Yesterday was the 20th anniversary of the great East Asian financial crash. It started in Thailand then spread to much of Asia over several months. The crash resulted in a huge drop in U.S. interest rates because of the potential disinflation caused by the deep global crash. In the U.S. the economy was running at a very hot pace which implies a significant increase in inflation and interest rates would occur. Yet inflation remained at low levels and interest rates declined.
The lesson to learn was that massive money printing in Asia created a fake economic boom there that was killed off by excessive debt. The excess money was related to a significant increase in dollar denominated debt owed to other countries. When local currencies collapsed in comparison with the dollar then local borrowers could not pay foreign dollar based loans (since they suddenly cost double because of devaluation) and a wave of bankruptcies and business closings resulted.
Thus investors should beware of the risks that a booming economy is growing only because of excessive debt and that ultimately the debt will backfire, resulting in a collapse. This means that a booming economy, which may be inflationary, could actually suddenly reverse course and fall into a debt/deflation trap that is very hard to get out of.
Currently much of the world’s economic growth can be traced to Emerging Market regions that have issued excessive, and poorly underwritten debt. Thus a global disinflationary crash greater than the 1997 Asian crisis could occur. The ratio of global debt to GDP has never been as high as it is now. The dramatic growth of this ratio began about 1997 when low interest rates caused by the 1997 crash encouraged more domestic borrowing in the Developed countries.
The 1997 crash was the catalyst that started the U.S. Federal Reserve on a policy of inappropriate easing and money supply growth that triggered the gigantic tech stock bubble of 1997-2001. When this crashed in 2002 the Fed was unwilling to let it collapse and so it started a new bubble in housing. This collapsed in 2008 and then the Fed started the Quantitative Easing bubble of 2008 – 2014. The markets have been greatly distorted by excessive global central bank easing since 1997. Currently the central banks of Switzerland and Japan actually print up money and buy stocks, so there is a risk that stocks may be misguided by this and thus could eventually drop in price.
Assuming that zero rate or negative rate policies are inappropriate and dangerous then central banks have finally run out of ammunition and will be unable to reflate stocks in the next crash. Rates are so low that they can’t be cut 4% or 5% to produce stimulus since they would go negative. Remember how Thailand felt when their central bank gave up defending the currency and the currency then dropped 50% very quickly. What would happen if the U.S. Fed gave up trying to defend the economy with low rates?
In the U.S. there are too many economic actors who vitally need reasonable positive interest rates in order to survive and these actors will assert themselves and may be able to get Congress prevent the central bank from making rates going negative. Also businesses no longer trust the Fed’s ability to stimulate and thus they won’t be lured into taking on more debt solely because of rate cuts, since they need to prepare for the risk that they can’t pay the principal on a loan even if the interest if zero.
Investors need independent financial advice about the risks of a global crash like East Asia’s July 2, 1997 crash.