The case for a global recession in 2015

Monthly job growth in 2014 is, on average, faster than at any point since the financial crisis. Overall economic growth appears to picking up too, with real GDP growing by more than 4% in the second quarter of this year, and many economists predicting higher overall growth compared to
last year.

But news outside the U.S. isn’t so bright. European economies are still battling depression-era levels of unemployment and the threat of deflation. And emerging economies, like China, are having trouble maintaining the kind of growth they have become accustomed to in recent years. The most recent readings out of China have the world’s second-largest economy growing at roughly 7.5% per year, down from the 10% growth it averaged for two decades before its economy began to slow in 2012. And this pattern holds for other emerging economies like Brazil and Russia.

Optimists hope that an accelerating U.S. economy will have what it takes to drag the rest of the world out of the doldrums, as it has done during so many past recoveries. But David Levy, economist and chairman of the Jerome Levy Forecasting Center, argues that the problems of the rest of the world will end up taking the U.S. down, rather than the other way around.

Levy is calling for a 65% chance that there will be a global recession by the end of 2015, based on the simple fact that emerging markets have continued to invest in an export infrastructure to sell goods to the West that it no longer has the wherewithal to buy.

Levy is an intellectual descendant of the economist Hyman Minsky, a heterodox thinker who spent many years working at the Jerome Levy Economic Institute and whose theories were largely ignored by economists up until the latest financial crisis. Once the crisis struck, however, Minsky’s ideas seemed to make a lot more sense. He argued that capitalist economies slowly and naturally become unstable over time, as banks and private businesses take on more and more debt, until the system finally snaps under the weight of these obligations. After surveying the wreckage caused by an over-leveraged banking system, which had gorged itself on debt backed by overvalued real estate, the economics world has begun to pay much closer to attention to Minsky and his views on financial instability.

Indeed, Minsky and his ideas have captured the attention of big-name figures like hedge fund titan Ray Dalio and economist and Financial Times columnist Martin Wolf, who began his latest book with a quote from Minsky arguing that economists ought to formulate theories in which depressions are a naturally occurring state for capitalist economies. These thinkers have been drawn to the Minksian notion that, over the long run, capitalist economies will inevitably suffer from the kind of trouble we’ve been in recently because capitalist systems encourage the growth of debt.

We hear a lot of people warning about the dangers of debt, specifically the government variety. But for Minksy and his followers, it’s private sector debt that is the problem. Here’s how economist Paul Krugman has described the Minskian concept of debt:

He argued that conventional views of financial crisis were too narrowly focused on the specific issue of bank runs. In Minsky’s vision, excessive leverage—too much reliance on borrowed money—creates a risk of crisis whoever the borrower. Banks, which in effect borrow money short-term from their depositors but invest in assets that can’t easily be converted to cash, may be especially vulnerable. But business and household debt also expose the economy to the possibility of a self-reinforcing downward spiral.

The following chart, provided by Levy, shows the accumulation of private debt in the U.S. and in China:

As you can see, debt in the U.S grew and grew until the trend was finally snapped in 2008. This process of “deleveraging” is beginning to end in America, but in places like China, the debt buildup hardly paused, and now the ratio of debt to GDP held by non-financial businesses in China is higher than it ever was in the U.S. So, what is this debt financing? Investment in businesses and real estate, to fund the great Chinese export machine. The problem is that exports haven’t grown in China to justify that demand, as the following chart shows:

You can see the same general trend for other emerging markets. They’ve continued to invest, hoping that the export growth catches up to pre-crisis levels. Eventually, the consequences of this overinvestment will be clear, just like the U.S. economy had to deal with its own over-investment in real estate.

So what happens when emerging markets are finally forced to face the music? It’s tough to say what a financial crisis in China would look like, Levy argues. The government in Beijing has the ability to take a much more activist role in protecting the financial system than even the U.S. did. But either way, the world’s second largest economy, and others like it, are headed toward much slower economic growth.

Twenty years ago, a recession across the emerging world might not have been a huge deal for the U.S., but the American economy is more reliant on global trade today than it has been in a long while. Thirty percent of the jobs added since the financial crisis has been the result of rising exports, according to the Treasury Department, and there are now more firms exporting goods and services in America than ever before.

The U.S. economy is even more closely connected to the European economy, which Levy also shows has done a poor job of deleveraging:

The European banking system never really recovered from the financial crisis. A stress test released on Sunday showed that 25 out of 130 institutions are unsound while critics argue that the failure rate should be far higher. Levy has little confidence that Europe will be able to withstand an economic shock stemming from the emerging economic world. And once Europe is dragged under, he says, there isn’t enough economic strength at home to keep the U.S. economy from avoiding another recession.