U.S. Economy

Look East to Find the Next U.S. Recession

Two years ago it looked as if China would slip up and take America with it. That risk hasn't gone away.

The gathering darkness.

Photographer: Dai Yongyuan

Despite some mild weakness in recent economic numbers, the U.S. economy doesn’t seem headed for trouble. The economic expansion, already eight years old, continues to chug along. Of course, when trouble comes, it tends to arrive suddenly -- no economic model is very good at forecasting recessions. What could cause a downturn in the next couple of years?

The biggest danger sign for a recession is probably a financial crisis. Many economists, and most of the general public, believe that the implosion of the financial system caused the Great Recession in 2008, and other protracted slumps -- Japan’s “lost decade” in the 1990s, the Great Depression -- were also preceded by big bank failures and/or asset market crashes.

U.S. banks’ leverage ratios are substantially lower than their pre-2008 levels, though some economists claim that they are still overleveraged. Household debt relative to gross domestic product is much lower than before the 2008 crisis, and holding steady. Asset markets generally look expensive, though house prices aren’t nearly as high relative to rents as before the bubble burst. So although the U.S. financial system doesn’t look rock-solid, it also doesn’t look like it’s about to collapse under its own weight -- it seems like something from outside would be needed in order to touch off a crash.

One potential trigger is higher interest rates. For example, the dual recessions in the early 1980s are thought to have been caused by Federal Reserve Chairman Paul Volcker’s inflation-fighting efforts, when he jacked up short-term rates as high as 20 percent. But although the Fed is slowly tightening, it appears to be moving very cautiously, keeping alert for the first signs of economic weakness. And rates themselves continue to be at or near historical lows.

So there’s no obvious Sword of Damocles hanging over the U.S. economy -- no giant bubble, no central bank threat. But many worry that a major shock could hit the U.S. from outside. The main source of concern seems to be China.

Two years ago, China looked like it was headed for an economic meltdown. Its stock market crashed, losing about 40 percent from its peak:

That Had to Hurt

Shanghai Stock Exchange Composite Index

Source: Bloomberg

That crash precipitated a huge and sustained outflow of capital, causing some to speculate that China was in for a classic emerging-market crisis:

Goodbye to All That

China Estimated Net Capital Flow*

Source: Bloomberg

* in billions

The typical story of an emerging-markets crisis is that a country’s central bank spends down its foreign-exchange reserves trying to keep the currency from depreciating too quickly. If the capital outflow goes on long enough and the bank runs out of reserves, it abruptly loses its ability to defend the currency, which then plunges, often making it impossible for borrowers to repay overseas creditors. Financial institutions fail, and a deep and long recession tends to follow.

During the 2000s and early 2010s, China’s central bank built up a mountain of reserves, held in the form of U.S. assets. In the recent capital outflow episode, it spent down a lot of those reserves -- about $800 billion -- but didn’t come close to exhausting its stockpile, which stand at about $3 trillion. But China tightened up its capital controls and managed to slow the outflows, and its reserves are no longer shrinking very much. At least for now, the classic emerging-market crisis has been averted.

There are other ways a China bust could emerge, of course. It might experience a deflationary bust, similar to the Great Depression, the Great Recession or Japan’s 1990s episode. If excessive debt leads to a crash in real estate markets, it could be much more damaging to Chinese households than the 2015 stock market bust was. That could lead to widespread bank failures, necessitating major government bailouts and causing lending -- and therefore economic activity -- to abruptly dry up. It could also cause Chinese households to abruptly stop spending, compounding the shortage of demand.

Many people point to China’s increasing debt levels as a warning sign that this kind of crash could be imminent. China’s total debt has surpassed 300 percent of GDP; for reference, the U.S. was at about 380 percent on the eve of the Great Recession. Government officials have warned that Chinese banks are highly leveraged. And some economists point to signs that China’s real estate market is in a bubble.

China has shown remarkable resilience during the past two years, defying the critics, avoiding a currency crisis, stemming the bleeding from its stock market crash and preventing its housing market from imploding. But the fundamental vulnerabilities remain. And that poses risks for the U.S. economy.

Should China suffer an epic bust, it will no doubt affect the U.S. The U.S.’s imports from China far exceed exports to that country, so a reduction in Chinese demand won’t be catastrophic for American producers. U.S. banks’ exposure to China isn’t that large, so a Chinese bust seems unlikely to crash the American financial system. A Chinese sell-off of U.S. bonds probably wouldn’t be that damaging either -- that’s already been happening, and so far there has been no noticeable harm. China could also hurt the U.S. if it caused Europe’s fragile banks to fail, though this would be an indirect effect.

None of these would be crippling alone -- it’s the sum of them that could hurt the U.S. economy. A slowdown in trade, combined with a weakening of U.S. banks and losses for some American investors, could prompt richly valued U.S. markets to crash, perhaps sending the country into a recession. It might not look like 2008, but it would put an end to the current good times.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Noah Smith at nsmith150@bloomberg.net

    To contact the editor responsible for this story:
    James Greiff at jgreiff@bloomberg.net

    Before it's here, it's on the Bloomberg Terminal.