External headwinds for a US economic recovery

Anyone who thinks that after the coronavirus lockdown has been lifted the United States will experience a V-shaped economic recovery has not been paying sufficient attention to a brewing repeat of the European sovereign debt crisis. Nor have they been paying much attention to the increased signs of real trouble in the emerging market economies that now constitute around half of the world economy.

One of the key economic lessons of the past decade or so was that the 2008 bankruptcy of Lehman Brothers, a relatively small U.S. investment bank, could have major spillover effects on the rest of the world economy. Another lesson was that a 2010 sovereign debt crisis in Greece, a relatively small European country, could cast a dark cloud over the prospects for a global recovery.

Recalling those lessons should be sensitizing U.S. economic policymakers to the possibility that in the same way that a crisis at a U.S. investment bank could send the rest of the world into a recession, economic troubles abroad could hobble a U.S. recovery from its deepest economic recession in the post-war period. 

Those lessons should also be cautioning U.S. policymakers that while it might be very well to hope for the best, they should be carefully planning for the worst. In particular, they should be making contingency plans now for a possible full-blown Eurozone sovereign debt crisis later this year centered on Italy, a country that is around ten times the size of Greece. They should also be bracing themselves for an all-too-likely wave of emerging market debt defaults and for the all-too-probable move of China, the world’s second largest economy, to a markedly lower long-run economic growth path.

Unfortunately, there are many reasons to think that Italy, the Eurozone’s third largest economy, could be heading for real trouble. It certainly has not helped matters that Italy found itself at the epicenter of the European coronavirus pandemic. Not only did that force the country to adopt a virtual total lockdown with devastating consequences for its economy. It also has had the effect of decimating its all- important tourism industry as international travel came to an abrupt halt.

It also has not helped matters that stuck in a Euro straitjacket, Italy does not have its own monetary and exchange rate policy to help extricate it from what is bound to be a major economic slump. Constrained by Eurozone rules, Italy also has little room to engage in budget pump priming. As an indication of Italy’s poor prospects of economic renewal, it is well to recall that while the U.S. already has taken budget measures of 10 percent of GDP in response to the economic fallout from the coronavirus pandemic, Italy has taken less than 2 percent of GDP of such measures.

All of this makes it difficult to see how Italy will be able to manage servicing its public debt problem. Already before the pandemic, Italy had a public debt to GDP ratio of 135 percent. Now after the pandemic, with Italy’s economy likely to contract by at least 10 percent in 2020, the country’s public debt to GDP ratio will soar to well over 150 percent. Equally troubling will be the country’s poor prospects of being able to subsequently grow its way out of its debt problem.

To be sure, in principle the European Central Bank (ECB) could keep Italy afloat by buying an ever-increasing share of its public debt. But the amounts could be daunting even for the ECB. Over the next two years, the ECB might need to buy over EUR 1 trillion in Italian public debt and provide another EUR 1 trillion in support for the Italian banking system. But judging by the present strong resistance of Italy’s northern European partners to the issuance of a joint European coronavirus bond, it is far from clear that they will go along with such ECB largesse.

An Italian debt crisis would be a major global economic event at any time. But it would particularly be the case at a time when China, formerly the main engine of world economic growth, is likely to move to a much lower economic growth path than before following the corona-induced bursting of its epic credit and housing market bubble. It would also be the case at a time when the perfect storm of low international commodity prices, a record rate of capital repatriation and depressed external demand is bound to set off a wave of emerging market debt defaults.

At a time of considerable economic uncertainty, it is all very well for economic policymakers to make upbeat comments about the country’s economic prospects with a view to boosting household and corporate confidence. But one must hope that in formulating the appropriate policy response to the economic crisis, policymakers are being realistic in their private assessment of the serious international challenges that now face a U.S. economic recovery. 

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.