Yesterday’s daily featured four views on a potential global recession and financial crisis by the end of the year 2020. Nouriel Roubini had the view I think easiest to deconstruct because he lays out ten separate trigger points that could weaken the economy and precipitate recession. So I want to go through each of those points briefly, one by one.
1 – Will US fiscal stimulus lessen?
In Roubini’s piece he says the following:
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%.
I have looked at the numbers and don’t see any reason to believe Trump’s stimulus will dissipate by 2020.
For example, the Peterson Institute says that the fiscal stimulus will “will yield an extra boost to GDP of 0.5 percent by 2020” even taking cyclical impacts that lower the stimulative nature of Trump’s policy into account. They are saying there is at least an extra boost of 0.5% by 2020, whereas Roubini says there will be a fiscal drag by 2020. I think Roubini is being too pessimistic here. But he has good company. Former Fed Chair Bernanke is saying the same thing:
The stimulus “is going to hit the economy in a big way this year and next year, and then in 2020 Wile E. Coyote is going to go off the cliff.”
I don’t see it. There is no sunsetting of tax cuts in 2020. Why would the stimulus lessen? The only thing I can think of is a monetary offset – meaning the real risk here is that you see a lot of rate hikes, raising the risk the Fed overshoots and triggers a recession. But that’s on the Fed.
For what it’s worth, the Congressional Budget Office forecasts show stimulus boosting economic growth this year to 3.3%, and slowing to 2.4% in 2019 and 1.8% in 2020.
2 – Was the stimulus poorly timed?
This second point is related to the first because of monetary offset. Here’s how Roubini puts it:
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 normalisation, which will reduce global liquidity and put upward pressure on interest rates.
BINGO! It’s all about the monetary offset. But let’s also not forget what the Peterson Institute analysis showed: fiscal multipliers vary in impact across the cycle. And that means we are getting less bang for the deficit-spending buck now than we would if we saw these kinds of cuts in 2010 or 2011.
And remember, these cuts are to economic agents that have the highest marginal propensity to save. Corporations are spending more buying back shares than they are on capital investment. If the tax cuts had been weighted to the middle class, we would see a bigger impact.
In short, Roubini is right. Not only are the cuts poorly timed, they are poorly designed.
3 – Escalating trade disputes will lower growth
Here’s Roubini on trade:
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.
Today’s daily post was on this so I’m not going into great detail here. At the margin trade disputes will cut growth. It’s not a killer for growth but it will definitely knock global growth down a peg.
4 – Is stagflation really a risk here?
This is Roubini’s hobby horse and it reminds you how economists are stuck in the early 1980s, fearing yesterday’s demons. He writes:
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.
Almost all of this is bunk. And the immigrant restrictions are about nativism and xenophobia, not stagflation. I have no fear of stagflation because the inflation we see is cyclical. It will disappear in the next recession. And the fears will turn to deflation instead of stagflation.
5 – Growth outside the US will slow
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.
I agree with Roubini here. And let’s remember that, as the Fed tightens, emerging markets will take it on the chin. EM is much more important in today’s global economy. And so, that slowdown will boomerang back on developed markets.
6 – Europe will slow too
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 risk-sharing. Under these conditions, another global downturn could prompt Italy and other countries to exit the eurozone altogether.
My last post made exactly these points. The question here is timing and causation. Nouriel says policy tightening, trade frictions, and public debt will precipitate the slowing. I am less sure. I think the ECB wants to tighten. But will they tighten appreciably before a slowing occurs. And the debt scenario is a political issue in Italy that is an unknown. I don’t see it as a primary risk for recession, frankly.
7 – Financial markets are over-extended
Here’s Nouriel’s take:
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.
This seems right to me.
Again, though, notice the preoccupation with public debt and yields. The logic is false. If all of the triggers he enumerates add up, then it will cause investors to seek safe haven shelter in monetarily sovereign public debt. That means lower yields. It’s important to get this call right too because government bonds are a big portion of any investor’s portfolio.
The rest is just fine.
8 – A financial crisis is possible
As Roubini puts it:
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 high-frequency/algorithmic trading will raise the likelihood of “flash crashes.” And fixed-income instruments have become more concentrated in open-ended exchange-traded 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 normalisation underway, the backstop that central banks provided during the post-crisis years can no longer be counted on.
There are too many moving parts in this prediction for me. But, directionally, I agree with the premise that liquidity will evaporate in an economic downturn, creating crisis conditions. Municipal bonds are an arena Nouriel doesn’t mention where I have worries. And I don’t see inflation as a concern.
A financial crisis would make the economic downturn much worse, especially with limited policy tools.
9 – Will Trump start a war?
I think this is a possibility, yes.
For his part, Nouriel says:
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.
Trump’s attacks on the Fed aren’t the issue here. The issue is that we could see a war that raises the cost of oil. We’ve seen multiple recessions in the post-War period that coincided with or were precipitated by steep increases in oil prices. So while this is not my primary concern regarding a recession prediction, if we do see a war, it would be a big problem.
10 – Are policy tool limits self-imposed?
Here’s Roubini’s take:
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.
I have made the case for thinking about policy tool limitations as mostly self-imposed. And in a crisis, those self-imposed limits will be thrown off if the situation gets bad enough. In the case of a military confrontation, for example, don’t expect deficits to be a concern in the US. In the case of Italy threatening to leave the eurozone, don’t expect the ECB to interpret its mandate as strictly.
People have a way of meeting crisis by bending the rules. Just look at the mark-to-market rule in the US and how it was rescinded in 2009. For me, that was a big factor in ending the panic phase of the Great Financial Crisis.
Conclusion: Much to worry about but…
The big factors here are the vulnerability of the global financial system to a crisis due to the high level of private debt, the elevated level of asset prices, the interconnectedness of the financial system and the self-imposed policy constraints. I am much less worried about inflation than Roubini is. And I am also less worried about government debt than he is. Only in the eurozone and emerging markets, where governments borrow in foreign currencies, is government debt a real issue.
But overall, Roubini makes a reasonably good case that we should be worried about a recession and financial crisis. And I think timing-wise, his 2020 call is as good as any. My biggest worry in all of this is the Fed because we are in the most dangerous part of the business cycle, where over-tightening is not just possible but likely.