Opinion: Looming stagflationary debt crisis will give markets and economies a punch
NEW YORK (Project Syndicate) — In April, I warned that today’s extremely loose monetary and fiscal policies, combined with a number of negative supply shocks, could lead to 1970s-style stagflation (inflation high accompanied by a recession). In fact, the risk is even greater today than it was then.
After all, the debt ratios of advanced economies and most emerging markets were much lower in the 1970s, which is why stagflation has never been associated with debt crises. On the contrary, the unexpected inflation of the 1970s wiped out the real value of nominal debt at fixed rates, thus reducing the public debt burden of many advanced economies.
“The warning signs are already apparent in today’s high price-to-earnings ratios, low equity risk premiums, inflated real estate and technology assets, and the irrational exuberance surrounding special-purpose acquisition companies. (SPAC), the crypto sector, high yield corporate debt, secured loan bonds, private equity, meme stocks and runaway retail day trading.”
Conversely, during the financial crisis of 2007-2008, high debt ratios (private and public) caused a severe debt crisis – with the bursting of real estate bubbles – but the recession that followed resulted in low inflation, or even outright deflation. Due to the credit crunch, there has been a macro shock to aggregate demand, while the risks are now on the supply side.
The worst of both worlds
So we are left with the worst of the stagflationary 1970s and the 2007-10 period. Debt ratios are much higher than in the 1970s, and a mix of loose economic policies and negative supply shocks threatens to fuel inflation rather than deflation, paving the way for the mother of the crisis. stagflationary debt over the next few years.
For now, loose monetary and fiscal policies will continue to fuel asset and credit bubbles, propelling a slow shipwreck. The warning signs are already apparent in the current high SPX P/E ratios,
low equity risk premia, inflated housing and COMP tech assets,
and the irrational exuberance surrounding special purpose acquisition companies (SPACs), the BTCUSD crypto sector,
high yield corporate debt, secured loan bonds, private equity, AMC meme stock,
and uncontrollable day trading.
At some point, this boom will culminate in a Minsky moment (a sudden loss of confidence), and tighter monetary policies will trigger a meltdown and crash.
But until then, the same lax policies that fuel asset bubbles will continue to drive consumer price inflation, creating the conditions for stagflation whenever the next negative supply shocks hit. Such shocks could result from renewed protectionism; population aging in advanced and emerging economies; immigration restrictions in advanced economies; the relocation of manufacturing to high-cost regions; or the balkanization of global supply chains.
The Recipe for Macroeconomic Disorder
More broadly, the Sino-American decoupling threatens to fragment the global economy at a time when climate change and the COVID-19 pandemic are pushing national governments toward greater autonomy. Add to this the production impact of increasingly frequent cyberattacks on critical infrastructure and the social and political backlash against inequality, and the recipe for macroeconomic disruption is complete.
Worse still, central banks effectively lost their independence, as they had no choice but to monetize massive budget deficits to prevent a debt crisis. With public and private debt skyrocketing, they are caught in a debt trap.
“Central banks will be damned if they do and damned if they don’t, and many governments will be semi-insolvent and therefore unable to bail out banks, businesses and households. The catastrophic loop of sovereigns and banks in the Eurozone after the global financial crisis will be repeated around the world”
As inflation rises over the next few years, central banks will face a dilemma. If they start phasing out unconventional policies and raising key rates to fight inflation, they risk triggering a massive debt crisis and a severe recession; but if they keep monetary policy loose, they risk double-digit inflation and deep stagflation when the next negative supply shocks hit.
But even in the second scenario, policymakers would not be able to prevent a debt crisis. While nominal fixed-rate government debt in advanced economies can be partly wiped out by unexpected inflation (as happened in the 1970s), foreign-currency-denominated debt in emerging markets would not. Many of these governments should default and restructure their debts.
At the same time, the private debts of advanced economies would become unsustainable (as they did after the global financial crisis) and their spreads over safer government bonds would widen, setting off a chain reaction of defaults. Highly indebted corporations and their reckless shadow bank creditors would be the first to fall, soon to be followed by indebted households and the banks that funded them.
The Volcker Moment
To be sure, real long-term borrowing costs may initially decline if inflation rises unexpectedly and central banks are still behind the curve. But, over time, these costs will be increased by three factors. First, rising public and private debt will widen sovereign and private interest rate differentials. Second, rising inflation and deepening uncertainty will increase inflation risk premia. And, third, a rising misery index – the sum of inflation and the unemployment rate – will eventually require a “Volcker moment”.
When former Fed Chairman Paul Volcker raised rates to fight inflation in 1980-82, the result was a severe double-dip recession in the United States, a debt crisis and a decade lost for Latin America. But now that global debt ratios are almost three times higher than in the early 1970s, any anti-inflation policy would lead to a depression rather than a severe recession.
“The question is not if but when.”
Under these conditions, central banks will be damned if they do and damned if they don’t, and many governments will be semi-insolvent and therefore unable to bail out banks, businesses and households. The catastrophic loop of sovereigns and banks in the Eurozone after the global financial crisis will be repeated around the world, also sucking in households, businesses and shadow banks.
As things stand, this slow-motion train wreck seems inevitable. The Fed’s recent pivot from an ultra-dovish position to a majority dovish position does not change anything. The Fed has been in a debt trap at least since December 2018, when a stock and credit market crash forced it to reverse its tightening policy a full year before COVID-19 hit. With rising inflation and looming stagflationary shocks, it is now even more trapped.
The same goes for the European Central Bank, the Bank of Japan and the Bank of England. The stagflation of the 1970s will soon meet the debt crises of the post-2008 period. The question is not if but when.
Nouriel Roubini is CEO of Roubini Macro Associates and Chief Economist at Atlas Capital Team.
This commentary was posted with permission from Project Syndicate — The Looming Stagflationary Debt Crisis.
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