CITY OF NEW YORK: In April, I warned that today’s ultra-loose monetary and fiscal policies, combined with a slew of negative supply shocks, might lead to stagflation, or high inflation and a recession akin to the 1970s. In reality, today’s risk is far greater than it was back then.
After all, debt ratios in industrialized countries and most emerging markets were substantially lower in the 1970s, which explains why stagflation hasn’t historically been linked to debt problems.
In fact, unforeseen inflation in the 1970s wiped out the actual value of fixed-rate nominal debts, decreasing the burden of public debt in many industrialized economies.
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High debt ratios (private and public) triggered a serious debt crisis during the 2007-2008 financial crisis, as housing bubbles burst, while the accompanying recession resulted in modest inflation, if not outright deflation.
There was a macro shock to aggregate demand due to the credit crunch, but the dangers currently are on the supply side.
As a result, we have the worst of both the stagflationary 1970s and the years 2007-2010.
Debt ratios are substantially greater than they were in the 1970s, and a combination of permissive economic policies and negative supply shocks promises to fuel inflation rather than deflation in the coming years, laying the stage for the mother of all stagflationary debt crises.
READ: Commentary: The financial markets are acting like it’s 2008 all over again.
For the time being, weak monetary and fiscal policies will keep fueling asset and credit bubbles, resulting in a slow-motion train crash.
WHAT KIND OF WRECK COULD IT BE?
High price-to-earnings ratios, low equity risk premia, inflated housing and technology assets, and irrational exuberance surrounding special purpose acquisition companies (SPACs), the crypto sector, high-yield corporate debt, collateralised loan obligations, private equity, meme stocks, and runaway retail day trading are all warning signs.
This bubble will eventually lead to a Minsky moment – a sudden loss of trust – and stricter monetary policies will precipitate a bust and crash.
However, the same lax policies that are fueling asset bubbles will continue to promote consumer price inflation, setting the stage for stagflation when the next negative supply shock occurs.
Inflation in Gas Prices
Renewing protectionism, demographic ageing in advanced and emerging economies, immigration limitations in advanced economies, reshoring of manufacturing to high-cost locations, and the balkanization of global supply chains might all result in such shocks.
In a broader sense, the Sino-American decoupling risks fragmenting the global economy at a time when climate change and the COVID-19 pandemic are pressuring national governments to become more self-reliant.
Add in the impact of increasingly regular cyber-attacks on essential infrastructure on output, as well as the social and political backlash against inequality, and you’ve got a formula for macroeconomic disruption.
IS IT POSSIBLE FOR CENTRAL BANKS TO MAKE A DIFFERENCE?
To make matters worse, central banks have basically lost their independence as a result of being forced to monetize enormous budget deficits in order to avoid a debt catastrophe.
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They are in a debt trap, as both governmental and private obligations have risen.
Central banks will have a conundrum when inflation rises over the next few years.
They risk triggering a massive debt crisis and severe recession if they begin to phase out unconventional policies and raise policy rates to combat inflation; however, if they maintain a loose monetary policy, they risk double-digit inflation – and deep stagflation when the next negative supply shocks emerge.
Investors will be watching Fed Chairman Jerome Powell’s comments closely after the central bank pushed forward its expectations for raising interest rates. ERIC BARADAT/AFP
Even under the second scenario, though, officials would be powerless to prevent a debt crisis.
While unexpected inflation in established countries can wipe out nominal government fixed-rate debt, as it did in the 1970s, emerging-market debt denominated in foreign currency cannot.
Many of these governments would have to default on their obligations and restructure them.
At the same time, private loans in industrialized nations would become unsustainable, as they did during the global financial crisis, and spreads on safer government bonds would rise, causing a chain reaction of defaults.
Indebted households and the banks that supported them would be the first to fall, followed by highly leveraged firms and their reckless shadow-bank creditors.
IS IT POSSIBLE FOR GOVERNMENTS TO BECOME INVOLUNTARY?
To be sure, if inflation increases suddenly and central banks are still behind the curve, real long-term borrowing costs may initially decline. However, three variables will drive increase these prices over time. READ MORE: India’s COVID-19 problem may leave long-term economic wounds To begin with, rising public and private debt will widen sovereign and private interest rate spreads. Inflation risk premia will rise as inflation rises and uncertainty deepens. Finally, an increasing misery index — the sum of inflation and unemployment – will finally need a “Volcker Moment.” In 1980-1982, when former Fed Chair Paul Volcker raised interest rates to combat inflation, the result was a devastating double-dip recession in the United States, as well as a debt crisis and a lost decade for Latin America.
Paul A. Volcker, former Chairman of the Federal Reserve Board of the United States, talks at a news conference in New York, United States, on June 8, 2015. REUTERS/File Photo/Mike Segar
However, because global debt ratios are nearly three times greater now than they were in the early 1970s, any anti-inflationary policy would result in a depression rather than a severe recession.
Central banks will be damned if they do, damned if they don’t, and many governments will be semi-insolvent, unable to bail out banks, firms, and people under these conditions.
After the global financial crisis, the doom loop of sovereigns and banks in the eurozone will be reproduced globally, sucking in households, corporations, and shadow banks.
READ: Commentary: The contours of Singapore’s post-COVID economy are becoming more visible. As things stand, it appears that this slow-motion train crash is unavoidable. The Fed’s recent shift from ultra-dovish to mostly-dovish policy makes no difference. The Fed has been in a debt trap at least since December 2018, when a stock and credit market crisis compelled it to reverse policy tightening a year before COVID-19. It has become even more trapped as inflation rises and stagflationary shocks loom. The European Central Bank, the Bank of Japan, and the Bank of England are all in the same boat. The debt difficulties of the post-2008 period will soon meet the stagflation of the 1970s. The question isn’t whether it will happen, but when. Roubini Macro Associates’ CEO and Atlas Capital Team’s Chief Economist is Nouriel Roubini./n
