Opinion: With the world economy being pressured from all sides, the Great Stagnation has come

NEW YORK (Project Syndicate) – The world economy is undergoing a radical regime change. Decades of Great Moderation are over.

After the stagflation (high inflation and severe recessions) 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 hence positive bond yields) due to the secular fall in inflation; and sharply rising values ​​of risky assets such as US, SPX, -0.35% DJIA, -0.13% COMP, -1.08% and global equities GDOW, -0.19%.

This prolonged period of low inflation can usually be explained by central banks moving to credible inflationary policies after the easy monetary policies of the 1970s and governments sticking to relatively conservative fiscal policies (with significant stimulus only during recessions). But more important than demand-side measures have been the many positive supply shocks, which have boosted potential growth and lowered production costs, thereby keeping inflation in check.

Reduction of production costs

During the post-Cold War era of hyper-globalization, China, Russia and other emerging economies became more integrated into the world economy, providing it with low-cost goods, services, energy and raw materials. Large-scale migration from the Global South to the North kept wages in check in advanced economies, technological innovations reduced the cost of producing many goods and services, and relative geopolitical stability allowed production to be efficiently allocated to the most cost-effective locations without concern about investment security.

But the Great Moderation began to break during the 2008 global financial crisis and then during the 2020 COVID-19 recession. In both cases inflation initially remained subdued in the face of demand shocks and easy monetary, fiscal and credit policies prevented the onset of deflation. But now inflation is back and rising sharply, particularly over the past year, due to a mix of demand and supply factors.

On the supply side, the backlash against hyper-globalization has gained momentum, creating opportunities for populist, nativist and protectionist politicians. Public anger at the stark income and wealth disparity has also increased, prompting more action to support workers and the ‘left behind’. Well-intentioned as they are, they are now contributing to a dangerous spiral of wage-price inflation.

political resistance

To make matters worse, renewed protectionism (from both left and right) has restricted trade and the movement of capital. Political tensions (both within and between countries) are driving a process of reshoring (and “friend-shoring”). Political opposition to immigration has restricted the global movement of people and put additional upward pressure on wages. National security and strategic considerations have further restricted the flow of technology, data and information. And new labor and environmental standards, important as they are, are hampering trade and new construction.

This balkanization of the world economy is deeply stagflationary and coincides with demographic aging, not only in developed countries but also in large emerging economies like China. Since young people tend to produce and save while older people spend their savings, this trend is also stagflationary.

The same is true of today’s geopolitical turmoil.

Russia’s war in Ukraine and the West’s response to it have disrupted trade in energy, food, fertilizers, industrial metals and other commodities. Western decoupling from China is accelerating in all dimensions of trade (goods, services, capital, labour, technology, data and information).

Other strategic Western rivals may soon be adding to the chaos. Iran crossing the nuclear weapons threshold would likely provoke military strikes by Israel or even the United States and trigger a massive oil shock; and North Korea still regularly rattles its nuclear saber.

climate change

Now that the US Dollar BUXX, +0.02%, has been fully armed for strategic and national security purposes, its position as the main global reserve currency may start to decline and a weaker dollar would of course increase inflationary pressures. A smooth world trading system requires a smooth financial system. But sweeping primary and secondary sanctions have thrown a spanner in the works and massively increased the transaction costs of trade.

On top of that, climate change is also 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, calls for decarbonization have led to underinvestment in fossil fuel capacity before renewable energy investments have reached the point where they can make up the difference. Today’s big energy price spikes CL00, +0.07% NG00, +3.22% were therefore inevitable.

Pandemics will also be an ongoing threat, giving further impetus to protectionist strategies as countries rush to stockpile essential stocks of food, medicines and other essential supplies. After two and a half years of COVID-19, we now have monkeypox. And due to human encroachment on fragile ecosystems and the melting of Siberia’s permafrost, we could soon be dealing with dangerous viruses and bacteria that have been locked away for millennia.

Finally, cyber warfare remains an underestimated threat to economic activity and even public safety. Businesses and governments will either face more stagflationary production disruptions or spend fortunes on cybersecurity. In any case, the costs will increase.

On the demand side, loose and unconventional monetary, fiscal and credit policies have become a feature of the new regime, not a problem. With today’s rising levels of private and public debt (as a percentage of GDP) and the huge unfunded liabilities of pay-as-you-go social security and healthcare systems, both the private and public sectors face increasing financial risks. Central banks are thus caught in a “debt trap”: any attempt to normalize monetary policy will cause debt service burdens to skyrocket, leading to massive insolvencies, cascading financial crises and impacts on the real economy.

With governments unable to reduce high debt and deficits through lower spending or higher revenues, those able to borrow in their own currency will increasingly resort to the “inflation tax”: relying on unexpected price increases to inflate long-term debt wipe out nominal debt at fixed interest rates.

Thus, as in the 1970s, sustained and repeated negative supply shocks are combined with easy monetary, fiscal, and credit policies to produce stagflation. In addition, high debt ratios will create the conditions for stagflationary debt crises. During the Great Stagflation, both components of any traditional investment portfolio – long-dated bonds TMUBMUSD10Y, 2.793% and US and global equities – will suffer and potentially incur massive losses.

Nouriel Roubini, Professor Emeritus of Economics at New York University’s Stern School of Business, is Chief Economist on the Atlas Capital team and author of the forthcoming “MegaThreats: Ten Dangerous Trends Threatening Our Future And How To Survive Them(Little, Brown and Company, October 2022).

This comment is published with permission from Project Syndicate – From Great Moderation to Great Stagflation

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