Risks to the Economic Recovery

There is an apocryphal story about the sinking of the Titanic. When asked at the inquest why he did not steer the ship away from the iceberg, the Titanic's captain replied "What iceberg?"

We have to wonder whether something similar might be said of today's Federal Reserve. It hews to the course of maintaining high interest rates even at a time when the economy is slowing and inflation is coming down steadily towards the Fed's two percent inflation target. It also does so despite a number of economic and political icebergs that could sink the US and world economies that are in plain sight.

Starting at home, one bullet that will need to be dodged next year is the slow motion train wreck currently underway in the commercial real estate market. That train wreck could lead to another round in the regional bank crisis. Due to record high vacancy rates as a result of changed work and shopping habits following the pandemic, commercial property prices are plummeting and property developers are already starting to default on the $900 billion in property loans that fall due this year. This will hit the banks especially hard at a time when high interest rates have wrought serious damage on the banks' loan and bond portfolios. It is estimated that the banks are currently sitting on more than $1 trillion in mark-to-market losses on those portfolios.

According to a recent National Bureau of Economic Research study, close to 400 small and medium-sized banks could fail as a result of high interest rates and the commercial property crisis. Were such failures to materialize, they would be reminiscent of the 1980s Savings and Loan crisis that contributed importantly to an economic recession.

Another home-grown risk to the economic recovery is the United States' drift toward protectionist policies especially against China. One clear indication of this drift is the emphasis in the current election cycle on the need to protect American jobs from foreign competition. Donald Trump has made clear that if he wins the election, he would impose a 60 percent import tariff on China and a 10 percent across-the-board tariff on all other countries' exports. This would carry the risk of retaliation by our trade partners and a return to the economically destructive beggar-thy neighbor policies of the 1930s.

Looking abroad, there is no shortage of geo-political risks. Russia and Ukraine are still actively engaged in the largest European land war since the Second World War. Meanwhile, Israel is engaged in a series of conflicts with a number of Iranian proxies in Gaza, Lebanon, Syria, and Yemen. Those conflicts are disrupting trade flows through the Suez Canal and have the potential to spread to the rest of the oil-rich Middle East.

There is also no shortage of economic risks abroad. China, the world's second-largest economy and until recently its main engine of economic growth, is struggling to cope with the fallout from the bursting of its massive housing and equity bubble. That has already led to a marked slowing in Chinese economic growth to around 4.75 percent and raised serious questions as to whether China might be headed for a Japanese-style lost economic decade. The last thing that an export- dependent Chinese economy needs right now would be a tightening of United States and European trade restrictions.

Meanwhile, heavily indebted France and Italy are raising the specter of another round of the Eurozone sovereign debt crisis. Both of these countries have gaping budget deficits and public debt levels considerably higher than they were at the time of the 2010 Eurozone debt crisis. With France now showing clear signs of ungovernability, it is difficult to see how that country will muster the political will to restore public debt sustainability. Any Eurozone debt crisis today would be worse than the 2010 Greek debt crisis given that the French and Italian economies are many times the size of that of Greece.

In early 2008, the Fed chose to ignore the subprime loan problems that were in plain sight and eventually led to the Great Economic Recession. We have to hope that, chastened by that experience, the Fed will soon start paying more attention to the multiple risks that currently beset the US and world economies. Maybe then, the Fed will start an interest rate cutting cycle soon.

Learn more: The Economic Consequences of a Second Trump Term | China's Economy Is in Deep Trouble | France Swings Left. Fiscal Sanity Will Have to Wait. | The Fed Is Blind to Economic Risks

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