How a looming economic crash abroad could hit US shores

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In 2008 we experienced how strongly interconnected the world economy is. A bankruptcy of Lehman, a relatively small US investment bank, rocked the world financial system. It also plunged the global economy into what was then the worst post-war recession.

This interconnectedness is why our economic leaders would be well advised to pay careful attention to the economic problems brewing beyond our shores. Much like the failure of one of our banks in 2008 wreaked havoc on the rest of the global economy, a debt crisis in Europe or in emerging markets could hurt our already struggling economy.

Another round of sovereign debt crises in the Eurozone gives particular cause for concern. Unlike 2010, when the eurozone debt crisis was centered in Greece, this time it is likely to be centered in Italy, whose economy is about 10 times the size of Greece’s. If the Greek debt crisis shook US financial markets in 2010, how much more would an Italian debt crisis do today?

In 2010, disaster struck Greece after the economy collapsed.
AP

Unfortunately, Italy seems all too vulnerable to another debt crisis. In the wake of the pandemic, its budget deficit skyrocketed and its public debt skyrocketed to over 150% the size of its economy – the highest on record. Caught in a euro straitjacket that prevents it from using currency depreciation to boost its exports, there is little chance that an economically sclerotic Italy can grow its way out of its sovereign debt mountain.

So far, the European Central Bank has kept Italy afloat with its low interest rate policy and massive purchases of Italian government bonds. However, with European inflation hitting a record 8.5% and the euro sinking like a rock, the ECB will need to halt its bond purchases and raise interest rates to bring inflation back under control.

Stock trader on the New York Mercantile Exchange.
The stock market is preparing for a recession.
AP

All too aware of Italy’s economic vulnerability, the ECB is considering launching a new credit facility that would allow the Italian government to finance its large gross borrowing needs at reasonably low interest rates. But such efforts are all too likely to be hampered by strong political opposition in Germany and by Italian general elections early next year, in which anti-euro parties are likely to do well.

Perhaps more immediate than a possible European debt crisis is the prospect of an emerging market debt crisis in the near future. Emerging markets have never been as indebted as they are today. Rarely have their economies been hit as hard as they are today by the ongoing COVID pandemic and the surge in oil and food prices following the Russian invasion of Ukraine.

Adding to the concerns of emerging markets is that the Federal Reserve has recently turned to a tight monetary stance. As has often been the case before, higher US interest rates are already leading to increased repatriation of capital from emerging markets to the United States. It asks the World Bank to repeat it his warnings that it is only a matter of time before we see a wave of defaults in emerging market debt.

Sri Lanka, Argentina, Venezuela, Zambia and others have already defaulted, along with a number of Chinese real estate development firms. Many other countries are likely to follow. Collectively, these defaults can have a systemic impact, especially as we face credit issues in our own heavily leveraged debt market and in the cryptocurrency debt market.

It would never be a good time for us to face a debt crisis in Europe or emerging markets. However, now seems to be a particularly bad time. With the US economy already showing clear signs of slowing down and the stock market just wrapping up a miserable first half, the last thing we need is another external economic shock in the form of a debt crisis.

In setting monetary policy in today’s international economic context, the Federal Reserve should perhaps pay close attention to how its actions might affect economies abroad. Not least because of the possibility that economic developments abroad could cripple both our financial markets and our economy.

Desmond Lachman is a Senior Fellow at the American Enterprise Institute. He was Associate Director in the Policy Development and Review Division of the International Monetary Fund and Chief Strategist for Emerging Markets at Salomon Smith Barney.

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