zinn
2022-10-17 08:11:41 UTC
Inflation is back, and it is rising sharply, especially over the past
year, owing to a mix of both demand and supply factors. This rise in
inflation may not be a short-term phenomenon: the Great Moderation of the
past three decades may be over, and we may be entering a new era of Great
Stagflationary Instability.
Unless you are middle-aged and gray-haired, you probably hadnt heard
about the term stagflation until very recently. You may have barely heard
about inflation. For a long time, until 2021, inflationthe increase in
prices year to yearwas below the advanced economies central banks
target of 2%. Usually inflation is associated with high economic growth.
When aggregate demand for goods, services, and labor is strong, coupled
with positive animal spirits, optimism about the future, and possibly
loose monetary and fiscal policies, you get stronger than potential
economic growth and higher than target inflation. Firms are able to set
higher prices because demand outstrips supply, and workers receive higher
wages given a low unemployment rate. In recessions, on the other hand, you
have low aggregate demand below the potential supply of goods, which leads
to a slack in labor and goods markets, with ensuing low inflation or even
deflation: prices go down as consumers spending declines. Stagflation is
a term that refers to high inflation that happens at the same time as
stagnation of growth or outright recession.
But sometimes the shocks hitting the economy, rather than coming from
changing demand, can come from the supply side: an oil-price shock, say,
or a rise in food or other commodity prices. When that happens, energy and
production costs rise, contributing to lower growth in countries that
import that fuel or food. As a result, you can get a slowdown of growth,
or even a recession, while inflation remains high. If the response to this
negative supply shock is loose monetary and fiscal policybanks setting
low interest rates to encourage borrowingto prevent the slowdown in
growth, you feed the inflation flames by stimulating rather than cooling
demand for goods and labor. Then you end up with persistent stag-flation:
a recession with high inflation.
In the 1970s we had a decade of stagflation as two negative oil shocks and
the wrong policy response led to inflation and recession. The first shock
was triggered by the oil embargo against the U.S. and the West following
the 1973 October War between Israel and the Arab states. The second shock
was triggered by the 1979 Islamic revolution in Iran. In both cases a
spike in oil prices caused a spike in inflation and a recession in the
oil-importing economies of the West. The inflation was fed by the policy
response to the shock because central banks did not rapidly tighten and
impose strong monetary and fiscal policy to contain the inflation. So we
ended up with double-digit inflation and a severe recession that doomed
the presidencies of Gerald Ford and Jimmy Carter. It took a painful
double-dip recession in 1980 and again in 19811982 to break the back of
inflation when Fed Chairman Paul Volcker raised the interest rates to
double-digit levels.
Coming after the stagflation of the 1970s and early 1980s, the Great
Moderation was characterized by low inflation in advanced economies;
relatively stable and robust economic growth, with short and shallow
recessions; low and falling bond yields (and thus positive returns on
bonds), owing to the secular fall in inflation; and sharply rising values
of risky assets such as U.S. and global equities.
This extended period of low inflation is usually explained by central
banks move to credible inflation-targeting policies after the loose
monetary policies of the 1970s, and governments adherence to relatively
conservative fiscal policies (with meaningful stimulus coming only during
recessions). But more important than demand-side policies were the many
positive supply shocks, which increased potential growth and reduced
production costs, thus keeping inflation in check.
During the postCold War era of hyper-globalization, China, Russia, India,
and other emerging-market economies became more integrated in the world
economy, supplying it with low-cost goods, services, energy, and
commodities. Large-scale migration from the poor Global South to the rich
North kept a lid on wages in advanced economies; technological innovations
reduced the costs of producing many goods and services; and relative
geopolitical stability after the fall of the Iron Curtain allowed for an
efficient allocation of production to the least costly locations without
worries about investment security.
The Great Moderation started to crack during the 2008 global financial
crisis and then finally broke during the 2020 COVID-19 recession. In both
cases there were severe recessions and financial stresses, but inflation
initially remained low given demand shocks; thus, loose monetary, fiscal,
and credit policies prevented deflation from setting in more persistently.
But this time its different, as inflation has been rising since 2021, and
many serious and important questions are now emerging and being debated by
economists, policymakers, and investors. What is the nature of the current
inflation? How persistent will it be? Is it driven by bad policiesloose
monetary and fiscal policiesor bad negative aggregate supply shocks? Will
the attempt of central banks to fight inflation lead to a soft landing or
a hard landing? And if the latter, will this be a short and shallow
recession or a more severe and protracted one? Will central banks remain
committed to fight inflation, or will they blink and wimp out and cause
persistent long-term inflation? Is the era of Great Moderation over? And
what will be the market consequence of a return to inflation and
stagflation?
First question: Will the rise in inflation in most advanced economies be
temporary or more persistent? This debate has raged for the past year, but
now it is largely settled: Team Persistent won, and Team
Transitorywhich included most central banks and fiscal authoritieshas
now admitted to having been mistaken.
The second question is whether the increase in inflation was driven more
by bad policies (i.e., excessive aggregate demand because of excessively
loose monetary, credit, and fiscal policies), or by bad luck
(stagflationary negative aggregate supply shocks including the initial
COVID-19 lockdowns, supply-chain bottlenecks, a reduced U.S. labor supply,
the impact of Russias war in Ukraine on commodity prices, and Chinas
zero-COVID policy). While both demand and supply factors were in the mix,
it is now widely recognized that supply factors have played an
increasingly decisive role. This matters because supply-driven inflation
is stagflationary and thus increases the risk of a hard landing (increased
unemployment and potentially a recession) when monetary policy is
tightened.
That leads directly to the third question: Will monetary-policy tightening
by the U.S. Federal Reserve and other major central banks bring a hard
landing (recession) or a soft landing (growth slowdown without a
recession)? Until recently, most central banks and most of Wall Street
were in Team Soft Landing. But the consensus has rapidly shifted, with
even Fed Chair Jerome Powell recognizing that a recession is possible and
that a soft landing will be very challenging.
Will the coming recession be mild and short-lived, or will it be more
severe and characterized by deep financial distress?
A model used by the Federal Reserve Bank of New York shows a high
probability of a hard landing, and the Bank of England has expressed
similar views. Several prominent Wall Street institutions have now decided
that a recession is their baseline scenario (the most likely outcome if
all other variables are held constant). Indeed, in the past 60 years of
U.S. history, whenever inflation has been above 5%it is now above 8%and
the unemployment rate below 5%it is now 3.7%any attempt by the Fed to
bring inflation down to target has caused a hard landing. So,
unfortunately, a hard landing is much more likely than a soft landing in
the U.S. and most other advanced economies.
The Fourth question: Are we in a recession already? In both the U.S. and
Europe, forward-looking indicators of economic activity and business and
consumer confidence are heading sharply south. The U.S. has already had
two consecutive quarters of negative economic growth in the first half of
this year, but job creation was robust, so we werent yet in a formal
recession. But now the labor market is softening, and thus a recession is
likely by years end in the U.S. and other advanced economies.
Now that a hard landing is becoming a baseline for more analysts, a new
fourth question is emerging: Will the coming recession be mild and short-
lived, or will it be more severe and characterized by deep financial
distress? Most of those who have come late and grudgingly to the hard-
landing baseline still contend that any recession will be shallow and
brief. They argue that todays financial imbalances are not as severe as
those in the run-up to the 2008 global financial crisis, and that the risk
of a recession with a severe debt and financial crisis is therefore low.
But this view is dangerously naive.
There is ample reason to believe the next recession will be marked by a
severe stagflationary debt crisis. As a share of global GDP, private and
public debt levels are much higher today than in the past, having risen
from 200% in 1999 to 350% today. Under these conditions, rapid
normalization of monetary policy and rising interest rates will drive
highly leveraged households, companies, financial institutions, and
governments into bankruptcy and default.
When confronting stagflationary shocks, a central bank must tighten its
policy stance even as the economy heads toward a recession. The situation
today is thus fundamentally different from the global financial crisis or
the early months of the pandemic, when central banks could ease monetary
policy aggressively in response to falling aggregate demand and
deflationary pressure. The space for fiscal expansion will also be more
limited this time, and public debts are becoming unsustainable.
Moreover, because todays higher inflation is a global phenomenon, most
central banks are tightening at the same time, thereby increasing the
probability of a synchronized global recession. This tightening is already
having an effect: bubbles are deflating everywhereincluding in public and
private equity, real estate, housing, meme stocks, crypto, SPACs, bonds,
and credit instruments. Real and financial wealth is falling, and debt and
debt-servicing ratios are rising.
Thus, the next crisis will not be like its predecessors. In the 1970s, we
had stagflation but no massive debt crises, because debt levels were low.
After 2008, we had a debt crisis followed by low inflation or deflation,
because the credit crunch had generated a negative demand shock. Today, we
face supply shocks in a context of much higher debt levels, implying that
we are heading for a combination of 1970s-style stagflation and 2008-style
debt crisesthat is, a stagflationary debt crisis.
The fifth question is whether a hard landing would weaken central banks
hawkish resolve on inflation. If they stop their policy tightening once a
hard landing becomes likely, we can expect a persistent rise in inflation
and either economic overheating (above-target inflation and above-
potential growth) or stagflation (above-target inflation and a recession),
depending on whether demand shocks or supply shocks are dominant.
Indeed, while currently the debate is on soft vs. hard landing and how
severe the hard landing will be, that assumes that central banks that are
now talking hawkishly will stick to their commitment to return to 2%
regardless of whether that policy response leads to a soft or hard
landing. Most market analysts seem to think that central banks will remain
hawkish, but I am not so sure. There is a chance that central banks will
wimp out and blink, and not be willing to fight inflation. In this case
the Great Moderation of the past 30 years may be over, and we may enter a
new era of Great Inflationary/Stagflationary Instability fed by negative
supply shocks and policymakersas in the 1970sbeing unwilling to fight
the rising inflation.
On the demand side, loose and unconventional monetary, fiscal, and credit
policies have become not a bug but rather a feature. Between todays
surging stocks of private and public debts (as a share of GDP) and the
huge unfunded liabilities of pay-as-you-go social-security and health
systems, both the private and public sectors face growing financial risks.
Central banks are thus locked in a debt trap: any attempt to normalize
monetary policy will cause debt-servicing burdens to spike, leading to
massive insolvencies and cascading financial crises.
With governments unable to reduce high debts and deficits by spending less
or raising revenues, those that can borrow in their own currency will
increasingly resort to the inflation tax: relying on unexpected price
growth to wipe out long-term nominal liabilities at fixed rates.
Early signs of wimping out are already discernible in the U.K. Faced with
the market reaction to the new governments reckless fiscal stimulus, the
Bank of England has launched an emergency quantitative-easing (QE) program
to buy up government bonds (the yields on which have spiked).
Monetary policy is increasingly subject to fiscal capture. Central banks
will talk tough, but there is good reason to doubt their willingness to do
whatever it takes to return inflation to its target rate in a world of
excessive debt with risks of an economic and financial crash.
On the supply side, the backlash against hyper-globalization has been
gaining momentum, creating opportunities for populist, nativist, and
protectionist politicians. Public anger over stark income and wealth
inequalities also has been building, leading to more policies to support
workers and the left behind. However well intentioned, these policies
are now contributing to a dangerous spiral of wage-price inflation.
Making matters worse, renewed protectionism (from both the left and the
right) has restricted trade and the movement of capital. Political
tensions, both within and between countries, are driving a process of
reshoring. Political resistance to immigration has curtailed the global
movement of people, putting additional upward pressure on wages. National-
security and strategic considerations have further restricted flows of
technology, data, and information.
This balkanization of the global economy is deeply stagflationary, and it
is coinciding with demographic aging, not just in developed countries but
also in large emerging economies such as China. Because young people tend
to produce and save, whereas older people spend down their savings, this
trend also is stagflationary.
The same is true of todays geo-political turmoil. Russias war in
Ukraine, and the Wests response to it, has disrupted the trade of energy,
food, fertilizers, industrial metals, and other commodities. The Western
decoupling from China is accelerating across all dimensions of trade
(goods, services, capital, labor, technology, data, and information).
Other strategic rivals to the West may soon add to the havoc. Irans
crossing the nuclear-weapons threshold would likely provoke military
strikes by Israel or even the U.S., triggering a massive oil shock.
Now that the U.S. dollar has been fully weaponized for strategic and
national-security purposes, its position as the main global reserve
currency may begin to decline, and a weaker dollar would of course add to
the inflationary pressures. A frictionless world trading system requires a
frictionless financial system. But sweeping primary and secondary
sanctions against Russia have thrown sand into this well-oiled machine,
massively increasing the transaction costs of trade.
On top of it all, climate change, too, is stagflationary. Droughts, heat
waves, hurricanes, and other disasters are increasingly disrupting
economic activity and threatening harvests (thus driving up food prices).
At the same time, demands for decarbonization have led to underinvestment
in fossil-fuel capacity before investment in renewables has reached the
point where they can make up the difference. Todays large energy-price
spikes were inevitable.
Pandemics will also be a persistent threat, lending further momentum to
protectionist policies as countries rush to hoard critical supplies of
food, medicines, and other essential goods. After 2œ years of COVID-19, we
now have monkeypox.
Finally, cyberwarfare remains an underappreciated threat to economic
activity and even public safety. Firms and governments will either face
more stagflationary disruptions to production, or they will have to spend
a fortune on cyber-security. Either way, costs will rise.
Thus, as in the 1970s, persistent and repeated negative supply shocks will
combine with loose monetary, fiscal, and credit policies to produce
stagflation. Moreover, high debt ratios will create the conditions for
stag-flationary debt crises; i.e., the worst of the 1970s and the worst of
the post-global-financial-crisis period.
That leads to a final question: How will financial markets and asset
pricesequities and bondsperform in an era of rising inflation and return
to stagflation? It is likely that both components of any traditional asset
portfoliolong-term bonds and U.S. and global equitieswill suffer,
potentially incurring massive losses. Losses will occur on bond
portfolios, as rising inflation increases bond yields and reduces their
prices. And inflation is also bad for equities, as rising interest rates
hurt the valuation of firms stock. By 1982, at the peak of the
stagflation decade, the price-to-earning ratio of S&P 500 firms was down
to 8; today it is closer to 20. The risk today is a protracted and more
severe bear market. Indeed, for the first time in decades, a 60/40
portfolio of equities and bonds has suffered massive losses in 2022, as
bond yields have surged while equities have gone into a bear market.
Investors need to find assets that will hedge them against inflation,
political and geopolitical risks, and environmental damage: these include
short-term government bonds and inflation-indexed bonds, gold and other
precious metals, and real estate that is resilient to environmental
damage.
The decade ahead may well be a Stagflationary Debt Crisis the likes of
which weve never seen before.
Adapted from MegaThreats: Ten Dangerous Trends That Imperil Our Future,
and How to Survive Them, published by Little Brown on October 18th
https://time.com/6221771/stagflation-crisis-debt-nouriel-roubini/
year, owing to a mix of both demand and supply factors. This rise in
inflation may not be a short-term phenomenon: the Great Moderation of the
past three decades may be over, and we may be entering a new era of Great
Stagflationary Instability.
Unless you are middle-aged and gray-haired, you probably hadnt heard
about the term stagflation until very recently. You may have barely heard
about inflation. For a long time, until 2021, inflationthe increase in
prices year to yearwas below the advanced economies central banks
target of 2%. Usually inflation is associated with high economic growth.
When aggregate demand for goods, services, and labor is strong, coupled
with positive animal spirits, optimism about the future, and possibly
loose monetary and fiscal policies, you get stronger than potential
economic growth and higher than target inflation. Firms are able to set
higher prices because demand outstrips supply, and workers receive higher
wages given a low unemployment rate. In recessions, on the other hand, you
have low aggregate demand below the potential supply of goods, which leads
to a slack in labor and goods markets, with ensuing low inflation or even
deflation: prices go down as consumers spending declines. Stagflation is
a term that refers to high inflation that happens at the same time as
stagnation of growth or outright recession.
But sometimes the shocks hitting the economy, rather than coming from
changing demand, can come from the supply side: an oil-price shock, say,
or a rise in food or other commodity prices. When that happens, energy and
production costs rise, contributing to lower growth in countries that
import that fuel or food. As a result, you can get a slowdown of growth,
or even a recession, while inflation remains high. If the response to this
negative supply shock is loose monetary and fiscal policybanks setting
low interest rates to encourage borrowingto prevent the slowdown in
growth, you feed the inflation flames by stimulating rather than cooling
demand for goods and labor. Then you end up with persistent stag-flation:
a recession with high inflation.
In the 1970s we had a decade of stagflation as two negative oil shocks and
the wrong policy response led to inflation and recession. The first shock
was triggered by the oil embargo against the U.S. and the West following
the 1973 October War between Israel and the Arab states. The second shock
was triggered by the 1979 Islamic revolution in Iran. In both cases a
spike in oil prices caused a spike in inflation and a recession in the
oil-importing economies of the West. The inflation was fed by the policy
response to the shock because central banks did not rapidly tighten and
impose strong monetary and fiscal policy to contain the inflation. So we
ended up with double-digit inflation and a severe recession that doomed
the presidencies of Gerald Ford and Jimmy Carter. It took a painful
double-dip recession in 1980 and again in 19811982 to break the back of
inflation when Fed Chairman Paul Volcker raised the interest rates to
double-digit levels.
Coming after the stagflation of the 1970s and early 1980s, the Great
Moderation was characterized by low inflation in advanced economies;
relatively stable and robust economic growth, with short and shallow
recessions; low and falling bond yields (and thus positive returns on
bonds), owing to the secular fall in inflation; and sharply rising values
of risky assets such as U.S. and global equities.
This extended period of low inflation is usually explained by central
banks move to credible inflation-targeting policies after the loose
monetary policies of the 1970s, and governments adherence to relatively
conservative fiscal policies (with meaningful stimulus coming only during
recessions). But more important than demand-side policies were the many
positive supply shocks, which increased potential growth and reduced
production costs, thus keeping inflation in check.
During the postCold War era of hyper-globalization, China, Russia, India,
and other emerging-market economies became more integrated in the world
economy, supplying it with low-cost goods, services, energy, and
commodities. Large-scale migration from the poor Global South to the rich
North kept a lid on wages in advanced economies; technological innovations
reduced the costs of producing many goods and services; and relative
geopolitical stability after the fall of the Iron Curtain allowed for an
efficient allocation of production to the least costly locations without
worries about investment security.
The Great Moderation started to crack during the 2008 global financial
crisis and then finally broke during the 2020 COVID-19 recession. In both
cases there were severe recessions and financial stresses, but inflation
initially remained low given demand shocks; thus, loose monetary, fiscal,
and credit policies prevented deflation from setting in more persistently.
But this time its different, as inflation has been rising since 2021, and
many serious and important questions are now emerging and being debated by
economists, policymakers, and investors. What is the nature of the current
inflation? How persistent will it be? Is it driven by bad policiesloose
monetary and fiscal policiesor bad negative aggregate supply shocks? Will
the attempt of central banks to fight inflation lead to a soft landing or
a hard landing? And if the latter, will this be a short and shallow
recession or a more severe and protracted one? Will central banks remain
committed to fight inflation, or will they blink and wimp out and cause
persistent long-term inflation? Is the era of Great Moderation over? And
what will be the market consequence of a return to inflation and
stagflation?
First question: Will the rise in inflation in most advanced economies be
temporary or more persistent? This debate has raged for the past year, but
now it is largely settled: Team Persistent won, and Team
Transitorywhich included most central banks and fiscal authoritieshas
now admitted to having been mistaken.
The second question is whether the increase in inflation was driven more
by bad policies (i.e., excessive aggregate demand because of excessively
loose monetary, credit, and fiscal policies), or by bad luck
(stagflationary negative aggregate supply shocks including the initial
COVID-19 lockdowns, supply-chain bottlenecks, a reduced U.S. labor supply,
the impact of Russias war in Ukraine on commodity prices, and Chinas
zero-COVID policy). While both demand and supply factors were in the mix,
it is now widely recognized that supply factors have played an
increasingly decisive role. This matters because supply-driven inflation
is stagflationary and thus increases the risk of a hard landing (increased
unemployment and potentially a recession) when monetary policy is
tightened.
That leads directly to the third question: Will monetary-policy tightening
by the U.S. Federal Reserve and other major central banks bring a hard
landing (recession) or a soft landing (growth slowdown without a
recession)? Until recently, most central banks and most of Wall Street
were in Team Soft Landing. But the consensus has rapidly shifted, with
even Fed Chair Jerome Powell recognizing that a recession is possible and
that a soft landing will be very challenging.
Will the coming recession be mild and short-lived, or will it be more
severe and characterized by deep financial distress?
A model used by the Federal Reserve Bank of New York shows a high
probability of a hard landing, and the Bank of England has expressed
similar views. Several prominent Wall Street institutions have now decided
that a recession is their baseline scenario (the most likely outcome if
all other variables are held constant). Indeed, in the past 60 years of
U.S. history, whenever inflation has been above 5%it is now above 8%and
the unemployment rate below 5%it is now 3.7%any attempt by the Fed to
bring inflation down to target has caused a hard landing. So,
unfortunately, a hard landing is much more likely than a soft landing in
the U.S. and most other advanced economies.
The Fourth question: Are we in a recession already? In both the U.S. and
Europe, forward-looking indicators of economic activity and business and
consumer confidence are heading sharply south. The U.S. has already had
two consecutive quarters of negative economic growth in the first half of
this year, but job creation was robust, so we werent yet in a formal
recession. But now the labor market is softening, and thus a recession is
likely by years end in the U.S. and other advanced economies.
Now that a hard landing is becoming a baseline for more analysts, a new
fourth question is emerging: Will the coming recession be mild and short-
lived, or will it be more severe and characterized by deep financial
distress? Most of those who have come late and grudgingly to the hard-
landing baseline still contend that any recession will be shallow and
brief. They argue that todays financial imbalances are not as severe as
those in the run-up to the 2008 global financial crisis, and that the risk
of a recession with a severe debt and financial crisis is therefore low.
But this view is dangerously naive.
There is ample reason to believe the next recession will be marked by a
severe stagflationary debt crisis. As a share of global GDP, private and
public debt levels are much higher today than in the past, having risen
from 200% in 1999 to 350% today. Under these conditions, rapid
normalization of monetary policy and rising interest rates will drive
highly leveraged households, companies, financial institutions, and
governments into bankruptcy and default.
When confronting stagflationary shocks, a central bank must tighten its
policy stance even as the economy heads toward a recession. The situation
today is thus fundamentally different from the global financial crisis or
the early months of the pandemic, when central banks could ease monetary
policy aggressively in response to falling aggregate demand and
deflationary pressure. The space for fiscal expansion will also be more
limited this time, and public debts are becoming unsustainable.
Moreover, because todays higher inflation is a global phenomenon, most
central banks are tightening at the same time, thereby increasing the
probability of a synchronized global recession. This tightening is already
having an effect: bubbles are deflating everywhereincluding in public and
private equity, real estate, housing, meme stocks, crypto, SPACs, bonds,
and credit instruments. Real and financial wealth is falling, and debt and
debt-servicing ratios are rising.
Thus, the next crisis will not be like its predecessors. In the 1970s, we
had stagflation but no massive debt crises, because debt levels were low.
After 2008, we had a debt crisis followed by low inflation or deflation,
because the credit crunch had generated a negative demand shock. Today, we
face supply shocks in a context of much higher debt levels, implying that
we are heading for a combination of 1970s-style stagflation and 2008-style
debt crisesthat is, a stagflationary debt crisis.
The fifth question is whether a hard landing would weaken central banks
hawkish resolve on inflation. If they stop their policy tightening once a
hard landing becomes likely, we can expect a persistent rise in inflation
and either economic overheating (above-target inflation and above-
potential growth) or stagflation (above-target inflation and a recession),
depending on whether demand shocks or supply shocks are dominant.
Indeed, while currently the debate is on soft vs. hard landing and how
severe the hard landing will be, that assumes that central banks that are
now talking hawkishly will stick to their commitment to return to 2%
regardless of whether that policy response leads to a soft or hard
landing. Most market analysts seem to think that central banks will remain
hawkish, but I am not so sure. There is a chance that central banks will
wimp out and blink, and not be willing to fight inflation. In this case
the Great Moderation of the past 30 years may be over, and we may enter a
new era of Great Inflationary/Stagflationary Instability fed by negative
supply shocks and policymakersas in the 1970sbeing unwilling to fight
the rising inflation.
On the demand side, loose and unconventional monetary, fiscal, and credit
policies have become not a bug but rather a feature. Between todays
surging stocks of private and public debts (as a share of GDP) and the
huge unfunded liabilities of pay-as-you-go social-security and health
systems, both the private and public sectors face growing financial risks.
Central banks are thus locked in a debt trap: any attempt to normalize
monetary policy will cause debt-servicing burdens to spike, leading to
massive insolvencies and cascading financial crises.
With governments unable to reduce high debts and deficits by spending less
or raising revenues, those that can borrow in their own currency will
increasingly resort to the inflation tax: relying on unexpected price
growth to wipe out long-term nominal liabilities at fixed rates.
Early signs of wimping out are already discernible in the U.K. Faced with
the market reaction to the new governments reckless fiscal stimulus, the
Bank of England has launched an emergency quantitative-easing (QE) program
to buy up government bonds (the yields on which have spiked).
Monetary policy is increasingly subject to fiscal capture. Central banks
will talk tough, but there is good reason to doubt their willingness to do
whatever it takes to return inflation to its target rate in a world of
excessive debt with risks of an economic and financial crash.
On the supply side, the backlash against hyper-globalization has been
gaining momentum, creating opportunities for populist, nativist, and
protectionist politicians. Public anger over stark income and wealth
inequalities also has been building, leading to more policies to support
workers and the left behind. However well intentioned, these policies
are now contributing to a dangerous spiral of wage-price inflation.
Making matters worse, renewed protectionism (from both the left and the
right) has restricted trade and the movement of capital. Political
tensions, both within and between countries, are driving a process of
reshoring. Political resistance to immigration has curtailed the global
movement of people, putting additional upward pressure on wages. National-
security and strategic considerations have further restricted flows of
technology, data, and information.
This balkanization of the global economy is deeply stagflationary, and it
is coinciding with demographic aging, not just in developed countries but
also in large emerging economies such as China. Because young people tend
to produce and save, whereas older people spend down their savings, this
trend also is stagflationary.
The same is true of todays geo-political turmoil. Russias war in
Ukraine, and the Wests response to it, has disrupted the trade of energy,
food, fertilizers, industrial metals, and other commodities. The Western
decoupling from China is accelerating across all dimensions of trade
(goods, services, capital, labor, technology, data, and information).
Other strategic rivals to the West may soon add to the havoc. Irans
crossing the nuclear-weapons threshold would likely provoke military
strikes by Israel or even the U.S., triggering a massive oil shock.
Now that the U.S. dollar has been fully weaponized for strategic and
national-security purposes, its position as the main global reserve
currency may begin to decline, and a weaker dollar would of course add to
the inflationary pressures. A frictionless world trading system requires a
frictionless financial system. But sweeping primary and secondary
sanctions against Russia have thrown sand into this well-oiled machine,
massively increasing the transaction costs of trade.
On top of it all, climate change, too, is stagflationary. Droughts, heat
waves, hurricanes, and other disasters are increasingly disrupting
economic activity and threatening harvests (thus driving up food prices).
At the same time, demands for decarbonization have led to underinvestment
in fossil-fuel capacity before investment in renewables has reached the
point where they can make up the difference. Todays large energy-price
spikes were inevitable.
Pandemics will also be a persistent threat, lending further momentum to
protectionist policies as countries rush to hoard critical supplies of
food, medicines, and other essential goods. After 2œ years of COVID-19, we
now have monkeypox.
Finally, cyberwarfare remains an underappreciated threat to economic
activity and even public safety. Firms and governments will either face
more stagflationary disruptions to production, or they will have to spend
a fortune on cyber-security. Either way, costs will rise.
Thus, as in the 1970s, persistent and repeated negative supply shocks will
combine with loose monetary, fiscal, and credit policies to produce
stagflation. Moreover, high debt ratios will create the conditions for
stag-flationary debt crises; i.e., the worst of the 1970s and the worst of
the post-global-financial-crisis period.
That leads to a final question: How will financial markets and asset
pricesequities and bondsperform in an era of rising inflation and return
to stagflation? It is likely that both components of any traditional asset
portfoliolong-term bonds and U.S. and global equitieswill suffer,
potentially incurring massive losses. Losses will occur on bond
portfolios, as rising inflation increases bond yields and reduces their
prices. And inflation is also bad for equities, as rising interest rates
hurt the valuation of firms stock. By 1982, at the peak of the
stagflation decade, the price-to-earning ratio of S&P 500 firms was down
to 8; today it is closer to 20. The risk today is a protracted and more
severe bear market. Indeed, for the first time in decades, a 60/40
portfolio of equities and bonds has suffered massive losses in 2022, as
bond yields have surged while equities have gone into a bear market.
Investors need to find assets that will hedge them against inflation,
political and geopolitical risks, and environmental damage: these include
short-term government bonds and inflation-indexed bonds, gold and other
precious metals, and real estate that is resilient to environmental
damage.
The decade ahead may well be a Stagflationary Debt Crisis the likes of
which weve never seen before.
Adapted from MegaThreats: Ten Dangerous Trends That Imperil Our Future,
and How to Survive Them, published by Little Brown on October 18th
https://time.com/6221771/stagflation-crisis-debt-nouriel-roubini/