For many years, two growth engines, the United States and China, powered the global economy. Both of those engines have now failed. Consequently, the global economy is rapidly losing altitude. Return to your seats and buckle your seat belts. A global economic nosedive may be in your immediate future.
For decades, the US economy was driven by rapid credit growth. The ratio of total credit to GDP rose from 150% in 1980 to 370% in 2007. So long as credit expanded, the Americans had more money to spend even though their wages had long since stagnated. The more they spent, the more the US imported. Surging imports - and an out of control trade deficit that earlier generations could not even have imagined – set off a global economic boom that transformed the world.
If only the Americans could have kept borrowing more every year forever, all the age-old problems of mankind would have dissolved away. Unfortunately, debt has to be repaid – even in America. When that became impossible in 2008, credit began to contract, banks began to fail, major institutions were nationalized, spending fell, and imports contracted. Trillions of dollars of fiscal and monetary stimulus prevented a total economic breakdown, but US imports no longer grew rapidly enough to drive the global economy. One of the engines of global economic growth had seized up.
That left China. China’s economic miracle was export-led and investment-driven. When the US crisis began, China’s exports fell. To prevent an economic collapse, Chinese policymakers ramped up investment. Industrial capacity was expanded. New cities were built. New highways and train tracks crisscrossed the country. This investment was funded with debt. Chinese bank loans tripled between 2009 and now. In that way, China’s economy continued to grow and to pull in imports from the rest of the world.
China’s leaders had hoped that the US economy would soon recover and that China could resume exporting its way to ever-greater prosperity. That didn’t happen. Once US fiscal and monetary stimulus faded, US imports began to contract again. During the first seven months of 2015, US imports were down by an average of 2.2% a month relative to the same period last year.
Meanwhile, China’s credit-fuelled investment boom had produced excess industrial capacity on a scale the world had never seen before. The supply glut across all industries caused product prices to plunge. Reduced corporate revenues became insufficient to pay even the interest on the debt that had funded the investments. Growing non-performing loans are once again threatening the solvency of China’s banking system. Additional investment would only make matters worse.
China had no choice but to begin to invest less. Reduced investment means less demand for the rest of the world’s commodities. As the Chinese slowdown gathered pace in 2014, Chinese imports began to weaken. They then began to contract. During the first eight months of 2015, Chinese imports were down by an average of 14% each month relative to the first eight months of 2014. As a result, global commodity prices have collapsed, falling to levels last seen in the twentieth century. The second engine of global growth has clearly broken down.
Falling demand from China and plunging prices sent the economies of the commodity producing countries into a tailspin. Russia, Brazil and Canada have fallen into recession. The currencies of numerous Emerging Market economies have fallen sharply. The earnings of the metals, mining and energy companies are being hard hit. New investment will inevitably decline, while unemployment will rise. Now, the global selloff in stocks is producing a negative wealth effect that will soon take a toll on consumption.
All of these negative conditions are likely to become worse before they get better. Credit growth in the United States is not going to reaccelerate enough to drive the global economy. The slowdown in Chinese investment has only just begun. The global economy has descended to a recessionary altitude. Turbulence is worsening. Visibility is poor. The flight plan is lost. Confidence in the pilots is low. Hang on. We are flying into trouble. A hard landing may be the best-case scenario.
I discussed this engine failure during an interview on CNBC Squawk Box Asia on September 14th. If you would like to watch the interview, here’s the link: