Something strange is going on in the markets and in economic policymaking circles. Despite the world having just suffered from its worst economic recession in the past ninety years, the overwhelming consensus view is that the U.S. will experience a strong economic recovery in the second half of this year and the economy will soon return back to normal.
Such a strong recovery would be in marked contrast to that following the 2008-2009 Great Economic Recession, which was the slowest economic recovery on record and which was punctuated by a number of fits and starts. Those fits and starts included the 2010 European sovereign debt crisis and the 2013 taper tantrum in the emerging market economies.
Those pointing to an early return to U.S. economic normality are counting on a majority of the U.S. population being vaccinated by mid-year and on the absence of virus mutations that might be vaccine-resistant. They are also counting on the maintenance of the extraordinary amount of fiscal and monetary policy stimulus that the U.S. economy is now receiving.
One major item that the consensus view is choosing to overlook is the great damage that the pandemic has inflicted on the emerging market economies, which now account for around half of the global economy. According to the IMF, the pandemic caused those economies to contract in 2020 by almost 6 percent, which was by far their worst post-war economic performance. That economic slump in turn has caused those economies’ budget deficits to balloon and their public debt to skyrocket to record high levels.
Blinded by the current state of abundant global liquidity, markets are choosing to ignore the warnings of Carmen Reinhart, the World Bank’s Chief Economist, and a renowned debt expert. She is suggesting that it is only a matter of time before we have a major emerging market debt crisis that could once again roil the world financial system.
Another item to which the upbeat consensus view is choosing to turn a blind eye is the dire economic and political straits of Italy, which has an economy some ten times the size of that of Greece. In the pandemic’s wake, the Italian economy slumped by 10 percent, which has resulted in a ballooning of its budget deficit and a skyrocketing in its public debt to GDP ratio to its highest level in the country’s 150-year history.
Stuck within a Euro straitjacket, which precludes currency depreciation to offset the adverse economic effect of budget austerity, it is difficult to see how Italy can avoid an eventual restructuring of its debt once the European Central Bank tires of buying unlimited amounts of the Italian government’s debt to keep the country afloat.
Closer to home, markets and policymakers seem to be overly relaxed about the global equity and credit market bubbles that have been spawned by many years of ultra-easy monetary policy. It does not seem to bother them that by most measures, U.S. equity valuations today are at very lofty levels last seen on the eve of the 1929 stock market crash. Nor does it seem to bother them that a record US$ 18 trillion of global bonds bear negative interest rates or that risky borrowers can borrow money freely at interest rates very little different from those at which the US government borrows.
It does not seem to have occurred to the optimists that the overly expansionary budget policies now being pursued in the United States are bound to cause interest rates to rise and global liquidity to dry up. This would be particularly the case if we do get the strong economic recovery that they are expecting. Past experience would suggest that when interest rates start to rise and liquidity dries up, the global equity and credit market bubbles will burst with all of their nasty ramifications for the U.S. and global economies.
It is often said that policymakers should hope for the best and plan for the worst. It would seem that this advice could not be more appropriate today with a global economy that is characterized by so many major vulnerabilities and that is so much need of global economic policy cooperation.
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.
