A hard landing for the global economy

As the world’s major central banks begin to adopt hawkish monetary policy stances, there is some good news and some bad news about the world economic outlook.

The good news is that the world economy does not appear to be suffering from the same vulnerabilities that made the 2008-2009 Great Recession so severe. The bad news is that the world economy now suffers from a different set of troubling vulnerabilities. Those new vulnerabilities make it likely that the forthcoming global economic recession will be more severe than the average post-war economic recession, albeit not as severe as the 2008-2009 recession.

Among the factors that made for the severity of the 2008-2009 global recession was a once-in-a-century U.S. housing and credit market bubble coupled with very poor bank lending standards. Those poor standards included the infamous sub-prime lending and NINJA loans.

Fortunately, lessons were learned from that painful experience. U.S. bank regulation was improved and the banks were forced to better capitalize themselves. This makes a repeat of the global financial market mayhem that followed the September 2008 Lehman bankruptcy very unlikely.

But we now have other vulnerabilities that do not bode well for the world economic outlook. In particular, today the world economy’s main vulnerability is that it finds itself in a situation where U.S. and European inflation are now at multi-decade highs at the same time that bubble-like conditions characterize all too many world equity, housing and credit markets.

This challenging situation of inflation together with a so-called global “everything” asset price and credit market bubble has been the result of the world’s main central banks’ excessive reaction to the COVID-19-induced recession of early 2020. Not only did they keep interest rates too low for too long. They also flooded the markets with liquidity with their unprecedentedly rapid pace of bond buying. That bond buying saw the combined size of the Federal Reserve and the European Central Bank’s balance sheet increase by a staggering $10 trillion over the past two years.

Former Treasury Secretary Larry Summers has correctly noted that there has been no post-war example of the Federal Reserve having successfully reduced inflation by 4 percentage points without precipitating an economic recession. But what has not received due attention is the notion that today’s global “everything” bubble has been premised on the mistaken assumption that interest rates would stay ultra-low forever and that we would avoid a recession.

Should that rosy assumption be mistaken, we could have bursting asset price bubbles amplifying the recession’s depth by precipitating strains in the financial system. To be sure, the world’s banking system is better prepared than it was in 2008 to handle sharp declines in asset and credit market prices. But the same might not be said about the largely unregulated and highly leveraged non-bank part of the financial system, which could lead to the kind of troubles seen in Long Term Capital Market in 1988.

Yet another reason for concern about today’s world economic outlook is China’s challenging economic position. Not only is China’s property and credit-led growth model now showing every sign of having run out of steam. That country’s no-tolerance COVID strategy is leading to a sharp economic slowdown, which will only aggravate its property sector problems. This makes it highly improbable that China will once again be able to play the role of the world’s economic growth locomotive, as it did during the 2008-2009 Great Recession and soften the blow of a synchronized economic recession in the rest of the world.

All of this would suggest that there can be no room for economic complacency about today’s world economic outlook. With the world now on the cusp of a synchronized global economic slowdown that could cause real strains in the world financial system, it also suggests that if ever there has been a need for global economic policy coordination, it is now. Hopefully the Biden administration will rise to the challenge by offering the American leadership necessary for such coordination.

Desmond Lachman is a senior 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.