About the Author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was previously Deputy Director of the Policy Development and Review Department of the International Monetary Fund and Chief Emerging Market Economics Strategist at Salomon Smith Barney.
The 2008-2009 global economic and financial crisis taught the world a painful lesson about Minsky times. Such a moment occurs when asset prices collapse and interest rates on risky loans skyrocket after a prolonged period of reckless speculative activity.
Hyman Minsky, the American credit cycle expert, told us that a prolonged period of stability in financial markets tends to create the conditions for severe instability in financial markets. By this he meant that as economic confidence and asset prices soar, the financial system tends to grant increasingly risky loans on the assumption that asset prices will rise forever. When asset prices eventually stop rising and lenders realize that they may not be repaid, the whole house of cards in the credit market collapses.
If ever we have had a period of high risk credit in a context of rapidly rising asset prices, it has been the last eighteen months. The financial system has loaned with abandon even as U.S. stock valuations soared to staggering levels they’ve only seen once in the past 100 years and U.S. house prices adjusted for l inflation exceeded their pre-crisis peak in 2006. This lending frenzy was fueled by Federal Reserve bond purchases of around $ 5,000 billion in response to the pandemic that prompted investors to seek returns.
One indication of excessive lending is the over $ 1 trillion loaned to heavily indebted US companies and the skyrocketing global debt to a level well above its pre-crash peak in 2008. According to the International Institute for Finance, global debt reached nearly $ 300 trillion in the second quarter of 2021. Relative to GDP, it was around 350%, above the 280% before the bankruptcy de Lehman in September 2008.
A particularly disturbing example of gross credit misallocation is that which characterizes emerging market economies, which now represent about half of the global economy. Over the past 18 months, these economies have taken on more debt than ever at relatively low interest rates as global investors seek returns. This has been the case despite the fact that the pandemic has wreaked havoc on their economies and, in too many cases, put their public debt on an unsustainable trajectory.
While the current combination of an “everything” asset price bubble and an extended period of reckless lending would seem to make a Minsky moment inevitable, the timing of that moment is still difficult to predict. However, there is good reason to believe that this moment could come this year either because of tighter global liquidity conditions or because of a tougher-than-expected Chinese economic landing.
Already at its last meeting, the Federal Reserve indicated that it intended to step up the pace at which it would scale down its bond purchase program with a view to ending it in March. This would pave the way for interest rate hikes to bring inflation back under control. With US inflation now reaching its fastest rate in the past 40 years and with the Omicron variant likely to delay repairing the global supply chain and exacerbate labor shortages in the country, there is a real risk that the Fed will be forced to raise interest. rate at a much faster rate than what the market now expects. This seems to be especially the case when you consider how far negative interest rates are currently adjusted for inflation.
Problems also appear to be brewing in the Chinese economy, which has been the main engine of economic growth for the world economy and its largest consumer of international commodities. In particular, the severe financial difficulties of Evergrande, the world’s most indebted real estate company, and the unusually large build-up of credit over the past decade suggest that China’s real estate and credit growth pattern might have been out of breath. This could cause real problems for the highly indebted and commodity dependent emerging market economies.
Economists and the Federal Reserve are reassured 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 blind them to the high level of exposure of the largely unregulated non-bank part of the financial system. This could set us up for a series of long-term capital management-type crises when the Minsky moment finally arrives. US and global economic policymakers do not seem at all prepared.
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