When trying to assess the global economic outlook, it is well to recall that at least four major economic policy blunders have been made over the past few years. Since it would seem highly unlikely that, over the year ahead, the global economy will succeed in dodging the economic consequences of all four of those policy mistakes. It would also seem to be imprudent for global policymakers to exclude the possibility that the consequences of more than one of these errors will be triggered within the next twelve months. That would all too likely have very untoward consequences for the global economic outlook.
In order of importance, the first mistake was the Federal Reserve’s decision in September 2012 to embark on a third and open-ended round of quantitative easing. That unprecedented round of monetary policy easing almost doubled the size of the Federal Reserve’s balance sheet to its present level of around $4.5 trillion. In the process, it fueled a strong boom in global asset prices--like those of international commodities, US high yield bonds, and emerging market debt-- which bore little relation to the underlying fundamentals of those assets.
Little wonder then that, as the Federal Reserve began intimating that it would start the process of normalizing interest rates, we have seen heightened global financial market volatility that now threatens the global economic recovery. It is also little wonder that we are now seeing acute economic stress in a number of major emerging market economies like Brazil, Russia, South Africa and Turkey. Those economies, which were first buoyed by massive capital inflows as a consequence of ultra-easy global liquidity conditions, are now being battered by large capital outflows as global liquidity conditions tighten.
A second major policy mistake, similar to that made by the Federal Reserve and also with systemic consequences for the global economy, was that made by China in response to the Great Economic Recession of 2008-2009. In an attempt to insulate the Chinese economy from the effects of the global economic recession, Chinese policy makers engaged in an unprecedented degree of monetary and fiscal policy stimulus. As a result, Chinese credit to the corporate sector increased by around 90 percent of Chinese GDP making the credit boom preceding the US housing bust of 2006 pale. In turn, that credit boom spawned a series of domestic property bubbles and also contributed to a massive degree of excess manufacturing capacity in China.
Little wonder then that we are now seeing a pronounced slowing in the Chinese economy as its credit bubble has burst. Nor should it be any wonder that we are now seeing capital pouring out of China at the staggering rate of around $100 billion a month. That pace of outflow is now raising speculation about the likelihood of a further destabilizing depreciation of the Chinese currency that could trigger a global currency war.
A third economic policy mistake of epic proportions was that made by a number of major European countries, which adopted the Euro as their common currency in 1999 and then did not play by the rules of a monetary union. Those rules, which require the maintenance of budget discipline and of vigilance against inflation, were generally honored in the breach. Now stuck in a Euro straitjacket, the countries in Southern Europe have had the greatest of difficulties in restoring balance to their public finances and in regaining lost international competiveness.
The net result has been that the European economy has failed to grow over the past eight years and it is yet to regain its 2008 level of production. Equally troubling is the fact that poor economic performance has contributed to a fragmentation of European politics and it has made it difficult for countries in the European periphery to reduce their very high public debt burdens. This makes the European economy especially vulnerable to any renewed global economic downturn.
A fourth major policy mistake was made in 2014 by British Prime Minister David Cameron, who committed his country to an up-down referendum on Britain’s continued membership in the European Union. At a minimum, one must expect considerable pound sterling weakness in the run-up to that referendum, which is now scheduled for June 23. At worst, in the event of vote to leave Europe, we could see not only the disintegration of the United Kingdom as Scotland pressed again for independence. Rather, we could also see a strengthening of those political forces in the rest of Europe, which are opposed to further European integration and which are already all too evident in many Eurozone member countries.
Hopefully, we will be lucky and somehow the global economy will dodge the many bullets that now seem to threaten it. However, experience would suggest that the probability of dodging all of those bullets is low and that policymakers would be well advised to start preparing for the worst.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
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