Since we are in totally uncharted waters, no one can know exactly how the world’s bold experiment with highly unorthodox monetary policy will end. However, judging by past experience with credit booms, there are already all too many indications that this experiment will end in tears. Indeed, it would seem that a confluence of factors spawned by years of global monetary policy largesse could very well have set the stage for a world economic and financial crisis on the scale of that which occurred in the wake of the September 2008 Lehman bankruptcy.
As an indication of how aggressively unorthodox global monetary policy has been in recent years, it is well to start with the Federal Reserve’s balance sheet. While it took the Fed some 100 years to increase the size of its balance sheet to $800 billion, it took the Fed only six years from 2008 to 2014 to more than quintuple its balance sheet to its present level of around $4.5 trillion. Meanwhile, over the past eight years, as a result of similar action by the Bank of Japan, the People’s Bank of China, the European Central Bank, and the Bank of England, the total balance sheet of the world’s major central banks has increased from around $6 trillion to almost $18 trillion.
Among the more reliable indicators of future economic turbulence is an excessive buildup of debt. For this reason, it has to be of concern that years of ultra- easy monetary policy have taken global debt levels to new peaks. According to a recent IMF study, the world debt level today stands at 225 percent of world GDP. This is a significantly higher ratio than that which prevailed in 2008 on the eve of the Great Economic Recession.
Particularly troubling has to be the recent extraordinarily rapid buildup in Chinese corporate debt and the excessive corporate dollar borrowing in the major emerging market economies. Over the past eight years, Chinese corporate debt increased by a staggering 90 percent of GDP. This constitutes a more rapid buildup in debt than that which preceded either the U.S. housing bust in 2007 or Japan’s lost decade in the 1990s. Meanwhile, as the Bank for International Settlements does not tire of warning us, the major emerging market corporations have run up more than $ 3.5 trillion in U.S. dollar denominated debt. This makes those economies particularly vulnerable to any further U.S. dollar appreciation.
Another reliable indicator of future global financial market stress is gross mispricing in those markets. It can hardly be of comfort that as much as $12 trillion of the world’s sovereign bonds are trading at negative interest rates at a time that the world’s central banks are generally aiming at a 2 percent inflation target. Those negative interest rates would imply that large real losses would be realized on those bonds if held to maturity. Nor can it be of comfort that a country as troubled as Italy, which has the world’s third largest sovereign bond market, can borrow at lower rates than can the U.S. government or that a country with as troubled a public finances as Saudi Arabia has little trouble in placing a $ 17.5 billion bond at very favorable interest rates.
Yet another leading indicator of global financial crises is weaknesses at major systemic banks. Sadly, there would seem to be no shortage of troubled banks, especially in Europe, whose problems have been exacerbated by years of low interest rates and poor economic growth. As if to underline this point, recently the Bank of England requested its banks to provide it with information on their exposure to Deutsche Bank and to the major Italian banks.
It is always difficult to predict when a global credit bubble will burst and what might trigger such a bust. However, it would seem that two potential triggers for such a bursting might already be on the horizon. The first is the likelihood that the Federal Reserve will again start raising interest rates after the election. Such a move has the potential to cause both a major rethink in the global bond market as well as a further appreciation of the U.S. dollar. This would be the last thing that either the emerging market economies or the United Kingdom with its fast sinking currency now needs.
The second potential trigger could be the Italian referendum to be held on December 4. If Prime Minister Matteo Renzi loses that referendum, Italy could be in for a prolonged period of economic instability. This could prove to be highly unsettling for the $2.5 trillion Italian government bond market, especially considering how troubled are Italy’s banks, how high is its public debt to GDP ratio, and how sclerotic is its economy.
Let us hope that whoever wins the U.S. election will be paying close attention to global economic developments. In the coming year, those developments have real potential to cloud the U.S. economic outlook.
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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