Janet Yellen and the global economy

This morning, in congressional testimony reminiscent of that of Ben Bernanke’s sanguine testimony at the very start of the U.S. sub-prime mortgage market crisis in March 2007, Janet Yellen assures us that the global economy does not pose a meaningful threat to the U.S. economic recovery. She does so in seeming disregard of a currency crisis that has now engulfed a number of major emerging market economies as well as of clear signs of slowing in China, the world’s second largest economy. She also does so by seemingly overlooking both Europe’s move towards Japanese-style deflation and growing signs of European political fragmentation ahead of the May 2014 European parliamentary elections.

Over the past year, the currencies of Brazil, India, Indonesia, South Africa, and Turkey (the so-called Fragile Five) have depreciated by between 10 and 20 percent. They have done so as a reversal of emerging market capital inflows in response to higher U.S. long-term interest rates has exposed underlying weaknesses in these countries’ domestic and external economic fundamentals. Yellen’s assertion that she plans to continue with the Fed’s tapering policies is likely to further weaken these currencies as it results in further capital repatriation in response to higher US interest rates. An additional factor likely to weaken the Fragile Five’s currencies is the fact that each of these countries is due to have an important parliamentary or presidential election within the next six months.

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The sharp currency depreciations of the Fragile Five are very likely to lead to a substantial slowing in those economies. They will do so as those countries are forced to hike interest rates to contain the inflationary impact of their currency depreciations and to limit the easing in financial conditions that would otherwise result. This would appear to be particularly the case considering that those depreciations have been occurring against the backdrop of already relatively high domestic inflation rate.

Yellen could be excused for downplaying the global risks to the U.S. economy from the emerging market currency crisis if that crisis was playing out in isolation. However, this is far from the case. The Fragile Five’s crisis is occurring at the same time that there are growing signs of slowing Chinese economic growth, as that country tries to deflate a domestic credit market boom. In this context, it is worth recalling that the emerging market economies now constitute around 50 percent of the global economy and in recent years they have accounted for the major part of global economic growth.

The Fragile Five’s economic troubles are also occurring at a time that Europe’s economy is faltering as deflationary forces take hold. They are also occurring at a time that Europe’s politics are continuing to fragment, especially in places like France, where the Marine le Pen’s National Front is now ahead in the polls, and in Greece, where the Greek government is holding on to power by its finger nails. Slowing growth and unsettled politics would seem to be a potent recipe for the resurfacing of the European sovereign debt crisis later this year.

Yellen is probably correct in her judgment that the underlying strength of the U.S. economy will allow her to continue with the tapering policies of her predecessor. However, she does not do us a service by underplaying the very real risks to U.S. economic growth from a major part of the world economy.

Lachman is a resident fellow at the American Enterprise Institute.