America's Global Vulnerability

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by: Desmond Lachman

In promoting an 'America First' economic policy, Donald Trump appears to be blinding himself to the fragile state of the global economy. He also seems to be ignoring how deeply the US economic and financial system is integrated with the rest of the world. This raises the significant risk that Trump's economic policies could destabilise the world economy, with untoward consequences for the US economic recovery.

Trump's disdain for multilateral lending institutions is particularly worrying, as is his scepticism about the need for continued US economic leadership. This could be dangerous for the global financial system. Years of highly unorthodox monetary policies have created an international credit bubble - and it could burst.

Among Trump's immediate challenges is China, the world's second largest economy and until recently the major source of global growth. China's investment-led economic growth model has almost reached its limit and its own credit bubble is almost ready to burst. China's capital outflow problem is again gaining momentum and the Chinese authorities do not have good exchange rate policy options to stem the deluge.

Seemingly in disregard of China's fragile position and of its importance to the global economy, Trump keeps denouncing Beijing as a currency manipulator intent on cheapening its currency. He does so even though, over the past year, China has spent over $1tn of its international reserves to prevent an excessive weakening of the renminbi. Worse, Trump maintains that he is serious about the imposition of high tariffs on Chinese imports.

Another way in which Trump seems to be undermining China's growth prospects is his proposed expansionary fiscal policy. Although the US economy is at or very close to full employment, Trump is pushing for deep tax cuts and increased public expenditure on infrastructure and defence. Those policies would almost certainly force the Federal Reserve to raise interest rates several times in 2017 to contain inflation. This would in turn encourage the redirection of capital to the US from emerging markets, including China, and propel the dollar ever higher.

As the Bank for International Settlements keeps warning, emerging market economies pose a major risk to the global recovery because they have allowed their corporate sectors to increase their dollar-denominated debt by more than $3.5tn over the last eight years. Rising interest rates and a strong dollar could challenge major emerging economies like Brazil, Russia and South Africa, particularly at a time when commodity prices remain subdued.

Another factor which ought to worry Trump is the dire state of the European economy. Despite years of budget austerity, public debt has continued to rise in southern Europe. The economic disparity between the south and north of the continent has widened. Meanwhile, as was underlined by the UK and Italian referendums, populist politics appears to be on the march and support for the European project is waning.

Hopefully, it has not escaped Trump's notice that Europe has a crowded political calendar in 2017. In April and May, France will hold its presidential elections, in which the right-wing National Front might perform well. By the third quarter, Italy is likely to hold early elections that could result in gains for the anti-euro Five Star Movement. In September, Chancellor Angela Merkel's political authority could be further undermined in German parliamentary elections. These polls could prove to be particularly destabilising for Italy, the world's third largest sovereign bond market. Rome is already facing an accelerating pace of capital outflows and severe strains in its banking system.

Trump may get lucky. None of the vulnerabilities mentioned here may be triggered during his administration. However, given the confluence of economic fault lines and their potential to undermine a US recovery, Trump would be irresponsible if he framed domestic policy in total disregard of the rest of the world.

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