The Next Crisis for the Global Economy? Beware the End of the Dual Stimuli

China and the United States’ dual stimuli are coming to an end, and there is nothing to replace them. 

China and the United States’ dual stimuli are coming to an end, and there is nothing to replace them.

The U.S. and China first began stimulating the global economy more than a decade ago. With low interest rates during Alan Greenspan’s tenure as Fed chairman, the U.S. leveraged too much and splurged on housing. This leverage bubble compensated for the jobs donated to China as construction employment absorbed some of manufacturing losses. Still, the employment losses brought stagnant wages, low inflation, and a Fed willing to fight them.

And fighting them is the stimulus that built China. As low cost manufacturing shifted to China, Beijing was forced to build the necessary infrastructure to keep pace with seemingly ever increasing demand. But now the sustainability of China’s economic model of hyper-investment and low cost labor is beginning to show signs of fading.

The China stimulus, with its unprecedented infrastructure boom, drove the commodity countries of the world to build out their capacity. There is—at the moment—no outlet for the oversupply. But with China’s infrastructure build out peaking, if not winding down, there is little if any chance to replace the demand. The world is not simply losing Quantitative Easing or QE. The global economy is witnessing the dual taper—the U.S. and China are no longer going to stimulate the world.

The Dual Taper…

The US Fed has built its balance sheet to $4 trillion over the course of the recovery, the US is approaching a rate hike faster than markets anticipated, and the Fed is not intimating the extent to which they are willing to maintain the size of the balance sheet. China and its boom are on tenuous ground. Chinese banks are beginning to show signs of stress. A domestic housing boom has caused some banks to begin to reserve heavily against loan losses. The Industrial & Commercial Bank of China (ICBC), a Chinese bank with increasingly global aspirations, recently announced that non-performing loans rose 9 percent in the third quarter of 2014. Many have accused Chinese banks of not fully disclosing their bad loans, but even if they are being truthful the trend is still concerning. Should the trend continue--and there is reason to believe it will--Chinese stimulus may need to shift attention toward propping up banks with liquidity injections. China is also losing manufacturing competitiveness, and this raises the possibility of losing its foreign reserve stockpile and eventually its ability to endlessly stimulate and absorb any escalation in bad loans.

How Greenspan Built China

The Federal Reserve under Greenspan rode loose U.S. monetary policy for the better part of the pre-crisis 21st century, something he himself called “extraordinary.” After a half decade of QE, this statement loses its punch, but the Fed was then concerned with many of the same issues still being debated today—the global competition for jobs and rising levels of inequality at home. American manufacturing jobs were being relocated to China. Greenspan’s time at the Fed saw this trend accelerate as the job loss in manufacturing (due to cheaper labor elsewhere and better productivity at home) became increasingly difficult to ignore.

This loss of blue collar employment was likely part of the reason inflation stayed so tame in the 2000s—there was a lack of wage inflation to the middle skilled workforce. The Fed, seeing little inflation and an unusual jobs picture, kept interest rates abnormally low for abnormally long (or so it seemed back then) to spur job creation and spark some wage inflation. History is still in the process of judging this episode, but the thinking makes sense in retrospect. After all, the Fed was allowing a housing bubble to form to create the type of jobs impossible to find in other sectors of the economy—low to non-contestable jobs. These construction jobs were easy transitions from the manufacturing floor, and they could not be taken offshore easily.

How did this inter-occupational jobs transfer play out? Construction was spurred on as mortgage debt more than doubled between 2000 and 2008, and consumers leveraged their balance sheets with all kinds of credit. The Fed kept the debt cheap and fueled much of the housing and consumer boom, especially after the NASDAQ bubble burst and September 11th pulled the U.S. back to the Middle East. But Greenspan was not just overheating the U.S. To keep pace with the global demand for relatively cheap goods, China was driven to build its infrastructure rapidly as demand for its exports rose—especially from the U.S. Since 2000, U.S. demand for China’s goods has increased nearly four-fold. While it may have looked liked like a U.S. housing bubble with little or no implications for China, it was the demand for Chinese goods that spurred much of the infrastructure building. Greenspan, attempting to spur employment in America, built China.

China Builds Everything