The robust economy has hidden the next crisis


Nathan Gardels is the editor-in-chief of Noema Magazine.

In the United States, recovery from the financial crisis a decade ago has continued on as one of the longest economic expansions in American history. Unemployment is at a 50-year low. Fueled by this momentum, while ignoring the intense political disruptions of the past two years, the stock market soared to new heights — until the big plunge this week following an earlier slide in February.

To be sure, the volatile market will still have its ups as well as downs. But there are many likely reasons for the emergent crack in confidence. To start with, the consequences of the escalating trade war between the United States and China, especially for the tech sector, are beginning to appear. Tighter money and higher interest rates are on the horizon. A troubling level of over-indebtedness globally among companies and countries alike will be a challenge to finance as interest rates rise. While President Trump’s tax cuts have been an immediate stimulus to growth, the commensurate budget deficits they are creating are deeply worrisome for the long term.

Despite the historical record of recession inevitably following robust economic growth, the siren song of good times that never end has never failed to seduce too many before it is too late. Identifying the seeds of the next crisis residing in our present good fortune falls to those few sober minds who distrust the exuberant herd.

Raghuram Rajan is among those sober minds. A former chief economist of the IMF who warned of the impending financial crash in 2008-2009, he went on to become the governor of India’s central bank. Now, back in his academic perch at the University of Chicago, he is once again sounding a muted alarm.

Rajan worries about the re-leveraging that has taken place over the last decade, fueled by easy money at low borrowing rates, which are now gradually ratcheting upward as the Federal Reserve aims to quell an overheating economy. Referring to the financial crisis, he reminds us that, “before the last crisis — with rates rising but financial conditions still easy — lenders made mistakes.”

At greatest risk today, Rajan notes, are emerging markets. “Growth in much of the world is slowing,” he writes, “and many emerging markets are not well-positioned to weather slow growth. President Trump’s threats to trade may well have depressed investment sentiment elsewhere, as corporations wait to see how their supply chains will be affected. Moreover, China is a prime destination for many emerging-market exporters, and its economy has been slowing. This was happening even before Trump announced his $200 billion worth of tariffs on Chinese goods.”

Not to be too alarmist, he concedes that “emerging markets, by and large, have better macroeconomic policies than in the past, but not all are well-placed to weather slower growth. Rising oil prices, driven in part by impending sanctions on Iranian oil and collapsing Venezuelan production, are forcing oil-consuming countries to borrow more to finance their deficits. When combined with already-high dollar borrowing, rising U.S. interest rates and weakening domestic currencies, it is no surprise that foreign investors are shying away from such emerging markets, making financing more difficult.”

Despite today’s anti-globalization politics, the world remains so interconnected that contagion will be likely to spread from any crisis in the emerging economies. Interdependence, he further admonishes, is a two-way street. “The Trump administration also needs to recognize that the rest of the world is now more fragile and less able to navigate the stream of disruptive actions launched from Washington.”

Rajan’s wise advice: “Strong U.S. growth is sustainable only if policymakers act as if they believe it is not. Anything else and we are in for a rough ride.”

Tim Lee sees the common practice of “carry trading” as the most likely trigger of the next crisis. “Carry trading,” he explains, “is a financial activity that involves borrowing at low-interest rates to finance higher-yield investments in markets assumed to be relatively stable.”

He goes on: “The reason why carry trades are dangerous is that while they increase financial liquidity when they are growing, they create the basis for their own demise. As the U.S. and Turkish examples show, carry trades periodically crash when leverage becomes excessive and there is a forced unwinding of borrowing, which becomes self-reinforcing.”

The “tipping point” into a crisis will arrive, according to Lee, “when financial asset prices crash, hitting hard the economies that have become overly dependent on increasing financial wealth. That is why we must be alert to the dangers of carry trades, and central banks should implement policies in a way that does not encourage them. Carry trades are a worldwide phenomenon, and their unraveling could trigger the next global crisis.”

There are so many possible triggers of the next financial crisis, Kathryn Judge argues, that the wise course would be to prepare for how to deal with it in advance. “One way is to give the Treasury secretary an emergency guarantee authority,” she proposes. “When the government provides a guarantee, it promises to protect an investor from losing money on a particular investment. Guarantees have a long history of being used to prevent individuals and other investors from withdrawing funds en masse and damaging the financial system in the process. The emergency guarantee authority would allow the Treasury secretary to guarantee virtually any financial claim, giving him the flexibility needed to contain a panic wherever it erupts. The aim is to stabilize financial markets during a crisis while giving regulators the time to figure out root causes.” For Judge, saving the financial system from collapse trumps the risk of moral hazard.

Finally, former Mexican president Ernesto Zedillo offers a different take on the notion that Mexico and Canada conceded to the Trump administration’s bullying tactics in revamping the NAFTA accord. As he sees it: “Mexico and Canada did not cave to the U.S. government’s pretensions and preserved most of the important features of the old deal while the United States backed down.”

Most significantly, he argues, Mexico and Canada rejected a short-term sunset clause that would have deterred long-term investment plans by companies, preserved a robust dispute settlement procedure and rejected a seasonal tariff proposal for fruits and vegetables. The United States did succeed, he concedes, in a higher required level of “rules of origin” for North American production, albeit mitigated by a low 2.5 percent tariff on products that don’t meet that standard.

Zedillo is amused by the irony of the new name for the pact, United States-Mexico-Canada Agreement. Since Mexico’s formal name is the United Mexican States, the Spanish translation of the agreement’s new name is Estados Unidos-México-Canadá Acuerdo, which would appear to leave the United States of America out of the accord’s title.

This was produced by The WorldPost, a partnership of the Berggruen Institute and The Washington Post.