The next recession: worse than the last?

31 Jan 2019


With recent years signalling the collapse of faith in liberal democracy, it appears that the aftermath of the 2008 global financial crisis is reaching a crescendo. These firmly held middle fingers to the establishment manifested in many forms; from political lurches (to both the right and left) in South America to grassroots movements such as the ‘Gilet Jaunes’ activists in France. It is safe to say that global capitalism is on the ropes, increasingly likely to be knocked onto the canvas by their populist rivals.


However, amidst the chaos of Brexit and Trump, it is easy to forget that another economic crisis lurks around the corner. There are telling signs that 2019 may bring forth the next global recession. Whilst the direct consequences may not be as destructive as 2008, a fractured geopolitical system coupled with limited economic wriggle-room could serve a fatal blow to the west. 


Market analysts mutter about a global recession coming within the next 18 months. There are several key indicators of this. Firstly, the world is experiencing a global tightening of monetary policy. The U.S. Federal Reserve has just raised interest rates, whilst the European Central Bank (ECB) recently announced the end of a €2.5 tn Quantitative Easing programme. Worldwide contractionary monetary policy will undoubtedly slow growth, with the Fed lowering economic forecasts at their December meeting.


Furthermore, markets are demonstrating signs of imminent deterioration. 2018 witnessed 3 stock market tumbles, and most worryingly, the U.S. treasury yield curve has recently become inverted. An inverted, downward sloping yield curve means that interest rates on longer term bonds are lower than the rate on short term bonds. The implication of this is that markets expect a future cut in interest rates, usually as a response to a recession. In the past 50 years, a recession has followed an inverted yield curve in all but one time. Given that, according to the World Bank, the global economy has only just closed their negative output gap, this leaves markets incredibly fragile.


Optimists argue that new regulation has created a more sustainable position. Banks, in general are far more robust. They must now hold a minimum amount of liquid assets, whilst larger financial institutions must hold an additional capital buffer. Financial ring-fencing, which separates large bank’s retail banking from corporate activity, provides more protection to consumers.


Despite this, examining the potential response of key economic players to a recession is worrying. Inadequate leadership in America, China’s unsustainable economic model and limited policy available to institutions could plunge the developed world into dark times once again.



Make the world great again?


Traditionally, the United States has been crucial when it comes to steering the global economy away from a recession. As a sort of lender of last resort, they provided fully collateralised loans to Europe and much of the world in response to the 2008 crisis. Leaders look to the U.S. to provide economic support; it facilitates global trade by pumping liquidity into the economy and providing a monetary stimulus through cutting interest rates. The problem is, this time there are question marks over the ability of the world’s largest economy to engage with these recovery mechanisms.


The Federal Reserve has less room to manoeuvre than previously. In the last 3 recessions, the Fed’s cumulative interest-rate cuts have all been close to five full percentage points. The current benchmark funds rate stands at 2.5%. With negative interest rates an undesirable outcome, U.S. monetary policy will not command the strength that it previously has had. 


Those on the left call for a fiscal stimulus instead of monetary policy. Recent months have seen socialists across Europe and America demanding a Green New Deal: a large spending programme which would absorb the demand losses that a global recession would entail. Issues arise when one considers the amount of debt crippling the U.S. economy. With over $1.37tn worth of debt, there is only so much that the U.S. treasury can burden themselves with. 


Furthermore, the benefits of U.S. tax cuts are skewed towards the rich. President Bush’s tax cuts made the tax system less progressive. For example, in 2010, the year in which all of the Bush income and estate tax cuts were fully phased in, after-tax income of those making over $1 million increased by more than 7.3%, but after-tax income of the middle 20 percent of households rose by just 2.8%. 


Jerome Powell, the new Fed Chairman, has indicated a shift in the role of the Reserve. Adopting a less interventionist approach, Powell wishes to unwind market dependence on the Fed for predicting growth. This amplifies the already strained relationship between the institution and President Trump, who has frequently criticised the Fed for raising rates. A damaged dialogue between Powell and Trump could prove detrimental in a global recession, particularly given the speed and precision required to respond to an economic shock.


Trump’s stubborn nature will have effects stretching beyond monetary policy. His ‘America First’ philosophy may prove costly. In what is already a fierce trade war, recession may encourage the President may choose to increase tariffs to protect vulnerable industries. The result would be the strangling of further global growth. Global trade can provide strong, sustainable demand injections into the economy. Whilst tariffs may appear to shelter American firms, this blunt policy that may end up causing more harm to factories in Detroit and Pittsburgh than good.


One potential strategy for advisors may be to speak to the narcissist within Mr Trump. The  President recently withdrew U.S. troops from Syria, proclaiming that he had ‘defeated Isis’. Those with influence in the White House may be wise to play up to this attitude, persuading Trump that he can play the hero in the ‘I saved the World’ narrative.



The European Project: Last Chance Saloon


The economic and political shock experienced in the States doesn’t have a patch on Europe’s story. 2008, along with a sovereign debt crisis, plunged much of southern Europe into prolonged economic decline. Fearing that the debt crisis could sound the death knell of the Eurozone, the ECB, IMF and the European Commission (collectively known as the Troika) forced the likes of Greece, Spain and Portugal to implement harsh austerity programmes as part of their bailout loans. The Quantitive Easing programme was not enough to offset the fallout of these structural adjustment programmes, with support for Eurosceptic parties surging in recent years.


December’s decision to roll back QE has unsettled markets further. Paul Diggle, of Aberdeen Standard Investments, claims that the decision to end QE is ‘more about politics than economics’. With the general consensus that this decision was taken too quickly, fearful eyes turn to the jittery months ahead. Whether or not this was the right decision does little to change the fact that European institutions are ill-equipped to cope with another recession.


More so than their partners across the Atlantic, monetary policy can’t get much looser. For almost 3 years, the ECB has had negative interest rates, with this set to remain so until September 2019 at the latest. Slashing rates therefore does not appear to be a feasible response. Additionally, with a balance sheet of €4.7tn (47% of Eurozone GDP), it would be very unlikely to see another asset purchasing programme to steady markets, given concerns surrounding the expansion of excessive credit.


Fiscal policy in its current form does not look like a silver bullet either. Countries within the Eurozone must obey EU spending rules. Following the 2012 sovereign debt crisis, the ‘Stability and Growth Pact’ (SGP) capped budget deficits at no more than 3% of GDP. With the Euro area operating with a current deficit of 0.9%, the ability to provide a fiscal stimulus is limited under current rules. This paints a worrying picture when considering the debt levels of states that are in deeper crises. Italy, which has seen the decimation of their political and financial institutions, still runs a 2.3% deficit.


Not only are these rules reducing policy options, they are also implemented in a manner which fuels populist mentality. Many Eurosceptic parties have claimed that the Troika are lenient towards Germany and France, and it is easy to see why. In December the EU permitted President Macron to expand France’s budget deficit to 3.2% for the coming year. This ‘soft touch’ comes at the same time as Brussels telling Italy it must further reduce their deficit to 2%.


This ‘one rule for you, another for me’ approach will amplify frustration with the European project. If austerity is the proposed solution to another crisis, it is only the matter of time before the likes of Italy and Greece flirt with the prospect of leaving the Euro. The single currency is an important crutch that holds the European Union together, and the collapse of this important collection of nations would be detrimental to the European project.



Like a bull in a China shop


Although the U.S. and Europe are crucial actors, their relative influence is waning. Emerging markets are tightening their grip on policymaking; and no more is this demonstrated than with China. According to the Centre for Economics and Business Research, China is set to overtake the U.S. as the world’s largest economy by 2032.


One of the breakout stars from the 2008 crisis, China’s juggernaut economy managed to emerge from the recession unscathed, following a 4 trillion Yuan [approximatively $USD570bn (in 2008)] stimulus package. Worth 14% of their 2008 GDP, this expansionary fiscal policy soaked up the loss of demand from an export-dependent economy. Given the nature of China’s quasi-state managed banking system, this was an infrastructure and bank lending programme that could rapidly put the world’s second largest economy back on track. This was possible because China’s economic management before the crisis was very prudent, meaning that fiscally, they had room to manoeuvre. 


2008 fundamentally marks a true shift in global economic power. Chinese growth was the only reason that global growth in 2009 was positive. Whilst power moves eastward, risks also permeate across the Pacific. This means that Chinese economic damage is no longer contained, and a Chinese economic crisis would have significant worldwide effects.


Concern now lies with the recent debt surge. Half of Chinese debt is associated with real estate, which would render Hong Kong susceptible to a 2008 style crash.


The debt built up in China is largely U.S. Dollars. In a period of monetary tightening, higher interest rates would strengthen the Dollar relative to the Yuan. Consequently, dollar debts become larger for the Chinese, generating further risk.


Financial influence moving towards China globalises this danger. Following the crash, Asian banks expanded at the expense of European ones. UK finance demonstrates this. HSBC came out of the crisis comparatively stronger to the likes of Deutsche Bank, and Britain took notice. The City of London began marketing itself as an offshore centre for China- due to the ability of banks such as HSBC to straddle themselves between London and Hong Kong.


According to Colombia University’s Professor Adam Tooze, this tightly knit relationship between China and Britain could mean that the UK is ‘the first western domino to fall in the line’. In a period where the prospect of a no-deal Brexit looms, this further threat would magnify economic and political fallout. 



Cautious pessimism 


The effects of the next recession depend on numerous factors, including where the epicentre of the recession is, and the direct cause of it. The potential response from Europe rests upon events such as the 2019 European parliamentary elections. It seems as if every nation is fighting their own domestic battles, their myopic stance blinding them to the global problems that await them. Although states need to get their own house in order, a coherent, united message on a global stage would go a long way to quelling the consequences of the next recession. Failure to do so may result in the knockout blow for our liberal democratic institutions.

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