An Overly Complacent Federal Reserve
Judging by Janet Yellen’s recent Jackson Hole speech, one could be forgiven for thinking that the global economy poses little real threat to the U.S. economic recovery. Not only did the global economy barely get a mention in that speech, Chair Yellen also seems to believe that there is no need for Federal Reserve contingency planning for a global economic shock. In her judgment, under most conditions the Fed will be able to respond effectively to future challenges to the U.S. economy by utilizing the tools that it presently has at its disposal.
Chair Yellen’s seeming complacency is all the more surprising considering that not only is the world economy presently drowning in debt, largely as a result of the Fed’s own largesse with its printing press, but it is also characterized by an unusual confluence of risks in a number of key economies. That combination heightens the chances that a setback in any of those economies could trigger a global economic and financial crisis. It could do so in much the same way as did the Lehman setback in September 2008.
Among the more immediate global economic risks with which the Fed might have to contend is that which might come from Italy, the Eurozone’s third largest economy and the world’s third largest government bond market. Not only is the Italian economy highly sclerotic and its public finances on an unsustainable path. Italy also has major problems in its banking sector as exemplified by a mountain of non-performing loans, which have risen to 18 percent of the banks’ total loan portfolio.
Further clouding Italy’s economic outlook is the country’s political troubles as exemplified by the declining popularity of Matteo Renzi’s government. This raises the very real possibility that Italy could be plunged into a prolonged period of political uncertainty by a no vote in the country’s forthcoming constitutional referendum, which is most likely to take place in early December.
The Federal Reserve would be making a big mistake to underestimate the potential global fallout from a full blown Italian economic and financial crisis. Unlike Greece, Portugal, and Ireland, Italy is simply too large an economy for Europe to save. As such, Italy could very well pose an existential threat to the Euro’s very existence and could be a source of contagion to the rest of the Europe’s troubled economic recovery. It would also be fanciful to think that problems in the Italian government bond market would not send ripples through the world financial system. This is particularly the case considering that the Italian sovereign bond market now totals more than $ 2.5 trillion and 40 percent of those bonds are owned by foreigners.
Sadly, Europe is far from the only large economy that could pose a threat to the U.S. economic recovery in the year immediately ahead. China, the world’s second largest economy, is presently engaged in the difficult task of reorienting its economy away from an investment and export-led growth model at the same time that it is having to cope with the aftermath of a credit bubble of epic proportions. At a minimum, these challenges could result in very much slower Chinese economic growth than we have had to date. That in turn could very well keep international commodity prices depressed and thereby cloud the economic prospects of major emerging market economies like Brazil, Russia, and South Africa.
Japan, the world’s third largest economy, could be yet another source of major concern for the global economy in the year ahead. At a time that Japan’s gross public debt is already around 240 percent of GDP, the country’s economy is again faltering thereby raising the risk of a relapse into deflation. This would be the last thing that a highly indebted Japanese economy would now need. While it is true that Japan’s public finances have for long been on an unsustainable path, it would seem to be rash for U.S. policymakers to assume that this situation can go on indefinitely.
With so many major global economic challenges in the year ahead and with Fed policy constrained by the zero lower interest rate bound, one has to wonder whether Mrs. Yellen might have missed an opportunity at Jackson Hole to begin the discussion of a Plan B in the event of a global economic crisis. By striking as complacent a tone as she did, one would think that she will have made it more difficult for herself to sell a Plan B to the American public should that turn out to be necessary in the year ahead.
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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