Over the course of this year and next, the biggest economic risks will emerge in those areas where investors think recent patterns are unlikely to change. They will include a growth recession in China, a rise in global long-term real interest rates, and a crescendo of populist economic policies.
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The Twilight of the Global Order
The Twilight of the Global Order
The recent G7 summit in Biarritz signaled a broader shift in international governance away from constructive cooperation and toward vague discussions and ad hoc solutions. The conclusion of the summit could be a marker of the world order’s future – ending not with a bang, but with a whimper.
MADRID – We live in an era of hyperbole, in which gripping accounts of monumental triumphs and devastating disasters take precedence over realistic discussions of incremental progress and gradual erosion. But in international relations, as in anything, crises and breakthroughs are only part of the story; if we fail also to notice less sensational trends, we may well find ourselves in serious trouble – potentially after it is too late to escape.
The recent G7 Summit in Biarritz, France, is a case in point. Despite some positive developments – French President Emmanuel Macron, for example, was praised for keeping his American counterpart, Donald Trump, in check – little was achieved. And, beyond the question of substantive results, the summit’s structure portends a progressive erosion of international cooperation – a slow, steady chipping away at the global order.
It is somewhat ironic that the G7 presages the future, because it is in many ways a relic of the past. Formed in the 1970s, at the height of the Cold War, it was supposed to serve as a forum for the major developed economies: Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.
After the fall of the Soviet Union, the G7 continued to shape global governance on issues ranging from debt relief to peace operations and global health. In 1997, the G7 became the G8, with the addition of Russia. Still, the body epitomized an era of Western preeminence in an institutionalized liberal world order in full bloom.
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The Anatomy of the Coming Recession
The Anatomy of the Coming Recession
Unlike the 2008 global financial crisis, which was mostly a large negative aggregate demand shock, the next recession is likely to be caused by permanent negative supply shocks from the Sino-American trade and technology war. And trying to undo the damage through never-ending monetary and fiscal stimulus will not be an option.
NEW YORK – There are three negative supply shocks that could trigger a global recession by 2020. All of them reflect political factors affecting international relations, two involve China, and the United States is at the center of each. Moreover, none of them is amenable to the traditional tools of countercyclical macroeconomic policy.
The first potential shock stems from the Sino-American trade and currency war, which escalated earlier this month when US President Donald Trump’s administration threatened additional tariffs on Chinese exports, and formally labeled China a currency manipulator. The second concerns the slow-brewing cold war between the US and China over technology. In a rivalry that has all the hallmarks of a “Thucydides Trap,” China and America are vying for dominance over the industries of the future: artificial intelligence (AI), robotics, 5G, and so forth. The US has placed the Chinese telecom giant Huawei on an “entity list” reserved for foreign companies deemed to pose a national-security threat. And although Huawei has received temporary exemptions allowing it to continue using US components, the Trump administration this week announced that it was adding an additional 46 Huawei affiliates to the list.
The third major risk concerns oil supplies. Although oil prices have fallen in recent weeks, and a recession triggered by a trade, currency, and tech war would depress energy demand and drive prices lower, America’s confrontation with Iran could have the opposite effect. Should that conflict escalate into a military conflict, global oil prices could spike and bring on a recession, as happened during previous Middle East conflagrations in 1973, 1979, and 1990.
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Are Central Banks Losing Their Big Bet?
Are Central Banks Losing Their Big Bet?
Following the 2008 global financial crisis, central banks bet that greater activism on the part of other policymakers would be their salvation, helping them to normalize their operations. But that activism never came, and central bankers are now facing a lose-lose proposition.
ZURICH – In recent years, central banks have made a large policy wager. They bet that the protracted use of unconventional and experimental measures would provide an effective bridge to more comprehensive measures that would generate high inclusive growth and minimize the risk of financial instability. But central banks have repeatedly had to double down, in the process becoming increasingly aware of the growing risks to their credibility, effectiveness, and political autonomy. Ironically, central bankers may now get a response from other policymaking entities, which, instead of helping to normalize their operations, would make their task a lot tougher.
Let’s start with the US Federal Reserve, the world’s most powerful central bank, whose actions strongly influence other central banks. Having succeeded after 2008 in stabilizing a dysfunctional financial system that had threatened to tip the world into a multiyear depression, the Fed was hoping to begin normalizing its policy stance as early as the summer of 2010. But an increasingly polarized Congress, exemplified by the rise of the Tea Party, precluded the necessary handoff to fiscal policy and structural reforms.
Instead, the Fed pivoted to using experimental measures to buy time for the US economy until the political environment became more constructive for pro-growth policies. Interest rates were floored at zero, and the Fed expanded its non-commercial involvement in financial markets, buying a record amount of bonds through its quantitative-easing (QE) programs.
This policy pivot was, in the eyes of most central bankers, born of necessity, not choice. And it was far from perfect.
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The US Economy’s Dirty Secret
The US Economy’s Dirty Secret
Relatively strong US growth amid sluggishness elsewhere is not what economics textbooks would predict. But persistently low interest rates and weak inflation bring multiple benefits to American firms and consumers, while the adverse impact of the global slowdown on US exports should not be overstated.
SAN DIEGO – There is a dirty little secret in economics today: the United States has benefited – and continues to benefit – from the global slump. The US economy is humming along, even while protesters in the United Kingdom hurl milkshakes at Brexiteers, French President Emmanuel Macron confronts nihilist yellow-vested marchers, and Chinese tech firms such as Huawei fear being frozen out of foreign markets.
Last year, the US economy grew by 2.9%, while the eurozone expanded by just 1.8%, giving President Donald Trump even more confidence in his confrontational style. But relatively strong US growth amid sluggishness elsewhere is not what economics textbooks would predict. Whatever happened to the tightly integrated world economy that the International Monetary Fund and the World Bank have been advocating – and more recently extolling – since World War II?
The US economy is in a temporary but potent phase in which weakness abroad lifts spirits at home. But this economic euphoria has nothing to do with Trump-era spite and malice, and much to do with interest rates.
Borrowing costs are currently lower than at any time since the founding of the US Federal Reserve in 1913, or in the UK’s case since the Bank of England was established in 1694. The ten-year US Treasury bond is yielding about 2.123%, and in April, the streaming service Netflix issued junk bonds at a rate of just 5.4%.
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Time for a True Global Currency
Time for a True Global Currency
The International Monetary Fund’s global reserve asset, the Special Drawing Right, is one of the most underused instruments of multilateral cooperation. Turning it into a true global currency would yield several benefits for the global economy and the international monetary system.
NEW YORK – This year, the world commemorates the anniversaries of two key events in the development of the global monetary system. The first is the creation of the International Monetary Fund at the Bretton Woods conference 75 years ago. The second is the advent, 50 years ago, of the Special Drawing Right (SDR), the IMF’s global reserve asset.
When it introduced the SDR, the Fund hoped to make it “the principal reserve asset in the international monetary system.” This remains an unfulfilled ambition; indeed, the SDR is one of the most underused instruments of international cooperation. Nonetheless, better late than never: turning the SDR into a true global currency would yield several benefits for the world’s economy and monetary system.
The idea of a global currency is not new. Prior to the Bretton Woods negotiations, John Maynard Keynes suggested the “bancor” as the unit of account of his proposed International Clearing Union. In the 1960s, under the leadership of the Belgian-American economist Robert Triffin, other proposals emerged to address the growing problems created by the dual dollar-gold system that had been established at Bretton Woods. The system finally collapsed in 1971. As a result of those discussions, the IMF approved the SDR in 1967, and included it in its Articles of Agreement two years later.
Although the IMF’s issuance of SDRs resembles the creation of national money by central banks, the SDR fulfills only some of the functions of money. True, SDRs are a reserve asset, and thus a store of value. They are also the IMF’s unit of account.
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The Sorry State of the World Economy
The Sorry State of the World Economy
Data released in January paint a bleak picture of advanced-economy prospects. Even if some emerging economies – which face serious challenges of their own – manage to pick up some of the slack, the world economy will remain encumbered by the combination of economic interconnectedness and political balkanization.
NEW YORK – January is traditionally a time for assessing the developments of the previous year, in order to anticipate what the new one has in store. Unfortunately, even though we may be at a turning point for the better politically, the data that have emerged in the last month do not paint a promising picture of the global economy’s short-term prospects.
The tone was set early in the month by the World Bank’s Global Economic Prospects, along with the accompanying articles. The report paints a picture as bleak as its subtitle – “Darkening Skies” – and cuts the growth forecast for the advanced economies in 2020 to 1.6% (down from 2.2% in 2018).
Moreover, last week, the European Central Bank sounded the alarm over the eurozone economy. Between the prospect of a disorderly Brexit and rising protectionism, exemplified by the trade war between the United States and China, Europe is subject to increasing uncertainty.
Making matters worse, Germany is facing a growth slowdown. According to its own official data, the economy contracted by 0.2% in the third quarter of 2018, while the Purchasing Managers Index for manufacturing sank to 49.9 – a four-year low. Given Germany’s role as the backbone of the eurozone economy, its economic struggles are likely to cascade beyond its borders.
This is particularly problematic, because, after more than a decade of fighting crisis and recession, the advanced economies have depleted their ammunition for countering a slowdown. With the ECB’s benchmark interest rate at zero, there is little room for a cut.
Two Cheers for Population Decline
Two Cheers for Population Decline
Eventual gradual population decline, provided it results from free choice, should be welcomed. Indeed, the greatest demographic challenge to human welfare is not low fertility and population aging, but rather the high fertility rates and rapid population growth still seen in Pakistan, much of the Middle East, and Africa.
LONDON – Since China abolished its one-child policy on January 1, 2016, annual births, after a temporary increase to 17.86 million that year, have actually fallen, from 16.55 million in 2015 to 15.23 million in 2018. The baby boom that wasn’t should surprise no one.
No other successful East Asian economy has ever imposed a one-child policy, but all have fertility rates far below replacement level. Japan’s fertility rate is 1.48 children per woman, South Korea’s is 1.32 and Taiwan’s 1.22. China’s fertility rate will almost certainly remain well below replacement level, even if all restrictions on family size are now removed.
Population decline will inevitably follow. According to the United Nations’ medium projection, East Asia’s total population will fall from 1.64 billion today to 1.2 billion in 2100. Nor is this simply an East Asian phenomenon. Iran’s fertility rate (1.62) is now well below replacement level, and Vietnam’s 1.95 slightly so. Across most of the Americas, from Canada (1.56) to Chile (1.76), rates are already well below two, or falling fast toward it.
The clear pattern is that successful economies have lower fertility rates: Chile’s rate is much lower than Argentina’s (2.27), and wealthier Indian states, such as Maharashtra and Karnataka, already have fertility rates around 1.8. In the poorer states of Uttar Pradesh and Bihar, fertility rates over three are still observed.
We should always be cautious about inferring universal rules of human behavior, but, as Darrel Bricker and John Ibbitson suggest in their recent book Empty Planet: The Shock of Global Population Decline, it seems we can identify one.
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Risks to the Global Economy in 2019
Risks to the Global Economy in 2019
An Optimist’s Guide to Climate Change
An Optimist’s Guide to Climate Change
Grim environmental news is nothing new, but 2018 brought a deluge of it, and some now argue that the world has reached the point of no return for climate change. But new research shows that it is not too late to change course.
WASHINGTON, DC – During a recent commute to work, as my car inched along in rush-hour traffic, I watched a heron stalk the banks of the Potomac River. The majestic bird was a timely reminder that nature and beauty can be found in the unlikeliest of circumstances. And yet, even for optimists like me, it is getting harder to be hopeful about the fate of our planet.
Grim environmental news is nothing new, but 2018 brought a deluge of it. One report noted that vertebrate populations have declined by 60% in the last four decades, and less than a quarterof the Earth’s land has escaped the effects of human activity. By 2050, less than 10% of the planet’s land area will be untouched by anthropogenic change.
Perhaps most sobering was a study from the United Nations Intergovernmental Panel on Climate Change (IPCC), which warned that the world is not on track to meet emissions targets needed to keep global warming to 1.5° Celsius above pre-industrial levels, the threshold set by the 2015 Paris climate agreement. The consequences of this failure grow more extreme with every fraction of a degree by which the mark is missed.
Amid these negative trends, some now argue that the world has reached the point of no return for climate change. But, as new findings from The Nature Conservancy indicate, it is not too late to change course.
Last year, we collaborated with the University of Minnesota and 11 other leading academic and research institutions to assess how the world’s future food, water, and energy needs might affect environmental health.
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Central Bankers’ Fiscal Constraints
Central Bankers’ Fiscal Constraints
With policy interest rates near zero in most advanced economies (and just above 2% even in the fast-growing US), there is little room for monetary policy to maneuver in a recession without considerable creativity. But those who think fiscal policy alone will save the day are stupefyingly naive.
CAMBRIDGE – If you ask most central bankers around the world what their plan is for dealing with the next normal-size recession, you would be surprised how many (at least in advanced economies) say “fiscal policy.” Given the high odds of a recession over the next two years – around 40% in the United States, for example – monetary policymakers who think fiscal policy alone will save the day are setting themselves up for a rude awakening.
Yes, it is true that with policy interest rates near zero in most advanced economies (and just above 2% even in the fast-growing US), there is little room for monetary policy to maneuver in a recession without considerable creativity. The best idea is to create an environment in which negative interest-rate policiescan be used more fully and effectively. This will eventually happen, but in the meantime, today’s overdependence on countercyclical fiscal policy is dangerously naïve.
There are vast institutional differences between technocratic central banks and the politically volatile legislatures that control spending and tax policy. Let’s bear in mind that a typical advanced-economy recession lasts only a year or so, whereas fiscal policy, even in the best of circumstances, invariably takes at least a few months just to be enacted.
In some small economies – for example, Denmark (with 5.8 million people) – there is a broad social consensus to raise fiscal spending as a share of GDP. Some of this spending could easily be brought forward in a recession.
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Climate Change Action Cannot Ignore Social Issues
Climate Change Action Cannot Ignore Social Issues
Despite a series of troubling new reports and studies, the world has yet to respond adequately to the threat posed by global warming. One reason is that policymakers have not made the connection between climate action and the social and political challenges their countries face.
PRINCETON/VIENNA – Climate scientists are sounding the alarm about global warming, but the world is not responding. In October, the United Nations Intergovernmental Panel on Climate Change warned of catastrophic risks to health, livelihoods, water supplies, and human security if global warming is not limited to 1.5° Celsius relative to the pre-industrial level, a target set by the 2015 Paris climate agreement. At the moment, however, we are on track for a 3°C increase.
Then, in November, the Fourth National Climate Assessment in the United States predicted that without swift action to reduce greenhouse-gas emissions, the US economy would suffer “substantial damages.” But President Donald Trump’s administration appears utterly unconcerned.
How is it possible that the slow-motion threat of climate devastation has not yet been halted?
Insights from the social sciences can help answer this question. In a recent report and companion book, the International Panel on Social Progress (IPSP), where we serve as committee members, analyzed social justice and equality across a number of sectors. One conclusion stands out: the only way to tackle the threat posed by climate change is by simultaneously addressing social and political challenges.
When ignored, social issues can trigger political turmoil, which can undermine the political will to fight climate change. For example, despite the implementation deal that was reached on December 15 in Poland, the Paris agreement remains in jeopardy, owing to political upheaval in many countries. In the US and Brazil, voters angry over socioeconomic issues elected leaders who are hostile to climate action.
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Europe’s Year of Living Defensively
Europe’s Year of Living Defensively
With the future of the EU-UK relationship shrouded in uncertainty and crises brewing in France, Italy, and elsewhere, 2019 will be another difficult year for Europe. And if populist forces prevail in the European Parliament election in May, it could be an impossible one.
BERLIN – From a European perspective, 2019 promises to be another difficult year, dominated by large challenges that could easily turn into menacing crises. Barring a major reversal, the United Kingdom will withdraw from the European Union on March 29. A brewing economic and financial crisis in Italy will intensify, threatening the stability of the eurozone. And France will likely remain beset by populist protests, diminishing its potential to take a lead role in the pursuit of EU-level reforms.
Moreover, the European Parliament election in May could well deliver a nationalist majority or near-majority, which would then determine the next members of the European Commission, the leaders of the European Council and European Central Bank, and the High Representative for Foreign Affairs and Security Policy. Needless to say, a nationalist victory would be a disaster for the EU, because it would derail necessary reforms and further divide member states.
Whatever happens, Europe’s internal political drama will play out against a backdrop of international turmoil. At the same time that Russia is stepping up its aggression in eastern Ukraine, US President Donald Trump is waging a trade war against China, and could expand it to the EU (which he has deemed a “foe”). And, more broadly, the global economy is weakening, and growth will continue to slow in the months ahead.
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The Biggest Emerging Market Debt Problem Is in America
The Biggest Emerging Market Debt Problem Is in America
A decade after the subprime bubble burst, a new one seems to be taking its place in the market for corporate collateralized loan obligations. A world economy geared toward increasing the supply of financial assets has hooked market participants and policymakers alike into a global game of Whac-A-Mole.
CAMBRIDGE – A recurrent topic in the financial press for much of 2018 has been the rising risks in the emerging market (EM) asset class. Emerging economies are, of course, a very diverse group. But the yields on their sovereign bonds have climbed markedly, as capital inflows to these markets have dwindled amid a general perception of deteriorating conditions.
Historically, there has been a tight positive relationship between high-yield US corporate debt instruments and high-yield EM sovereigns. In effect, high-yield US corporate debt is the emerging market that exists within the US economy (let’s call it USEM debt). In the course of this year, however, their paths have diverged (see Figure 1). Notably, US corporate yields have failed to rise in tandem with their EM counterparts.
What’s driving this divergence? Are financial markets overestimating the risks in EM fixed income (EM yields are “too high”)? Or are they underestimating risks in lower-grade US corporates (USEM yields are too low)?
Taking together the current trends and cycles in global factors (US interest rates, the US dollar’s strength, and world commodity prices) plus a variety of adverse country-specific economic and political developments that have recently plagued some of the larger EMs, I am inclined to the second interpretation.
In what is still a low-interest-rate environment globally, the perpetual search for yield has found a comparatively new and attractive source in the guise of collateralized loan obligations (CLOs) within the USEM world.
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From Economic Crisis to World War III
From Economic Crisis to World War III
The response to the 2008 economic crisis has relied far too much on monetary stimulus, in the form of quantitative easing and near-zero (or even negative) interest rates, and included far too little structural reform. This means that the next crisis could come soon – and pave the way for a large-scale military conflict.
BEIJING – The next economic crisis is closer than you think. But what you should really worry about is what comes after: in the current social, political, and technological landscape, a prolonged economic crisis, combined with rising income inequality, could well escalate into a major global military conflict
The 2008-09 global financial crisis almost bankrupted governments and caused systemic collapse. Policymakers managed to pull the global economy back from the brink, using massive monetary stimulus, including quantitative easing and near-zero (or even negative) interest rates.
But monetary stimulus is like an adrenaline shot to jump-start an arrested heart; it can revive the patient, but it does nothing to cure the disease. Treating a sick economy requires structural reforms, which can cover everything from financial and labor markets to tax systems, fertility patterns, and education policies.1
Policymakers have utterly failed to pursue such reforms, despite promising to do so. Instead, they have remained preoccupied with politics. From Italy to Germany, forming and sustaining governments now seems to take more time than actual governing. And Greece, for example, has relied on money from international creditors to keep its head (barely) above water, rather than genuinely reforming its pension system or improving its business environment.
The lack of structural reform has meant that the unprecedented excess liquidity that central banks injected into their economies was not allocated to its most efficient uses. Instead, it raised global asset prices to levels even higher than those prevailing before 2008.
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The Makings of a 2020 Recession and Financial Crisis
The Makings of a 2020 Recession and Financial Crisis
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.
NEW YORK – 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.
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CAMBRIDGE – As Mark Twain never said, “It ain’t what you don’t know that gets you into trouble. It’s what you think you know for sure that just ain’t so.” Over the course of this year and next, the biggest economic risks will emerge in those areas where investors think recent patterns are unlikely to change. They will include a growth recession in China, a rise in global long-term real interest rates, and a crescendo of populist economic policies that undermine the credibility of central bank independence, resulting in higher interest rates on “safe” advanced-country government bonds.1
A significant Chinese slowdown may already be unfolding. US President Donald Trump’s trade war has shaken confidence, but this is only a downward shove to an economy that was already slowing as it makes the transition from export- and investment-led growth to more sustainable domestic consumption-led growth. How much the Chinese economy will slow is an open question; but, given the inherent contradiction between an ever-more centralized Party-led political system and the need for a more decentralized consumer-led economic system, long-term growth could fall quite dramatically.1
Unfortunately, the option of avoiding the transition to consumer-led growth and continuing to promote exports and real-estate investment is not very attractive, either. China is already a dominant global exporter, and there is neither market space nor political tolerance to allow it to maintain its previous pace of export expansion. Bolstering growth through investment, particularly in residential real estate (which accounts for the lion’s share of Chinese construction output) – is also ever more challenging.1
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