The Makings of a Global Debt Crisis Are in Place
In 2017, the financial world was filled with talk of synchronized sustainable growth in major economies for the first time since before the 2008 global financial crisis. This was being proclaimed by global financial elites including Christine Lagarde, head of the IMF.
Now that vision is in ashes. Synchronized global growth has turned into a synchronized global slowdown. Growth has already turned negative in two of the world’s largest economies, Japan and Germany, and is slowing rapidly in the world’s biggest economies, China and the U.S.
China may report something like 6.8% GDP growth, but when all the waste in its economy is stripped out the actual growth is probably closer to 4.5%. That’s still growth, but not nearly enough to sustain China’s massive debt overload. Its debt is growing faster than the economy and its debt-to-GDP ratio is even worse than the U.S.
For a sense of perspective, China had about $2 trillion total debt in 2000. Today, it’s about $40 trillion. That’s an unbelievable 2,000% increase in under 20 years.
Growth is also slowing in the U.S. The 2009–2018 recovery has already been the weakest recovery in U.S. history despite a few good quarters here and there. And there’s little reason to expect it to pick up from here.
GDP expanded 3.5% last quarter, which looks good on paper. But the trend is pointing down. Since this April, we’ve seen growth of 4.2% (Q2), and 3.5% (Q3). This trend tends to confirm the view that 2018 growth was a “Trump bump” from the tax cuts that will not be repeated. And Q4 GDP will probably be lower than Q3.
Goldman Sachs, for example, projects fourth-quarter GDP to expand at 2.5%. It further expects growth to drop to 2.2% by the second quarter of 2019, and to 1.6% by the end of the year.
Global slowdowns of the type we’re seeing now are exacerbated by the escalating trade wars and a new Cold War between the U.S. and China. But while global growth may be slowing down, debt creation is not.
I mentioned China. But it goes far beyond China. According to the Institute of International Finance (IIF), total debt held by economies it tracks (both mature and emerging) rose to a record $247 trillion in the first quarter of 2018. That’s up 11% over the same period in 2017.
But the IIF reports it required a record $8 trillion of freshly created debt to create just $1.3 trillion of global GDP. The trend is clear. The massive debts intended to achieve growth are piling on every day. But growth is slowing. Meanwhile, many of the debts taken on since 2009 are still on the books.
This is a crisis waiting to happen. The combination of slow or negative growth and unprecedented debt is a recipe for a new debt crisis, which could easily slide into another global financial crisis.
In some areas of China, home prices are being slashed 30%. And The Wall Street Journal reports that October auto sales fell 12% year over year. The Chinese stock market has also fallen 25% year to date, which places it squarely in a bear market.
There’s no reason to believe these problems will stay confined to China. As we learned in 2008, this shift from positive to negative conditions can happen seemingly overnight and spread rapidly.
But the problem is made worse by the Fed’s monetary tightening policies.
The Fed is trying to “normalize” interest rates. It’s determined to stay on its course of raising rates until the official policy rate reaches 4% in early 2020. And it’s ready to raise rates again on Dec. 19. It continues to see strong growth and expects inflation, based on the lowest unemployment rate in almost 50 years. But these views are highly misleading.
The real reason for Fed rate hikes is to prepare for a new recession. Research shows that it takes about 4% in rate cuts to pull the U.S. out of a recession. How do you cut 4% when rates are only 2.25% (the current level)?
The answer is you can’t. If a recession started today and the Fed cut rates to zero, it wouldn’t be enough to stop the recession.
The Fed is also drawing down its balance sheet with “quantitative tightening” (QT) by ceasing to roll over maturing positions in U.S. Treasuries.
It printed $3.7 trillion of new money from 2008–2014 under the banner of “quantitative easing,” or QE. But, behind the curtain, the Fed is also reducing the base money supply with QT to get their balance sheet down from $4 trillion to $2.5 trillion by the end of 2020.
Evidence suggests the impact of QT is roughly equivalent to another 1% per year of rate hikes. This means that the combination of nominal rate hikes and QT is equal to 2% of rate hikes per year off an extremely low base. In other words, the Fed is tightening more than it realizes and will probably cause a recession or worse by the time it realizes its mistake.
The trouble is that the Fed doesn’t set policy in a vacuum since it’s the most influential central bank in the world. Its tightening has created the need for other central banks to tighten or pause their easing in order to match it.
The global phenomenon is neatly illustrated in the chart below. This chart combines the QE and QT of the BoE, BoJ, Fed and ECB using colors to show the individual contributions of each central bank.
The Fed’s QE1 (2008), QE2 (2010) and QE3 (2012) stand out clearly in the three blue spikes. The BoE also had three waves of smaller magnitude shown as green waves from 2010–2016. The BoJ started late (in 2011) but has never stopped since, as shown in the red wave. Finally, the gray wave is the ECB. They were also late to the party but made it up in volume.
What’s important about this chart is not where we’ve been but where we’re going. The Fed is already in negative territory (the blue wave below the “0” line starting in 2018). The BoE is neutral but is also ready to go negative. The ECB and BoJ are still positive but trending down sharply; the ECB will go negative in 2019, according to current plans.
The black trend line shows the aggregate of all four central banks. It crashed in 2018 (mostly because of the Fed) and will go negative globally in 2019. Before long, the cartoon of Jay Powell shoveling cash into a furnace will have to be updated to include Mark Carney, Mario Draghi and Haruhiko Kuroda.
If another crisis happens, the Fed will cut rates back to zero. But it won’t be enough. Then they’ll have to abandon QT and go back to QE4. Other central banks will follow the Fed’s lead.
The market sees this coming, but the Fed does not. As usual, the Fed will be the last to know. Investors should prepare now for the inevitable crackup.
Having cash and gold are two places to start.
for TheDaily Reckoning