(Project Syndicate) — NEW YORK (Project Syndicate) — In April, I warned that today’s ultra-loose monetary and fiscal policies, along with a slew of negative supply shocks, might lead to stagflation akin to the 1970s (high inflation alongside a recession). 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.
Today’s high price-to-earnings ratios, low equity risk premiums, inflated housing and tech assets, and irrational exuberance surrounding special purpose acquisition companies (SPACs), the crypto sector, high-yield corporate debt, collateralized loan obligations, private equity, meme stocks, and runaway retail day trading are all warning signs.
High debt ratios (private and public) triggered a serious debt crisis during the 2007-08 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. Worst-of-both-worlds scenario As a result, we are left with the worst of both the 1970s stagflationary period and the 2007-10 period. 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. For the time being, weak monetary and fiscal policies will keep fueling asset and credit bubbles, resulting in a slow-motion train crash. Today’s high price-to-earnings ratios SPX, +0.12 percent, low equity risk premiums, inflated housing and tech assets COMP, -0.12 percent, and the irrational exuberance surrounding special purpose acquisition companies (SPACs), the crypto sector BTCUSD, -3.73 percent, and high-yield corporate debt BTCUSD, -3.73 percent, are all warning signs.
This boom will eventually end in a Minsky moment (a sudden loss of confidence), resulting in a bust and crash due to stricter monetary policies. In the meantime, the same loose 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. Renewing protectionism, population aging 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. Macroeconomic disruption is a recipe for disaster. 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 cyberattacks on essential infrastructure on output, as well as the social and political backlash against inequality, and you’ve got a formula for macroeconomic disruption. 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. They are in a debt trap, as both governmental and private obligations have risen.
“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 individuals. Following the global financial crisis, the doom loop of sovereigns and banks in the eurozone will be replayed globally.
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. Even under the second scenario, though, policymakers would be powerless to prevent a debt crisis. While unexpected inflation in established economies 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 debt in industrialized nations would become unsustainable (as it did after 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. The Volcker Affair 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. To begin with, rising public and private debt will widen sovereign and private interest rate spreads. Inflation risk premiums will rise as inflation rises and uncertainty deepens. Third, a rising misery index—the total of inflation and unemployment—will eventually necessitate a “Volcker Moment.” Former Fed Chair Paul Volcker increased rates to combat inflation in 1980-82, resulting in a severe double-dip recession in the US and a debt crisis and a lost decade for Latin America. 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.
“ The question isn’t whether, but when. ”
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. 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 main economist is Nouriel Roubini. The Looming Stagflationary Debt Crisis was published with the permission of Project Syndicate. Stagflationary pressures are gathering, according to Nouriel Roubini. Stagflation will be a challenge to the president in 2021, according to Peter Morici. Stephen Roach: Arthur Burns’ ghost haunts a complacent Federal Reserve that is stoking inflationary fires./n
Read More