Could Emerging Market Economies Be a Drag on U.S. Growth?

Economy watchers can’t seem to find anything to worry about, with the possible exception of a trade war that few believe will happen. The economy is growing, unemployment is down, labor force participation is up, inflation is hitting Fed targets, the stock market shrugs at bad news and embraces the good. As Fed chairman Jay Powell put it a few days ago in his self-described “plain English” style that is replacing Janet Yellen’s more academic prose, “The economy is doing very well.”

Certainly true of our economy. But unless you think we are immune to developments in the rest of the world, there are reasons for concern. Not the sort that should keep you sleepless, but the sort to keep in the back of your mind when you are told that the current trees that are our economy and stock prices will grow to the sky.

America is in the process of a sharp reversal of its monetary policy. For years the Federal Reserve Board has been printing money, the dollars in which most of the world’s commerce is conducted. It’s called quantitative easing. It used the newly printed dollars to buy treasury bonds and mortgages. That kept interest rates low in the United States.

Now, the Fed is reversing course, driving interest rates up, using two tools: the federal funds rate and sales of assets held on its bloated balance sheet. The median projection for the fed funds rate is 2.4 percent at the end of the year, rising to 3.1 percent in 2019 and then to 3.4 percent in 2020. In addition, the Fed is selling assets-the government’s IOUs and mortgages. The dollars it receives are, in effect, tossed into a shredder at the rate of $20 billion per month this year, $50 billion per month next year.

Most on Wall Street assume that with optimism about corporate profits running high, any impact of a few quarter-point increases in interest rates on share prices will be trivial. Not so the impact of rising interest rates here on Emerging Market Economies (EMEs).

Higher interest rates mean higher yields on U.S. bonds. When yields on our bonds were low, investors shifted their cash to higher-yielding bonds of EMEs. It’s called the search for yield, something small savers wish they had an opportunity to do. Now the yield gap between relatively safe U.S. bonds and riskier EME bonds is narrowing, resulting in a flood of cash out of the EMEs and into American securities. Also, the relative shortage of dollars as the Fed shredders reduce the supply of greenbacks by about $2.34 trillion over the next few years, makes them more expensive. EMEs need to buy dollars to pay for oil, which is traded in dollars, and to pay interest on money they borrowed and agreed to repay in dollars. Their own currencies don’t go as far as they once did. They could print more of their own currencies, but that would drive up inflation-in an extreme case to the 13,865 percent rate in socialist Venezuela, that makes the country’s currency worthless.

All of which brings us to modern-day Argentina. The country, rich in resources, somehow has never managed to control its tendency to outspend its means. It has reneged on its debt six times, most recently in 2001. Not even its central bank’s decision to raise interest rates to 40 percent could stem the flight from the peso, down 38 percent against the dollar this year, prompting the resignation of the president of the central bank and his replacement by finance minister Luis Caputo, who is said to be well respected in financial markets.

To stabilize the Argentine currency and its economy, the IMF (with the approval of America, its largest shareholder) will make available a 3-year credit line of up to $50 billion over three years, the largest it has ever offered.

But IMF loans come with strings attached. Argentina will be required to:
Cut its fiscal deficit to zero by 2020 by reducing spending.
Turn off what is called “the little machine,” the process by which the central bank prints money and sends it over to the treasury.
Give the central bank greater independence from political pressure.
Cut its inflation rate in stages from 25 percent to 9 percent in 2021.

This might turn Argentina’s anemic economic growth rate negative. Which reminds many of the pain inflicted on Greece by the German/IMF austerity program imposed when Greeks failed to beware of bankers bearing credits. And Argentines of the pain of the 2001-2002 austerity required of the country the last time it appealed to the IMF. With president Mauricio Macri’s government already unpopular, austerity might not be a sure-fire winner in next year’s election in a country not famous for a cordial reception to advocates of living within the country’s means. The IMF promises to mitigate the impact of austerity on the poor by allowing increases in benefits, but how one increases such spending while reducing deficits is not apparent.

There are good reasons to wonder whether classic IMF bailouts are not relics of the past. Bailouts are designed to make sure that creditors do not take too large a “haircut” (loss) should, for example, Argentina declare itself unable to repay its loans. Those international creditors are presumably experts in the appraisal of such a risk, and have been collecting interest payments to reward them for assuming that risk. Now that the risk is reality, they want the world’s taxpayers, led by Americans, to bail them out. If that requires cutting benefits to the poor and middle class, so be it. IMF go home.

Many American taxpayers were not keen on bailing out our own banks, and take an even dimmer view of bailing out international investors who know the risks of investing in EMEs. They argue that such bailouts create moral hazard-an expectation by investors that bailouts will always be available. And that the EMEs’ problems are home-grown, not made in the USA. In any event, Powell has made it clear to his complaining counterparts at EME central banks that he does not believe anything the Fed is doing has a major effect on EME economies. That might be a more polite way of saying what John Connolly, Richard Nixon’s Treasury secretary said in response to foreigners’ complaints about U.S. monetary policy: “The dollar is our currency, but your problem.”

The bottom line for American investors is that the threat of a world financial crisis as Latin American and other EME economies hit rough waters can’t be ignored. It may be a little cloud no bigger than a man’s hand, but it is a cloud nevertheless. And only one, if Thursday’s IMF report, with its emphasis on the negative effect of rising U.S deficits on our growth and inflation prospects is to be believed.

Which the Trump administration advises against.