A strange sense of complacency continues to characterize the thinking of both U.S. policymakers and mainstream U.S. economists about the potential risks to the U.S. economic outlook from the deepening emerging market economic crisis.
This is the case despite the fact that an ever-growing number of emerging market currencies are now swooning. It is also the case despite past bitter experience with emerging market crises, like the 1994 Mexican peso crisis or the 1998 Asian currency crisis. Those crises did have a material adverse impact on both the U.S. and the global economies.
{mosads}Seemingly, this complacency about the emerging markets is based on a number of basic misconceptions. Among the more important of these is that the U.S. economy is a large and relatively closed economy on which the emerging markets can have only a limited impact.
Never mind the fact that emerging market economies account for more than half of the global economy and that over the past decade they have been the main engine of world economic growth. If those economies cause the global economy to stumble, they almost certainly will cause the U.S. economy to stumble.
Another widely held misconception is that the U.S. financial system is not particularly exposed to the emerging market economies. Never mind the fact that according to the Institute of International Finance, the emerging market economies outstanding debt now amounts to a staggering $58 trillion — roughly 175 percent of their GDP.
Also, never mind that while the U.S. financial system’s direct exposure to the emerging market economies might be less than that of the rest of the world’s financial system, the U.S. does have very large indirect exposure to those economies. It does so by being so closely interlinked in the global financial system.
Surprisingly, all too many U.S. economists cling to the illusion that the problems characterizing individual emerging market economies are largely idiosyncratic and that those problems can be easily contained.
They do so despite the fact that currency problems that began in Argentina and Turkey have now spread to include Brazil, India, Indonesia, Russia and South Africa. They also do so despite the fact that $50 billion in financial support from the International Monetary Fund for Argentina has not managed to stabilize that country’s currency.
A principal mistake that many economists along with the Federal Reserve make is that they do not see the current emerging market currency problems as a part of the Fed’s interest rate cycle.
In particular, they fail to see that years of massive Fed balance sheet expansion and zero interest rates created the easiest of borrowing conditions for the emerging markets.
By so doing, they removed economic policy discipline from those economies and allowed large economic imbalances in those economies to develop especially in their public finances.
Now, as the Fed moves to raise U.S. interest rates and as the U.S. dollar strengthens, the money that flowed so easily to the emerging markets in the past is returning to the United States where safe assets now offer more attractive returns.
Sadly, for the emerging market economies, this capital flow reversal is revealing acute economic vulnerabilities built up in those economies during the years of easy money.
Another mistake that mainstream economists seem to be making is that they are taking excessive comfort from the fact that, unlike 10 years ago, today, most emerging market economies have floating rather than fixed exchange rates.
It is argued that this provides those economies with an exchange rate shock absorber if they are hit by some external shock.
One problem with the shock absorber argument is that it overlooks that almost $4 trillion in emerging market debt is dollar denominated. This means that as the emerging market economy’s currency swoons, the burden of that debt increases.
A more serious problem yet with the shock absorber argument is that it overlooks the fact that swooning currencies generally require sharp hikes in interest rates to stabilize them and to prevent inflation.
That in turn tends to plunge those economies into recession which, along with higher interest rates, substantially weakens those countries’ public finances and complicates their politics.
With the U.S. economy now being supercharged by the Trump fiscal stimulus and with U.S. inflation showing signs of acceleration, there is every prospect for more Fed interest rate hikes and for further dollar strengthening.
For which reason, I am not expecting any let up in the emerging market economic crisis anytime soon, but I am expecting those crises to gather pace and to eventually reach our shores.
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.