pol­icy tools needed to pre­vent a free fall, the pol­i­cy­mak­ers who must con­front the next down­turn will have their hands tied while over­all debt lev­els are higher than dur­ing the pre­vi­ous cri­sis.

Nouriel Roubini

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