After all, the debt ratios of advanced economies and most emerging markets were much lower in the 1970s, which is why stagflation has not historically been associated with debt crises. On the contrary, the unexpected inflation of the 1970s wiped out the real value of nominal fixed-rate debts, thereby reducing the public debt burden of many advanced economies.
Conversely, during the financial crisis of 2007-08, high debt ratios (private and public) caused a serious debt crisis, with the bursting of real estate bubbles, but the ensuing recession took hold. led to low inflation and even total deflation. Due to the credit crunch, there was a macro shock to aggregate demand, while the risks are now on the supply side.
So we end up with the worst of the stagflation of the 1970s and 2007-10. Debt ratios are much higher than in the 1970s, and a mix of accommodative economic policies and negative supply shocks threatens to fuel inflation rather than deflation, paving the way for the mother of all stagflationary debt crises over the next few years.
For now, accommodating monetary and fiscal policies will continue to fuel asset and credit bubbles, causing an idling train crash. The warning signs are evident in today’s high price-to-earnings ratios, low equity risk premiums, inflated real estate and tech assets, and the irrational exuberance surrounding special-purpose acquisition companies, the crypto industry, high yield corporate debt, private equity, meme stocks and runaway 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 crisis and crash.
But in the meantime, the same loose policies that fuel asset bubbles will continue to drive consumer price inflation, creating the conditions for stagflation whenever the next negative supply shocks occur. Such shocks could result from renewed protectionism; population aging in advanced and emerging economies; immigration restrictions in advanced economies; relocation of manufacturing to high cost regions; or the balkanization of global supply chains.
More broadly, Sino-US decoupling threatens to fragment the global economy at a time when climate change and the covid pandemic are pushing national governments towards greater autonomy. Add to that the production impact of increasingly frequent cyber attacks on critical infrastructure and a social and political backlash against inequality, and the recipe for macroeconomic disruption is complete.
Worse yet, central banks effectively lost their independence because they had no choice but to monetize massive budget deficits to prevent a debt crisis. With public and private debt soaring, they are trapped in debt. As inflation rises over the next few years, central banks will be faced with a dilemma. If they start to phase out unconventional policies and raise key rates to fight inflation, they risk triggering a massive debt crisis and severe recession; but if they maintain loose monetary policy, they risk double-digit inflation and deep stagflation when the next negative supply shocks materialize.
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 may be partly wiped out by unexpected inflation (as happened in the 1970s), emerging market debt denominated in foreign currencies would not. Many of these governments are expected to default and restructure their debts.
At the same time, private debts in advanced economies would become unsustainable (as they did after the global financial crisis) and their spreads against safer government bonds would increase, triggering a chain reaction of defaults. . Heavily indebted companies and their reckless shadow bank creditors would be the first to fall, soon followed by indebted households and the banks that funded them.
Certainly, the real costs of long-term borrowing may initially decline if inflation unexpectedly rises and central banks lag behind. But, over time, these costs will be pushed up by three factors. First, the increase in public and private debt will widen sovereign and private interest rate differentials. Second, rising inflation and increasing uncertainty will lead to higher inflation risk premia. And, third, a rising misery index – the sum of inflation and the unemployment rate – will eventually demand a “Volcker Moment”.
When former Fed Chairman Paul Volcker hiked rates to fight inflation in 1980-82, the result was a severe double-dip recession in the United States and 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-inflationary policies would lead to depression rather than severe recession.
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 eurozone sovereigns and banks after the global financial crisis will repeat itself around the world, sucking households, businesses and shadow banks as well.
As it stands, this idling train wreck seems inevitable. The recent shift of the Fed from an ultra-dovish position to a predominantly accommodative position does not change anything. The Fed has been in the debt trap at least since December 2018, when a stock and credit market crash forced it to reverse its policy tightening a full year before the covid hit. With rising inflation and stagflationary shocks looming, 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, really, but when. © 2021 / Project union
Nouriel Roubini is CEO of Roubini Macro Associates and Chief Economist at Atlas Capital Team.
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