Where are we in the global economic cycle? I wish I had the answer.
The unwinding of the Fed’s stimulus programs, combined with the risk of a global trade war and rising populism in a number of developed countries, increase the chance that this aging economic recovery could soon turn.
When that happens, the severity of the downturn will depend on the resiliency of the world’s two largest economies: ours and China’s. China may be better prepared. While we loosen financial regulation to achieve faster short-term growth, China is tightening regulation to contain bubbles and achieve sustainable, long-term growth, even if that means slowing its economy in the near-term.
China’s aggressive action on ‘shadow banking’
Last year, President Xi Jinping himself called for a multi-year regulatory effort to reduce leverage and curb risk taking, citing financial stability as one of the three great challenges to China’s long-term prosperity. In contrast, early in his tenure, President Donald Trump called Dodd-Frank, the post-crisis financial reform law, a “disaster” and promised to do “a big number” on financial regulations.
China has taken aggressive action against unregulated “shadow banking” activities, consolidated regulators to close gaps in supervision between banks and insurance companies, and created a cabinet-level council to better coordinate regulatory actions and data collection. In contrast, our administration has scaled back the Office of Financial Regulation, established post-crisis to promote better data collection across the financial system, and is disinclined to subject systemic non-bank institutions to Federal Reserve oversight, notwithstanding the role “shadow banks” such as AIG played in the 2008 financial crisis.
Chinese regulators have imposed toughened policies for risk management, governance, and loss recognition for nonperforming loans. American regulators have proposed rules to ease capital, liquidity, stress testing, and Volcker Rule requirements for the nation’s largest banks. Proponents of these changes argue that they are minor tweaks to simplify rules, and leave the core of the post-crisis regulatory regime intact. Perhaps. But virtually all trend in the direction of giving banks greater latitude to take more risks with more leverage. Their cumulative impact could be substantial.
The difference between debt in China and the U.S.
One could argue that China’s problems in its financial sector are more severe than ours, warranting these divergent approaches. But in truth, debt levels are too high in both countries. At least China is confronting its problem. China’s biggest challenge is corporate debt, constituting 160.3% of GDP, compared to 73.5% in the U.S.
But the vast majority of troubled corporate debt in China is held by state-owned enterprises (SOE), representing a huge waste of capital resources but not a threat to system stability as the government can control the timing and severity of SOE defaults. Corporate debt in the U.S., on the other hand, is privately held and at a record high. Over-leveraged companies will struggle to repay that debt as interest rates rise. Household debt in the U.S. is also high by historical standards, representing 78.7% of GDP, compared to 48.4% in China. Financial risk looms as well in our ratio of gross government debt to GDP: 108% in the U.S. compared to 51% in China.
Conventional wisdom suggests that the United States can better tolerate higher debt levels because of its strong, developed economy. Let me challenge that conventional wisdom. Over the past 20 years, China has sustained an annual growth rate above 6% and is expected to continue to do so. Ours has hovered in the 2-3% range. Wage growth in China has been strong, while real wages for the majority of American workers have stagnated, fundamentally challenging our consumer-driven economy. So which economy is better positioned to absorb its future debt obligations? The one growing at 6+% and building the purchasing power of its middle class, or the one that can barely breach 4%, with a middle class that continues to struggle?
The U.S. is loosening regulations at the wrong time
Confucius said: “Think of tomorrow. The past can’t be mended.”
Ben Franklin opined: “By failing to prepare, you are preparing to fail.”
Both provide good advice for this country.
Democracy will always be messier than state-directed socialist systems. It is the price we pay for our cherished freedoms. But that shouldn’t be an excuse to let our government off the hook for short-term thinking. We are regulating to the political, not the economic, cycle. If we learned anything from the financial crisis, it is that our banking system needs a firm, regulatory hand. While China eyes its long-term stability, we eye the November elections.
Nine years into the recovery, we are due for a downturn. The global economy is already starting to slow. We should be preparing for the next cycle by tightening supervision and building banks’ capital buffers. By loosening regulation at precisely the wrong time, we are setting ourselves up for the next fall.
If and when that happens, a more resilient China may be positioned to further encroach on our position as an economic power and market leader. If so, we have no one to blame but ourselves.
Sheila Bair is the former Chair of the FDIC and has held senior appointments in both Republican and Democrat Administrations. She currently serves as a board member or advisor to a several companies and is a founding board member of the Volcker Alliance, a nonprofit established to rebuild trust in government.