The Credit Cycle

In a very interesting article in the Economist Magazine the flow of debt was followed from banks to consumers to businesses and countries.  Studies were highlighted showing that debt burdens on consumers has a far larger impact on growth than debt held at businesses.  Furthermore it was shown that emerging economies are more prone to economic shocks due to swift changes in debt levels however these countries can be split further into those with current account deficits and low levels of foreign capital versus those with current account surpluses and large foreign reserves.  The former is subject to large swings in its economic fortunes and the value of its currency versus the latter who can weather the storm.  This subset can be further divided into open economies and controlled economies with the former more readily able to shed the dead wood versus controlled economies that can drag bad debt along like an anchor for years.

As an example China, a controlled economy, keeps lumping more and more debt onto poorly run and money losing state enterprises creating a drag on economic growth.  The money spent could easily be used to create jobs and economic benefit elsewhere.  In contrast countries such as the United States are relatively good at letting bad investments die however this will be sorely tested during the next  recession as the problem of too big to fail will once put into question political stomach versus the economic merit of holding onto poorly run enterprises.

As the United States' thinks about raising interest rates this is sending shock waves through the emerging markets particularly those economies like Brazil which are prone to runs on its capital reserves.  An interest rate rise should propel the dollar higher resulting in a larger burden on Brazil to pay its dollar denominated debt and making the Real fall in value.  This will be exacerbated by a flow of capital out of Brazil dragging the economy into a recession.

Now back in the good old days that would not have mattered much to the first world economies but in 2015 emerging markets make up the lions share of global GDP.  In fact they are approaching 60% of the world's GDP.  In addition they are the engine of global growth able to produce sustained periods of growth well above 5%.  This type of GDP growth has not been seen in developed economies in decades and more than likely will never be witnessed again.  So if the world is to exit from the cycle of growing debt levels the only way out that I can see is for global GDP to grow at a rapid pace and the only place that this will come from is the emerging markets.

As I have mentioned before while the United States believes that it is in good enough shape to raise rates it cannot withstand a sharp slowdown in emerging economies growth rates.  For this reason while the Federal Reserve may be stupid enough to raise rates next month they will not have the latitude to continue to move them higher as the repercussions of a strengthening dollar will undermine any form of global recovery forcing them to end the interest rate increases.  Worse still as the debt funnels back from emerging economies to the United States the result might be that the world's debt crisis may end up right back where it all started, in the hands of the Federal Reserve and that would be worrisome!