The world economy will be in trouble – not as individual spies, but in the form of battalions. They are doing this on multiple fronts, in the United States, China and Europe. Combined with renewed geopolitical tensions in the Middle East, these problems increase the likelihood of a full-blown global economic and financial market crisis by the middle of next year.
One of the biggest threats to the U.S. and global economic recovery is the recent rise in U.S. Treasury yields, the key interest rate for the global economy. Within two months, the 10-year Treasury yield rose from less than 4 percent to over 4 ¾ percent – a 16-year high. This came in response to Federal Reserve warnings that interest rates would remain high for longer to curb inflation, as well as growing market fears about how the US government will finance its budget deficit of 8 percent of gross domestic product.
The sharp rise in interest rates has already pushed the interest rate on 30-year mortgages toward 8 percent and significantly increased the interest cost of buying a car. This is expected to soon pose a significant headwind for both home and automobile sales, just as most households have exhausted their pandemic-related savings and the government is facing another shutdown.
It will also likely exacerbate problems in commercial real estate, where real estate developers are already struggling with low occupancy rates in a post-COVID world. The last thing these developers needed was to pay higher interest rates on the more than $500 billion in commercial real estate loans coming due in the next few years.
Worse still, the rise in government bond yields is likely to soon lead to a credit crunch in the US. This will likely occur by raising solvency questions across much of the U.S. banking system in general and regional banks in particular.
Even before the recent spike in bond yields, it was estimated that the U.S. banking system was experiencing mark-to-market losses on its bond portfolio of more than $600 billion. The further collapse in bond prices will significantly increase these losses. This leaves regional banks particularly poorly positioned to absorb the expected wave of defaults on their commercial real estate loan portfolios, which make up almost 20 percent of their balance sheets.
It would never be a good time for the global economy when China, the world’s second largest economy and until recently its main engine of economic growth, moves to a significantly lower economic growth path. It would be a particularly bad time for such an event as the United States appears to be on the brink of a significant economic recession. But that’s exactly what appears to be happening now that this country’s huge real estate and credit bubble has burst. The bursting of this bubble, coupled with China’s very poor population structure, is now raising serious fears that China is well on its way to a Japanese-style lost economic decade.
Likewise, now appears to be a bad time for Europe to succumb to an economic recession and experience another round of its sovereign debt crisis, centered on Italy, a country with an economy about 10 times the size of Greece. But this now appears to be on the cards, as the European Central Bank continues to raise interest rates to bring inflation back under control at a time of economic weakness, and the Italian government has introduced an expansionary budget while keeping its public debt much higher than in 2012. The German economy has now experienced three consecutive quarters of negative economic growth as the spread between Italian and German bond yields widens worryingly.
All of this appears to have clear implications for U.S. economic policymakers. The Federal Reserve should withdraw its high interest rates for an extended period and prepare for a global economic and financial system crisis. At the same time, Congress should get its act together and begin meaningfully addressing the country’s long-term budget deficit problem.
Desmond Lachman, a senior fellow at the American Enterprise Institute, was deputy director in the International Monetary Fund’s Policy Development and Review Division and chief emerging market strategist at Salomon Smith Barney.
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