Fault Lines In The Global Economy

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by: Desmond Lachman

Markets often fail to predict major market-moving events even though in retrospect, they should have been obvious to anticipate. A prime example of such a failure was the 2008 global market bust, which followed the extraordinary U.S. housing and credit market bubble.

An earlier example was the world equity market panic in late July 1914 that followed the outbreak of World War I and that occasioned the closing for a few months of both the New York and London Stock Exchanges. As historian Niall Ferguson reminds us, on the eve of World War I, markets remained buoyant even though all the signs were long since pointing in the direction of the world sleepwalking toward a catastrophic war.

President-elect Donald Trump is broadcast on a screen on the floor at the New York Stock Exchange (NYSE) in Manhattan, New York City, December 27, 2016. REUTERS/Andrew Kelly.

One has to wonder whether something similar might not be happening today. At a time that the world's major central banks are winding down their many years of ultra-easy monetary policies, global asset and credit markets remain very buoyant. They remain so even though a number of important fault lines in the global economy have appeared in plain sight, which could cause major financial market turbulence within the next 12 months as the world's central banks proceed with normalizing their monetary policies.

Among the more dangerous of these fault lines is Italy, the Eurozone's third-largest economy and the world's third-largest sovereign bond market with a public debt of almost $3 trillion. This makes the Italian economy too big to fail for the euro to survive. Yet it also makes it too big to save by its European partners if markets were to turn decisively against that country.

The danger that Italy might trigger a new round of the European sovereign debt crisis stems not simply from the likelihood that its very high public debt level and its very troubled banking system could soon be exposed as the European Central Bank ends its bond -buying program later this year.

It is also that earlier this year Italy elected a populist coalition government, comprising the Five-Star Movement and The League, which appear to be on a collision course with Europe. A showdown between the Italian government and its European partners could come as early as October when the Italian government is expected to present a budget that will likely violate the Eurozone's rules on budget deficit limits. It will do so by introducing a flat income tax as well as a basic income allowance.

An economic fault line closer to home for the United States is that of Brazil, the world's eighth-largest economy with a public debt of $1.5 trillion. One reason for thinking that Brazil could come under severe market pressure in a less benign global liquidity environment is that, with a budget deficit of 8 percent of GDP, a public debt of almost 80 percent of GDP, and a very feeble economy, its public finances are on a clearly unsustainable path.

Another reason for thinking that Brazil could soon come under serious market pressure is that it does not seem to have the political will to either reform its economy or to get a better grip on its public finances. Sadly, the Petrobras (NYSE:PBR) corruption scandal has totally discredited Brazil's political class. That makes it all too likely that in this October's scheduled elections, Brazil will elect a populist government of one flavor or another not committed to addressing the country's serious economic problems.

Perhaps more troubling yet than the shaky economic prospects for Italy and Brazil are those for China, the world's second-largest economy and the world's major international commodity consumer. A significant Chinese economic slowdown would come at an especially inopportune time for the emerging market economies, which already are being hit by a sharp reversal of capital flows back to the United States in the wake of the Federal Reserve's monetary policy tightening.

One reason for fearing that the Chinese economy will slow significantly in the year ahead is that the Chinese government is at last beginning to rein in the massive credit bubble that has been an important pillar of its economic recovery. Another is that the Chinese economy would seem to be the main loser of Donald Trump's America First policy that soon could see increased tariffs on $500 billion of Chinese exports.

With economic storm clouds now gathering over Brazil, China and Italy, three systemically important economies, the Trump administration would be making a grave mistake in thinking that present global market buoyancy is a sign that all is well in the world economy.

Rather, it would seem that the administration should be now taking advantage of the present market calm to plan how it might respond to a global economic crisis that could be triggered by political or economic events in Brazil, China or Italy. It might also want to repair its frayed relations with its G-7 partners whose cooperation might very well be needed in helping to resolve any future global economic crisis.