One of the greatest challenges President Obama faces in his last months in office is how to deal with a global economy teetering on the edge of a yet another crisis. For weeks now, the financial markets have been signaling major trouble ahead. Turbulent equity markets throughout the world have plummeted. Yields on long-term bonds in the United States have fallen to near historic lows, auguring extended economic weakness ahead. And interest rates have turned negative in Japan and some European economies, underscoring that these economies may be losing the fight against deflation. Meanwhile, the large flow of money into China and emerging economies that drove global growth after the great financial crisis has reversed, exposing those economies to years of debt buildup.
Indeed, one cannot rule out that the markets may be signaling something more serious than just a global economic slowdown. They could be foreshadowing the beginning of what might be called the third leg of the world economic crisis, one that would echo the US-centered housing bubble in 2008 (the first leg) and the eurozone crisis in 2010–11 (the second leg). This third leg would center on China and emerging markets. In the aftermath of the global crisis of 2008, with demand in the United States and Europe no longer available to power its export economy, China embarked on the largest expansion of credit in modern economic history. In the process, it built too many factories, too much housing, and too much infrastructure. The huge increase in debt worked to keep China’s economy growing and boosted emerging markets and commodity producers, but it created huge excesses and lots of bad debt in China and other economies dependent on China that now must be worked off.
Not surprisingly, the Chinese economy is now on a bumpy descent as it tries to manage its overinvestment bubble and as it transitions to a more consumer-oriented economy. The fear of a Chinese hard landing has created tremors throughout the global economy. The price of commodities, from oil to copper and iron ore, has collapsed in the face of global oversupply and expected weaker demand from China. Brazil, Russia, and other commodity producers are in recession. Manufacturing economies worry about a new wave of deflation coming out of China, driving down the price of manufactured goods. And everyone worries that China will have no choice but to let the yuan fall further, thereby setting off a series of competitive devaluations in Asia and beyond and setting the stage for a new emerging-market debt crisis. For as currencies fall, emerging markets will not be able to service their dollar-denominated debt, triggering a new financial crisis that will extend to European banks and the shadow banking system of US asset managers and hedge funds.
The US economy is in a better position than other economies to weather this third leg of the global crisis. But in today’s world, no economy is an island. It is unlikely that the United States can avoid a recession if Europe, Japan, and China are all pulled into one, and even more unlikely if there is a major credit crisis centered on emerging markets, energy, and Chinese debt, which would pull down many European banks and some US asset managers. Even as it is, US energy producers—solar and wind as well oil and gas—are being decimated by the wars of oversupply and weaker demand. And US manufacturing is contracting because of a strengthening dollar, which makes US exports more expensive. American consumers will of course benefit from lower energy costs and cheaper goods, but it will be difficult for them to hold up the global economy as they have done in the past, given their sizable debt burden and weak wage growth over the past six years.