That 2008 economic feeling

In March 2008, when first signs of trouble surfaced in the U.S. subprime mortgage market, then-Federal Reserve Chairman Ben Bernanke assured us that there was nothing much about which to worry. We all know what followed. Subprime mortgage troubles in the U.S. housing market contributed to the September 2008 Lehman Brothers bankruptcy. That in turn unleashed the worst global economic and financial market crisis in the post-war period.

Today, at a time that the coronavirus epidemic is spreading to the four corners of the world and at a time that it has already caused the economic equivalent of a cardiac arrest in China, the world’s second largest economy, Larry Kudlow, President Trump’s chief economic adviser, is blithely telling us that it is far too early for the Trump administration to be panicked into a significant economic stimulus package.

One has to wonder what Kudlow might have learned from the 2008 global economic crisis. In particular one wonders why he does not see how much in the same way as the bankruptcy of Lehman, a relatively small U.S. investment bank, triggered a financial market and economic crisis in the rest of the world, we could have the reverse occurring today. Serious coronavirus-related economic troubles in systemically important countries abroad could soon trigger a financial and economic crisis in the United States.

One reason to be surprised at Kudlow’s seeming lack of concern about the future health of the U.S. economy is that the coronavirus epidemic has now spread to at least 95 countries, including the United States. This is causing major problems in global supply chains as systemically important countries like China, Italy, Japan and South Korea have locked down significant parts of their populations. It is also totally upending the world travel industry and is exerting considerable pressure on the emerging market economies by driving down international commodity prices.

Another reason for surprise at Kudlow’s seeming insouciance about the deteriorating economic outlook is that the panic has already gripped U.S. and global financial markets. One indication of this panic is the fact that U.S. 10-year Treasury bond yields have plummeted to as low as ¾ percent, or to levels never seen before. Another is that U.S. equity prices have experienced their fastest 10 percent correction on record. That rapid destruction of wealth is bound to have a serious adverse impact on U.S. consumer confidence.

A key point that Trump’s economic team seems to be missing is that the coronavirus economic shock to the world economy is occurring precisely at a time when the world has been experiencing asset price bubbles and the gross misallocation and mispricing of credit. Those phenomena have been the product of years of ultra-easy monetary policy.

One indication of asset price bubbles is that at the start of this year, U.S. equity valuations were at lofty levels experienced only three times in the past 100 years. Meanwhile, one indication of gross credit misallocation is the fact that the world’s leveraged loan market has now grown to a size that is approximately double that of the U.S. mortgage subprime market on the eve of the 2008 world economic crisis.

The Trump economic team is choosing to discount the all too likely possibility that the coronavirus epidemic will cause the global equity price bubble to burst and will cause serious strains in the global financial system. It will cause the stock market bubble to burst by making a big dent in the unrealistically rosy corporate earnings outlook that would be needed to justify still currently high market valuations. Meanwhile, coronavirus-related economic trouble could cause a wave of widespread corporate defaults as economies falter. That, in turn, could cause financial system distress as credit risk is repriced.

Hopefully when the Trump economic team publicly tells us how strong the U.S. economy is and how much the coronavirus economic threat is overblown, they are busily preparing a well-thought-out policy response to the U.S. and world economy’s deepening troubles. If not, they are all too likely to get caught as flat footed as were their counterparts on the eve of the 2008-2009 Great Recession.      

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.