EAST ASIA FORUM-Preparing for the Next US Recession

Dec 6, 2018

One thing was clear from this weekend’s G20 summit. Asia and the world face many risks, and most of them emanate from the United States of America.

The Trump–Xi trade deal is a clear example. According to the statement from the White House, the United States has agreed not to increase tariffs from 10 to 25 per cent. In return, China has agreed to buy a ‘substantial’ amount of exports from the United States to ‘reduce the trade imbalance between our two countries’.

This is not how economies work.

America’s trade deficit with China reflects its dependency on the Chinese to finance US investment and consumption. China’s promise to buy a ‘substantial’ amount of US agricultural goods, for example, will require US farmers to expand production. Doing so will require investment. Given Americans do not save enough to finance this increase in investment, where does it come from?

The answer is overseas. This inflow of capital will push up the US dollar, worsening the trade deficit. When the agricultural products are finally bought by China, the US dollar will go up again, worsening the trade deficit even further.

The deal between Trump and Xi will change the composition of the US trade deficit — American farmers will undoubtedly be better off — but the deal will not change the underlying saving-and-investment behaviour and will not, therefore, alter the overall trade balance.

The deal does, however, achieve plenty of other things. It undermines the rules-based global trading system. It will divert trade away from other countries, including Australia’s farmers and energy suppliers. It will do nothing to support global growth. It will do nothing to address the ongoing challenges in the trading system. It doesn’t even promise a reduction in the existing tariffs. This deal highlights that the United States is increasingly a source of risk for the world. America’s trade war is disrupting Asian supply chains. It threatens growth and prosperity throughout the region. Tightening financial conditions led by the US Federal Reserve are shaking Asian financial and currency markets. A turbulent US stock market is reverberating around regional stock markets.

Trump’s attacks on institutions such as the US Federal Reserve at home and the World Trade Organization abroad threaten the predictability and certainty of policies that underpin investment and consumption. Elevated geopolitical tensions around the reimposition of US sanctions on Iran risk cascading into other challenges in the region.

At the heart of these risks is enormous policy uncertainty. What will Trump do next?

The mid-term election results certainly weakened the Trump administration. A Democrat-controlled House of Representatives is a welcome constraint on his power. But wounded beasts are unpredictable. Trump might respond to weakness domestically by projecting strength abroad. US presidents have limited influence when it comes to domestic policy. The opposite is true when it comes to foreign policy, particularly in trade, finance and security.

Trump’s next move will be heavily influenced by what happens in the US economy. The economic recovery will soon be the longest in US history. It began well before Trump entered the White House. Trump has used a strong economy to justify and expand his policy agenda. The economy is currently on full throttle with the stimulus of the Trump tax cuts superimposed on economic recovery.

But what happens if the US economy falters? Given that so many of the world’s risks are coming from the United States, the possibility that might happen warrants serious consideration.

In this week’s lead essay, Adam Triggs warns that all the indicators suggest that the next US recession is right around the corner. It is a matter of when, not if, and the implications for Asia are significant. The region best get ready now.

As Triggs notes, signals that predict US recessions are far from perfect. But what is striking right now is just how many of them are now flashing red.

One relates to the pattern of the US business cycle. The US economy has never gone longer than a decade without a recession, a milestone which is fast approaching.

Another is the monetary policy stance of the US Federal Reserve. Four of the last five episodes of Fed rate rises have been followed by a recession. With the latest episode already underway, investors expect at least four more rate rises before December 2019.

Term spreads are another predictor flashing red. A flattening yield curve — when short and long-term interest rates start converging — has predicted every US recession in the last 60 years.

Another recession predictor is how much spare capacity there is in the economy. The last 10 US recessions were preceded by a closing of the output gap. The US output gap is now near zero, employment is heading beyond full employment and, while inflation and wages are moving slowly, they are beginning to shift.

Triggs is not alone in his warning of a looming US recession. Many are forecasting an upcoming US recession. Bank of America Merrill Lynch, The Economist Intelligence Unit and two-thirds of the economists surveyed by the National Association for Business Economists all predict a recession around 2020.

The implications for Asia are as complicated as they are serious.

Triggs argues that, should the US economy in fact slow down, the US Federal Reserve will need to resort almost immediately to quantitative easing or some other form of politically controversial unconventional monetary policy. The last time the United States did this it sent a wall of capital towards Asia. While Asian economies welcomed the increased capital inflows, they did not welcome the volatility it wreaked on their financial markets and exchange rates, let alone when the tide pulled back at the end of it.

What should Asia do?

Now is the time for Asia to build domestic buffers against external economic shocks wherever possible: in fiscal policy, monetary policy and the accumulation of foreign exchange reserves. But, when the shock actually hits, regional cooperation will be key to seeing it off. Strengthening regional crisis-response efforts, like the Chiang Mai Initiative Multilateralization and the ASEAN+3 Macroeconomic Research Office, is the starting point.

Building the political will and framework for effectively activating regional support is even more important. Better linking these regional mechanisms to global institutions, like the International Monetary Fund, is key to ensuring effective surveillance of risks and strong responses if things go bad. And putting in place adequate swap arrangements to buttress these regional and multilateral mechanisms is an essential supplement.

There is much that Asia can do to weather the upcoming storm. But it needs to fix the roof while the sun is still shining.

The EAF Editorial Board is located in the Crawford School of Public Policy, College of Asia and the Pacific, The Australian National University.

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