We are in the downward portion of the global business cycle. Economic growth likely peaked in major economies last year and the slowdown has been pronounced especially in Europe but also in China and the United States. Coming at the end of a decade where interest rates are largely still at rock bottom and government debt levels are high, are there sufficient policy levers to prevent a recession?
Firstly, GDP or national output had contracted in major European economies earlier this year, such as Britain and Germany. Economic growth in the U.S. and China have both slowed. As they are the two engines of the world economy, global economic growth and world trade have both slowed this year. In this part of the cycle, factors such as the U.S.-China trade war and Brexit have the potential to increase uncertainty and dampen confidence which particularly do not help growth.
Of course there’s nothing unusual about booms and busts. In addition to the geopolitical tensions, what’s particularly worrying about this economic slowdown is that the recovery from the global financial crisis is not finished. During a recovery, inflation normally picks up with economic activity. That usually means that interest rates also rise.
In the U.S., interest rates had increased but that hasn’t really been the case in the Euro Zone or the UK. So, the U.S. Fed has scope to reduce the interest rate, and they have made three such cuts this year, but that’s not been the case for the European Central Bank. The ECB has cut some rates deeper into negative territory and restarted cash injections. The Bank of England would be in a not dissimilar position. For the People’s Bank of China, it has more leeway because China was not party to the banking crash a decade ago. But they have had a significant amount of downside pressure on the economy due to the US-China trade war. So, the Chinese central bank has had to boost lending and cut the cost of borrowing to counter some of those effects. The Bank of Japan continues its stimulative policies as well.
As there are concerns over the effectiveness of monetary policy, central bankers like the ECB’s Mario Draghi are pointing to fiscal policy to do more. European governments are wary of adding to the high levels of debt that they incurred over the past decade stemming from the financial crisis. The U.S. had implemented a large tax cut at the beginning of last year, which has also added to concerns over debt. But, at the same time, both America and Europe have promoted investment, particularly the latter in creating a fund to boost infrastructure. Such capital spending delivers returns in the future so is different than current spending and perhaps less worrying for debt markets, especially as the infrastructure investment often includes private financing. However, as a countercyclical fiscal policy, this sort of spending takes too long to be used to right the business cycle. This is why John Maynard Keynes in his seminal book, The General Theory, proposed state organised councils with infrastructure projects ready to be rolled out during an economic downturn.
In the current low rate environment, bond markets seem to be more concerned about a lack of growth than the level of debt for the major economies at least. That would suggest there was leeway for governments to use fiscal policy to help prevent a recession.
Debt, though, constrains China in a different way. To counteract the slowdown from the 2008 global financial crisis, China’s corporate debt levels grew on the back of the growth of looser credit, including through the shadow banking system which are loans that sit outside of the formal banking system. China has cut taxes this year to counteract the global slowdown and the impact from the higher tariffs from the U.S.-China trade war. But, there are also constraints as to its policies around easing credit because its financial markets do not allocate credit efficiently due to the state domination of the sector, so debt can build up in less efficient firms or as a result of not very productive projects.
And that’s the final part of whether this slowdown could become a recession. If there was a debt crisis, that would likely tip an economy into recession. As economic growth slows, it could become harder for firms and households to repay the debt that they borrowed. It’s not dissimilar for governments. As income growth slows, debt become less manageable. That could affect banks as the monies that they lent may not be repaid which weakens their balance sheet. So, a slowdown that triggers a debt crisis could then become a recession or worse.
Financial crises are hard to predict but resolving crises is better understood. In an interconnected global economy, the ability for major economies to cooperate with each other is crucial. When one country experiences a financial crisis, it is likely to spill-over into other economies. Central banks extending extend swap lines to ensure there was liquidity for financial institutions is one example. If governments coordinated their fiscal stimulus, that could also generate positive spillovers of greater demand for not only domestic output but also exports of other countries. Such cooperation was seen in varying degrees a decade ago which helped to address the global financial crisis. With today’s geo-political and geo-economic tensions, would that be possible among the world’s major economies?
There may not be a financial crisis of course. The current economic slowdown may result in recession in some economies. Technically, a recession is defined as two consecutive quarters of negative GDP growth. But, even without it being a technical recession, negative growth or stagnation or just a marked slowdown all point to the “bust” part of a boom and bust cycle.
There are already signs of some stabilisation as a result of monetary and fiscal policies. We can only hope that these measures are enough to get growth going again before a debt crisis is triggered. Resolving the U.S.-China trade war and the uncertainty over Brexit would also help to remove other downward pressures on economic growth at this vulnerable point in the global economic cycle.
To hear more, listen to the “Inside the Global Economy” – Is Europe facing a recession? What risk factors can lead to a global financial crisis? What are the possible policy responses? Linda Yueh, Adjunct Professor of Economics at London Business School, hosts eminent London Business School academics Hélène Rey, Lord Raj Bagri Professor of Economics, and Lucrezia Reichlin, Professor of Economics and Chairman and Co-Founder of Now-Casting Economics. See: