People use an escalator in front of a housing complex by Chinese property developer Evergrande, whose financial difficulties suggest that China’s property and credit-led growth model may be on the decline.
NOEL CELIS/AFP/Getty Images
About the author: 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.
The 2008-2009 global economic and financial-market crisis taught the world a painful lesson about Minsky moments. Such a moment occurs when asset prices collapse and interest rates on risky loans soar following a prolonged period of reckless, speculative activity.
Hyman Minsky, the late American credit-cycle expert, taught us that a prolonged period of financial-market stability tends to set up the conditions for pronounced financial-market instability. By this he meant that as economic confidence rises and as asset prices soar, the financial system tends to make increasingly risky loans on the assumption that asset prices will rise forever. When asset prices eventually stop rising and when lenders realize that they might not get repaid, the whole credit-market house of cards collapses.
If ever we have experienced a period of highly risky lending in the context of rapidly rising asset prices, it has to have been that of the past eighteen months. The financial system has lent with abandon even as U.S. equity valuations jumped to nose-bleed levels experienced only once over the past 100 years and as U.S. housing prices adjusted for inflation exceeded their 2006 precrisis peak. Fueling this lending spree was the approximately $5 trillion in Federal Reserve bond purchases in response to the pandemic that induced investors to stretch for yield.
One indication of excessive lending is the more than $1 trillion that has been loaned to highly leveraged U.S. companies and the skyrocketing of global debt to a level well in excess of its precrash 2008 peak. According to the International Institute for Finance, global debt reached almost $300 trillion by the second quarter of 2021. In relation to GDP, this was some 350%, above the 280% before September 2008 Lehman bankruptcy.
A particularly troubling instance of gross credit misallocation is that characterizing the emerging market economies, which now account for around half of the world economy. Over the past 18 months these economies have become more indebted than ever at relatively low interest rates as global investors have stretched for yield. This has been the case despite the fact that the pandemic has upended their economies and in all too many instances put their public debt on an unsustainable path.
While the current combination of an “everything” asset-price bubble and a prolonged period of reckless lending would seem to make a Minsky moment inevitable, the timing of that moment is always difficult to predict. However, there is good reason to think that this moment could come this year either as a result of a tightening in global liquidity conditions or as a result of a harder-than-expected Chinese economic landing.
Already at its last meeting, the Federal Reserve indicated that it intends to accelerate the pace at which it will taper its bond-buying program with a view to ending that program in March. That would pave the way for interest rate increases to bring inflation back under control. With U.S. inflation now running at its fastest pace in the past 40 years and with the Omicron variant likely to delay the repair of the global supply chain and exacerbate labor shortages at home, there is a real risk that the Fed will be forced to raise interest rates at a very much faster pace than the market is now expecting. This would seem to be especially the case considering how negative interest rates currently are in inflation-adjusted terms.
Trouble also seems to be brewing in the Chinese economy, which has been the world economy’s main engine of economic growth and its largest consumer of international commodities. In particular, the acute financial difficulties at Evergrande, the world’s most indebted property company, and the unusually large credit build-up over the past decade suggest that China’s property and credit-led growth model might have run out of steam. That could spell real trouble for the highly indebted and commodity dependent emerging market economies.
Economists and the Federal Reserve take comfort in the fact that today’s U.S. banking system is much better equipped to handle the bursting of an asset-price and credit-market bubble than it was in 2008. But this awareness seems to be blinding them to the high degree of exposure of the largely unregulated nonbank part of the financial system. That could be setting us up for a series of Long-Term Capital Management-like crises when the Minsky moment finally arrives. U.S. and world economic policymakers seem to be totally unprepared.
Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to [email protected].
