It is difficult to forecast when the next global economic recession will happen. It is much easier to predict its severity.
This is particularly the case in the light of excessively high global debt levels, asset price bubbles and the generalised mispricing of credit market risk. Those considerations, coupled with the lack of adequate policy instruments to respond to the next global slowdown, point to a much more severe crisis than the average post-war recession.
Among the more disturbing vulnerabilities of the global economy is the large amount of debt spawned by years of ultra-unorthodox monetary policy by the world’s major central banks. According to the International Monetary Fund, the global debt to GDP level is 250% – around 30 percentage points higher than it was on the eve of the 2008 financial crisis.
Handling a high debt level in the midst of a recession will be a major challenge for policy-makers. It may lead to a wave of defaults that could cause financial market distress, which in turn would risk deepening the recession. That challenge would be compounded substantially if that debt proved to be owed by borrowers of dubious creditworthiness.
There are many reasons to fear that years of unorthodox monetary policy and low interest rates have led to a marked deterioration in lending standards. As former US Federal Reserve Chair Janet Yellen cautioned recently, the size of the risky US leveraged loan market has doubled to more than $1.2tn from around $600bn on the eve of the 2008 recession.
At the same time, there has been a large increase in lending to corporations of questionable creditworthiness in emerging markets. Particularly troubling is the fact that more than $3tn of that debt is dollar-denominated, which will be difficult for those companies to repay if the world economy were to weaken and the dollar to strengthen.
An important reason to be more concerned about high debt levels today than we might have been in 2008 is that the mispricing of global debt in the current economic cycle has become much more pervasive. In 2008, that mispricing was largely limited to US mortgage lending. Today it appears to be across the board and around the world. This could lead to considerable financial market dislocation, if there is a serious repricing of risk to more normal levels and the asset price bubbles in the global equity and housing markets burst.
Examples of credit risk mispricing include the US high-yield debt market and the emerging economy corporate debt market. Borrowing rates in both markets have reached levels that do not nearly compensate the lenders for default risk. Mispricing was also evident in the sovereign debt markets of highly indebted countries like Italy, where until recently the government could borrow long-term at interest rates close to those in the US.
The US is less well-equipped now than it was in 2008 to fight the next recession. With interest rates still low and with considerable political resistance to another round of quantitative easing, the Fed has little room for manoeuvre. Similarly, with the US budget deficit already bloated by large tax cuts at a time of cyclical strength, there is little room for another fiscal stimulus package when the next economic downturn occurs.
The 2008 crisis caught global policy-makers flat-footed. A coordinated global policy response was required to get the world economy out of that recession. Hopefully this time policy-makers will be better prepared. When the next recession comes around, one must hope that President Donald Trump’s administration will take a more constructive stance with respect to the need for global economic policy coordination. However, judging by its ‘America first’ policy to date, this seems unlikely to happen.
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