When the US and Chinese economies sneeze together

Getty Images

It has been said that when the U.S. economy sneezes, the rest of the world economy catches pneumonia. If this is true, it raises serious questions about the current world economic outlook. Not only is the U.S. economy likely soon to be more than sneezing. So too is the Chinese economy, the world’s second largest economy. Those two economies combined now account for more than 40 percent of the monetary value of all the goods and services produced in the world. 

Among the reasons to fear that the U.S. economy will soon head for troubled waters is that the Federal Reserve has belatedly recognized that the country has an inflation problem and that it will soon have to raise interest rates to get the inflation genie back into the bottle.

With inflation now running at its fastest rate in the past 40 years, the Fed has announced that it will stop its bond-buying program in March, thereby paving the way for a round of interest rate increases. At his most recent press conference, Federal Reserve Chairman Jerome Powell said that the U.S. economy was strong enough now to withstand multiple interest rate increases. This is prompting Goldman Sachs to believe that there could be as many as five interest rate hikes this year

The Fed’s imminent interest rate hiking cycle will be taking place at a time when the country is experiencing both an equity and a housing market bubble. Indeed, at the start of this year, U.S. stock prices were at nosebleed levels experienced only once before in the last 100 years. At the same time, U.S. housing prices even after adjusting for inflation were above their level on the eve of the last U.S. housing market bust.

Heightening the chances that later this year the U.S. equity and housing market bubbles might burst is the fact that these bubbles have been premised on the mistaken idea that interest rates will remain at today’s ultra-low levels for ever. When it turns out that interest rates are very much on the rise and those bubbles burst, we will experience financial market stress, especially in the unreformed and largely unregulated non-bank part of the financial system.

At the best of times, any setback in the U.S. economy would have major implications for the rest of the global economy. But these are far from the best of times, especially since the Chinese economy is now confronted with a host of challenges that likely portend a further marked slowdown in that economy.

Among China’s main economic challenges are the serious difficulties in its property sector, which now accounts for around 30 percent of its economy. Many of the Chinese property developers, including most notably Evergrande, are defaulting on their loans. Meanwhile some 20 percent of Chinese urban properties are now unoccupied, and house prices in relation to incomes have risen to clearly unsustainable levels. 

China’s credit market bubble is equally troubling. According to the Bank for International Settlements, over the past decade, Chinese credit to the non-government sector has increased by 100 percent of GDP. That is a faster rate of credit increase than that which preceded Japan’s lost economic decade or the 2006 U.S. housing market bust. Generally, credit bubbles of the size that China is now experiencing are followed by many years of sub-par economic growth. 

Further clouding China’s long-term economic growth prospects are President Xi Jinping’s recent clampdown on the country’s high-tech sector and the pursuit of his Common Prosperity Program. Those measures appear to be rolling back at least in part Deng Xiaoping’s reforms of the late 1970s that underpinned the country’s economic miracle.     

The prospect of a simultaneous slowdown in the U.S. and Chinese economies casts a dark cloud over the economic outlook for the rest of the world economy in general and the emerging market economies in particular. Economic policymakers in those countries would ignore the impending world economic slowdown at their peril.

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.

Tags Bank for International Settlements China Economic bubble Economy of China evergrande Federal Reserve Financial economics Goldman Sachs Inflation Jerome Powell Real-estate bubble United States housing market correction

More Finance News

See All
See all Hill.TV See all Video

Most Popular

Load more

Video

See all Video