5 November 2015

A new crisis is coming – and here’s why

By Christopher Dembik

The oracles predicting an impending new global crisis are countless. Over the last two decades, economic cycles have been shortened due to deregulation, the financialisation of the economy, trade globalisation, and the acceleration of innovation cycles. During the last 25 years, the US economy has experienced three recessions: in 1991, 2001 and 2009. The outbreak of a new crisis in the coming years is inevitable. To forecast it amounts to acknowledging that capitalism now moves in cycles shorter than 10 years. There is no glory in that.

Until recently, the consensus assumed a strengthening of the global economy in 2016. Various downward revisions of growth forecasts by major international organisations, however, confirm that this assumption is becoming less and less likely.

Gross domestic product growth momentum, particularly in the US, is still the main driver of global growth. It is also weaker than it used to be during the previous recoveries, as shown by potential GDP growth which has been reduced to 2% for the 2015-2025 period, compared to 3% for 2000-2007.

The weakness of this recovery can be seen in the substantial slowdown of international trade growth. The increase of global imports in volume is significantly lower compared to the years from 1992 to 2008. The adverse effects of the subprime crisis still influence global dynamics.

The prospect of a new crisis brought the Great Divergence theory back to life. However, this circumstance has failed to materialise. In 2008, this model was steadily evoked but didn’t happen because it is based on the illusion that Asia, and particularly China, will prove able to take over from the US.

Still the bridesmaid

Beijing’s economic influence is clearly on the rise: the yuan is the fourth most exchanged currency in the world – ahead of the Japanese yen – and should overtake the British pound in financial transactions before the end of 2016.

The “new Silk Road” strategy, which aims to build an economic bridge between Europe and the South China Sea, is an incredible tool for providing leverage to develop the country and take a leadership role in international business.

Nevertheless, the emerging yuan zone is not able to compete with the large dollar zone’s hegemony. Any deterioration of the American economic outlook will have extended consequences on Asia and the whole emerging world.

The possibility of a Chinese monetary bazooka cannot be overlooked in the first half of 2016. Expectations regarding new stimulus are much likely to increase in the coming months as Western central banks’ monetary policy become less clear every day.

Still, there is no emergency given the stabilisation of the Chinese stock exchange and the macroeconomic evolution of the country, which does not indicate any worrying deterioration even if it is disappointing compared to the years between 1979 and 2012.

The Chinese central bank could lower its rates and it could also act on banks’ required reserve ratio – an oft-favored tool – to revive credit. With its $3.56 trillion in foreign exchange reserves (as of the end of August), China still maintains an unprecedented level of force.

Along with a dovish monetary policy, China could launch a Keynesian stimulus programme, relying on the already-expected bond issue plan which could raise 1 billion yuan. Even though president Xi Jinping proved reluctant to introduce massive economic stimulus package since coming into office in November 2012, preferring case-by-case adjustments, he won’t be able to avoid this option very long if he wants to meet the country’s official macroeconomic targets.

A Chinese monetary bazooka could temporarily reassure world markets but believing it would save the global economy if developed countries sink into crisis would be a bridge too far.

Everybody thought the global economy was on its way to a sustainable growth but more and more leading indicators (Empire Manufacturing in the US, industrial output and business sentiment in Japan, Canadian GDP, copper prices, etc.) raise concerns about a global recession.

Emerging countries are the first in line. Brazil opened the way and Turkey could be next. The increasing risk of recession should put further pressure on central bankers to keep providing liquidity.

The end of policy

The Federal Reserve’s possible announcement of negative rates would be seen as a desperate action with major negative consequences as rates below zero would emphasise financial distortions. Such behavior would confirm that it is impossible to get out of accommodating monetary policies.

This headlong rush will last as long as will central bankers’ credibility. But this credibility has already been damaged, particularly following the Swiss National Bank’s unexpected decision to abandon the Swiss franc’s cap earlier this year, as well as Fed chair Janet Yellen’s hesitation during the press conference held on September 17.

It is just a question of time before markets realise that the limits of monetary policy have been reached.

The crisis that never ended

The weakness seen in world economic activity is partly the result of the lack of a real purge of the financial system in 2008. It has become unimaginable to let entire parts of the system collapse, and the titling of some financial institutions as “systemic” is part of this logic.

Policymakers attempting to keep unhealthy economic and financial institutions alive are making a mistake. The very essence of capitalism lies in the process of creative destruction. If companies prove unable to innovate when confronted to new competitors or if they take disproportionate financial risks, they should bear the consequences.

In 2008, public authorities refused to take responsibility for the social cost of widespread bankruptcies. Despite their role as “lender of last resort”, however, states couldn’t avoid mass unemployment.

In refusing to reform the system they have compromised the prospects of a sustainable return to growth, and this is due to excess debt. Over the last seven years, private and public debt has increased by $57 trillion – a figure near-equivalent of global GDP.

What we see here is not a way out of the crisis. Instead, we are on the edge of a new financial disaster.

Christopher Dembik is an Economist at Saxo Bank France