Heavy tariffs on China’s goods could lead to a credit implosion, followed by a recession. That would imperil the U.S.
As I watch the Shanghai Composite melt like spring snow, courtesy of the overdue trade tensions with the United States, I am beginning to see headlines about how President Trump’s policies could cause a global recession If this turns out to be an ugly trade war, in the style of the 1930 Smoot-Hawley Tariff Act, those headlines may very well turn out to be warranted. But in the case of China, I don’t believe Trump’s tariffs will be the cause of China’s recession. Instead, it will be its epic credit bubble that has now popped and is deflating, as evidenced by the $1 trillion of foreign-exchange outflows since 2014. To China, Trump’s tariffs are what Lehman Brothers’ failure was to the Wall Street Crash of 2008 — the catalyst to the crash. It has been rather amusing to hear many times that “if Lehman had been bailed out” (a course of action I was in favor of), “Wall Street would have not crashed.” While the sell-off would not have been as quick or as sharp with such a bailout, the sell-off in the U.S. stock market would have happened, and it likely would have had a similar magnitude, but over a couple of years instead of one.
In 2008, Lehman Brothers was a gigantic band-aid on the side of the U.S. financial system that then-Treasury Secretary Hank Paulson had the fortitude to pull off rather abruptly. In other words, Lehman Brothers’ failure was a catalyst, not a cause, of the humongous losses in the U.S. stock market, along with the worst financial crisis in 70 years.
However, it was the real estate bubble, inflated by the mortgage finance bubble, that caused the recession, specifically AAA-rated subprime mortgage collateralized debt obligations (CDOs), some of which went to zero!It very well may turn out that the Trump tariffs are the same band-aid whose expeditious removal will cause the air of the epic Chinese credit bubble to start going out faster. We should find out soon enough, by the end of 2018. the Great Depression in the U.S. in the 1930s and the Asian Crisis in 1997-1998. As the Chinese economic growth rate has dramatically slowed since 2010, total social financing has continued to surge Note that the authorities are now clamping down on rampant borrowing and the building of empty cities, of which there are several dozen (see this Business Insider post). Both developments can be seen in the significant decline in the rates of fixed-asset investment and outstanding yuan loan growth. Still, neither of those credit aggregates capture the shadow banking system, which remains very much in the shadowsu I am sure that the Chinese leadership is trying to think of what to do in the present situation — as if Sun Tzu himself were in their position — but I don’t believe that even the legendary general (were he alive today) could prevent a bad recession in China. Still, a massive devaluation cannot be ruled out if the trade war spins out of control, which will likely turn out to be deflationary for the global financial system.