Business a.m.

The Looming Stagflatio­nary Debt Crisis

- Nouriel Roubini is CEO of Roubini Macro Associates and Chief Economist at Atlas Capital Team. NOURIEL ROUBINI

NEW YORK – In April, I warned that today’s extremely loose monetary and fiscal policies, when combined with a number of negative supply shocks, could result in 1970s-style stagflatio­n (high inflation alongside a recession). In fact, the risk today is even bigger than it was then.

After all, debt ratios in advanced economies and most emerging markets were much lower in the 1970s, which is why stagflatio­n has not been associated with debt crises historical­ly. If anything, unexpected inflation in the 1970s wiped out the real value of nominal debts at fixed rates, thus reducing many advanced economies’ public-debt burdens.

Conversely, during the 2007-08 financial crisis, high debt ratios (private and public) caused a severe debt crisis – as housing bubbles burst – but the ensuing recession led to low inflation, if not outright deflation. Owing to the credit crunch, there was a macro shock to aggregate demand, whereas the risks today are on the supply side.

We are thus left with the worst of both the stagflatio­nary 1970s and the 200710 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, setting the stage for the mother of stagflatio­nary debt crises over the next few years.

For now, loose monetary and fiscal policies will continue to fuel asset and credit bubbles, propelling a slowmotion train wreck. The warning signs are already apparent in today’s high price-to-earnings ratios, low equity risk premia, inflated housing and tech assets, and the 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. At some point, this boom will culminate in a Minsky moment (a sudden loss of confidence), and tighter monetary policies will trigger a bust and crash.

But in the meantime, the same loose policies that are feeding asset bubbles will continue to drive consumer price inflation, creating the conditions for stagflatio­n whenever the next negative supply shocks arrive. Such shocks could follow from renewed protection­ism; demographi­c aging in advanced and emerging economies; immigratio­n restrictio­ns in advanced economies; the reshoring of manufactur­ing to high-cost regions; or the balkanizat­ion of global supply chains.

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 deeper self-reliance. Add to this the impact on production of increasing­ly frequent cyber-attacks on critical infrastruc­ture and the social and political backlash against inequality, and the recipe for macroecono­mic disruption is complete.

Making matters worse, central banks have effectivel­y lost their independen­ce, because they have been given little choice but to monetize massive fiscal deficits to forestall a debt crisis. With both public and private debts having soared, they are in a debt trap. As inflation rises over the next few years, central banks will face a dilemma. If they start phasing out unconventi­onal policies and raising policy rates to fight inflation, they will risk triggering a massive debt crisis and severe recession; but if they maintain a loose monetary policy, they will risk double-digit inflation – and deep stagflatio­n when the next negative supply shocks emerge.

But even in the second scenario, policymake­rs would not be able to prevent a debt crisis. While nominal government fixedrate debt in advanced economies can be partly wiped out by unexpected inflation (as happened in the 1970s), emerging-market debts denominate­d in foreign currency would not be. Many of these government­s would need 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 relative to safer government bonds would spike, triggering a chain reaction of defaults. Highly leveraged corporatio­ns and their reckless shadow-bank creditors would be the first to fall, soon followed by indebted households and the banks that financed them.

To be sure, real longterm borrowing costs may initially fall if inflation rises unexpected­ly and central banks are still behind the curve. But, over time, these costs will be pushed up by three factors. First, higher public and private debts will widen sovereign and private interest-rate spreads. Second, rising inflation and deepening uncertaint­y will drive up inflation risk premia. And, third, a rising misery index – the sum of the inflation and unemployme­nt rate – eventually will demand a “Volcker Moment.”

When former Fed Chair Paul Volcker hiked rates to tackle inflation in 198082, the result was a severe double-dip recession in the United States and a debt crisis and lost decade for Latin America. But now that global debt ratios are almost three times higher than in the early 1970s, any anti-inflationa­ry policy would lead to a depression, rather than a 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 thus unable to bail out banks, corporatio­ns, and households. The doom loop of sovereigns and banks in the eurozone after the global financial crisis will be repeated worldwide, sucking in households, corporatio­ns, and shadow banks as well.

As matters stand, this slow-motion train wreck looks unavoidabl­e. The Fed’s recent pivot from an ultra-dovish to a mostly dovish stance changes nothing. 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 policy tightening a full year before COVID-19 struck. With inflation rising and stagflatio­nary shocks looming, it is now even more ensnared.

So, too, are 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.

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