NIFA featured article - Out of Ammo: Why the Next Slowdown may be Difficult to Counter

The biggest risk currently facing the global economy is the lack of sufficient tools – both fiscal and monetary – available to policymakers to counter another downturn, noted Carmen Reinhart, Minos A. Zombanakis Professor of the International Financial System at Harvard Kennedy School, in her keynote address titled "A Short Tour of Global Risks" at the 2019 Nomura Investment Forum Asia in Singapore.

Drawing on her wealth of experience, including as a policy adviser at the IMF and author of a best-selling book that documents the striking similarities between recurring booms and busts, Reinhart, predicted that the next slowdown will be different.

Space constraints

In the previous three downturns, the US Federal Reserve cut interest rates by more than five percentage points to boost activity. This time, however, there is no “space” available to do so, argued Reinhart. “With long rates around 2.5%, the scope for monetary easing is limited in the US, and even more limited in Japan and Europe.”

The leeway to use fiscal policy is also limited in advanced economies where debt levels have spiraled since the 2008 global financial crisis (GFC), according to Reinhart.

“At the end of World War II, the last peak of debt, the public sector was the entire story of debt in advanced economies. At present, that is not the case,” she said, pointing to high levels of corporate and household debt, which was not an issue before.

The prolonged European debt crisis, according to Reinhart, is another constraint on policy, especially in the context of government changes, and a source of market volatility.

Emerging market risks

The lack of room for policy maneuvers and the problem of rising debt are not limited to advanced economies, according to Reinhart. A significant slowing of China’s growth represents the biggest risk to emerging markets in her view.

“I don’t think the People’s Bank of China has a lot of room for monetary easing. You want easing to support the economy, but easing would also be associated with a depreciating currency, which isn’t feasible in the environment of a trade war,” she said.

Emerging markets are also seen being hamstrung by problems such as limited fiscal and monetary toolkits typically faced by advanced economies, Reinhart noted.

“We are in more vulnerable territory than the 2008-09 crisis, when emerging markets were in a good position to withstand a global downturn because they were lean and mean. But, as a class, emerging markets are no longer in lean and mean territory,” warned Reinhart.

Trade war takeaways

The ongoing US-China trade dispute and its potentially disruptive effects on global trade and growth have received much attention of late. But, as Reinhart pointed out, the erosion of globalization predates the trade war with trade growth having slowed markedly in the years since the GFC to an average of 2.4%, from 5.9% pre-crisis.

Reinhart made two key observations on the risk posed by trade wars. “Number one is the amply discussed drag on growth. But number two is it also has the potential to be associated with an adverse inflation shock, which is a lot like a supply shock. The last time advanced economies had real supply shocks was in the 1970s, with the oil price shocks,” she noted, echoing a point made by Nomura’s Chief US Economist Lewis Alexander in an earlier panel.

Expecting the unexpected

The decade since the global financial crisis has been marked by stimulus-fueled optimism, which has led to lax financial conditions, low market volatility benchmarks and a deterioration in the quality of borrowers, creating a high-yield corporate debt bubble, Reinhart warned.

Yet another similarity to the pre-GFC world, she said, was the huge overseas demand for collateralized loan obligation (CLO) instruments. “This is a reminder of the risks in the pre-crisis era,” Reinhart said.

While careful to avoid sparking alarm by painting a doom-and-gloom scenario, Reinhart was nonetheless willing to answer the biggest question on the minds of those present: What are the potential triggers of the next large-scale crisis?

A turning point may be around the corner in the form of a slowdown in the American economy, she predicted, possibly triggered by a surprise move in inflation or corporate defaults in the US or China with the potential to sharply readjust growth expectations.

“It's precisely the things that we are not expecting that could trigger a crisis,” she observed. “Corporates are not in great shape in either of the world's biggest economies.”

Watch the video below to learn Reinhart's views on the Chinese property market.


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