Another economic downturn is just a matter of time


It will be harder to fight than the last one, says Ryan Avent

Oct 11th 2018Print edition | Special report

JUST SOUTH of Indiana’s border with Michigan lies the city of Elkhart, with a population of just over 50,000. Apart from a small, shop-lined high street near where one river, the Elkhart, flows into another, the St Joseph, the city is mostly shapeless, tree-lined and suburban. Scattered around the outskirts are the factories of several of America’s largest producers of recreational vehicles (RVs). Rows of the finished products rest outside the giant sheds in which they are made.

Modern RVs are impressive, leather-upholstered land yachts fitted with flat-screen televisions and gas fireplaces, the perfect vessels in which to navigate the American continent. The RV business is one of the economy’s most strongly cyclical. Sales of big-ticket items like homes and cars inevitably rise and fall with the business cycle, but RVs are especially susceptible to such swings. It is only once cars and homes have been upgraded that consumers consider splashing out on rolling living quarters. And when financial fear stalks the land, RV-makers have a particularly hard time.

In Elkhart, more than a quarter of people in employment work on RVs. When the global financial crisis in 2007-08 plunged the world economy into its worst downturn since the 1930s, employment in the city’s factories fell by nearly half. The unemployment rate almost quintupled, to 20%. Incomes and population dropped. Elkhart was among the first places President Barack Obama visited after his inauguration in 2009: it exemplified the extraordinary economic challenge facing his administration.

But then the city edged away from the brink. By the end of Mr Obama’s first term its unemployment rate had fallen by more than half. By the end of his second, as President Donald Trump took office, the rate had more than halved again, and earlier this year it dropped to the extremely low level of 2% as Americans started to splash out on luxuries again. Companies in the area cannot fill the jobs they advertise. The good times are back.

But for how long? One day, the forces that turned the palest, thinnest of green shoots after the financial crisis into the second-longest American economic expansion on record will change direction, igniting a new recession—for which the world is woefully unprepared. When that might happen is hard to say. Studies of American business cycles suggest that the economy is as likely to flip from growth to contraction early in the life of a boom as later on. Indeed, America has no records of an expansion lasting longer than a decade, though many countries do: Australia, Canada and the Netherlands have all enjoyed sustained growth lasting more than 20 years in recent memory. Yet all good things come to an end.

It might not take much to bring on the next recession

Though there is no settled view on what constitutes a global recession, worldwide slumps are usually marked out by a sharp slowdown in global growth and a decline in real GDP per person. Roughly speaking, there have been four global recessions since 1980: in the early 1980s, the early 1990s, in 2001, and in the crisis of 2007-08. Each was marked by a slowdown in GDP growth, a sharp decline in trade growth, and retrenchment in the financial sector. According to the Behavioural Finance and Financial Stability project at Harvard University, an average of four countries a year suffered a banking crisis between 1800 and 2016. From 1945 to 1975, when the global financial system was tightly controlled, most years were entirely free of banking crises. Since 1975, however, an average of 13 countries have found themselves in the throes of one each year. Since the 1970s, the deregulation of national banking systems and the lifting of constraints on the global flow of capital ushered in a new era of financial boom and bust. Re-regulation since 2009 has not fundamentally changed this picture. The current value of outstanding cross-border financial claims, at $30trn (and growing), is below the peak of $35trn reached in 2008, but well above the 1998 level of $9trn.

Booms tend not to die of old age, and there are killers aplenty lurking in the shadows. Globally, policy is slowly but surely becoming less supportive of boom conditions. True, America only recently passed a budget-busting tax reform, which promises to swell its deficit and thus to boost American spending. But in most other rich countries government borrowing is flat to falling. Across much of the emerging world, too, deficits are expected to shrink in coming years. China’s government is trying to rein in the credit-dependency of its economy, with some success.

Central banks are pitiless executioners of long-lived booms, and monetary policy has shifted. America’s Federal Reserve has slowly been raising its benchmark interest rate since late 2015. The Bank of England followed suit in 2017 and is expected to continue to increase interest rates slowly over the next few years. The European Central Bank (ECB) will probably conclude its stimulative bond-buying in December and may begin to raise its benchmark rate in late 2019. Global financial conditions, though still fairly relaxed, have become slightly less so recently. Most central banks have become less concerned about economic weakness and more worried about inflation. If they overdo their reaction, they could slow down the global economy more than intended.

America’s Fed, in particular, is treading a difficult path. Over the past few decades economic and financial cycles in the global economy have become more closely connected. Some economists reckon that the link remains loose. Eugenio Cerutti of the IMF, Stijn Claessens of the Bank for International Settlements (BIS) and Andrew Rose of the University of California, Berkeley reckon that global financial factors explain no more than a quarter of the movement of capital across borders. Others disagree. Hélène Rey, of the London Business School, links the global financial cycle to worldwide swings in appetite for risk, which is in turn governed by the stance of American monetary policy. Òscar Jordà and Alan Taylor, of the University of California, Davis and colleagues have found cross-border wobbling in financial variables such as equity prices is at its most synchronised for more than a century.

Shifts in America’s monetary stance echo around global markets. In response to the financial crisis and the weak recovery that followed, the Fed worked hard to bolster American spending, mainly through quantitative easing (QE), the practice of printing money to buy assets such as government bonds. The effects of this policy were felt in the rest of the world; as Fed purchases depressed the yield on American government bonds, investors sought better returns elsewhere. Money flooded into the emerging world. The dollar-denominated debt of emerging-market firms other than banks roughly quadrupled. Chinese corporations now hold dollar-denominated debt of roughly $450bn, compared with almost none in 2009.

A more hawkish Fed means trouble for such borrowers. Since 2014 the dollar has risen by nearly 25%, on a trade-weighted basis, buoyed by a stronger American economy and rising interest rates. A dearer dollar makes life difficult for those with local-currency assets and dollar debts. As such borrowers tighten their belts, credit contracts. Trouble in emerging markets like Turkey and Argentina increases the appetite for safe-haven currencies. The resulting appreciation adds to the burden on other emerging markets, threatening to set off a cycle of contagion. The emerging world may avoid a cascading financial crisis for now, but its fast-growing economies, accounting for ever more of global growth, face a painful adjustment that will weigh on advanced economies too.

New world disorder

As this special report will explain, the rich world is ill-equipped to manage such stress. Handling a bout of economic weakness used to be simple: the central bank would cut short-term interest rates until conditions improved. But in the aftermath of the global financial crisis rates around the world fell to zero, and the weak recovery that followed kept them pinned there. Even the Fed, which has chalked up the most post-crisis rate increases, will almost certainly enter the next recession with a historically small amount of room to cut rates. In a downturn, central banks are likely to turn almost immediately to other tools used after the 2007-08 crisis, such as qe. But such tools are politically harder to deploy, and their stimulative effects are less certain.

Fiscal stimulus could pick up the slack, but mobilising government budgets to aid the economy will also prove a tall order. Across advanced economies the average government debt load has risen above 100% of GDP, up more than 30 percentage points from 2007. Debt in emerging markets has risen as well, from an average of roughly 35% of GDP to over 50%. Plans for large-scale fiscal stimulus were politically difficult to enact during the financial crisis, and will be harder still the next time around. In Europe, any debate about government borrowing threatens to revive the disastrous political showdowns of the euro-area debt crisis.

In the end politics may prove the greatest stumbling block to managing a new global downturn. A decade ago, when the weak link was a disintegrating financial system, co-operation among governments—from the close co-ordination of central-bank action around the world to the establishment of the G20 as a crisis talking-shop—helped prevent a bigger disaster. The world looks very different now. The American economy, which remains the linchpin of the global economic system, is now presided over by Mr Trump. Britain is close to leaving the European Union, possibly in chaotic fashion. The political climate across some of the rest of the EU has turned ugly. Most advanced economies now have viable populist or nationalist parties, waiting to capitalise on the first sign of renewed economic distress. Many emerging markets have regressed as well. Nationalism and strongman tactics are in the ascendant. Power in China is worryingly concentrated in the hands of one man, Xi Jinping. Thanks to Mr Trump’s trade war, relations between America and China have become openly hostile.

In 2007 financial markets were primed for a massive crisis, but governments were able to draw heavily on their monetary, fiscal and diplomatic resources to prevent that crisis from destroying the global economy. Today the financial dominoes are not set up quite so precariously, but in many ways the broader economic and political environment is far more forbidding. It might not take much to bring on the next recession.

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