Opinion: Opinion: High debt and stagflation will bring about the mother of all financial crises

NEW YORK (Project Syndicate)—The world economy is teetering towards an unprecedented confluence of economic, financial and debt crises, following the explosion of deficits, loans and leverage in recent decades.

In the private sector, the debt mountain includes households (such as mortgages, credit cards, auto loans, student loans, personal loans), businesses and corporations (bank loans, bond debt, and private debt), and the financial sector (liabilities of banking and non-banking institutions).

In the public sector, it includes central, provincial and local government bonds and other formal liabilities, as well as implicit debts such as unfunded liabilities from unfunded pension schemes and health care systems, which will continue to grow as societies age.

Stunning debt loads

Just looking at explicit debts, the figures are staggering. Globally, total public and private sector debt as a percentage of gross domestic product rose from 200% in 1999 to 350% in 2021. The ratio is now 420% in advanced economies and 330% in China.

In the United States it is 420%, which is higher than during the Great Depression and after World War II.

Of course, debt can stimulate economic activity if borrowers invest in new capital (machinery, houses, public infrastructure) that produces returns in excess of the cost of the loan. But much of the borrowing simply goes to finance consumer spending above your income on an ongoing basis, and that’s a recipe for failure.

Furthermore, investments in “equity” can also be risky, whether the borrower is a family buying a house at an artificially inflated price, a company looking to expand too fast regardless of yields, or a government spending the money on “white elephants” ” (extravagant but useless infrastructure projects).

Excessive loans

This over-indebtedness has been going on for decades, for various reasons. The democratization of finance has allowed income-strapped households to finance consumption with debt. Center-right governments have consistently cut taxes without also cutting spending, while centre-left governments have spent lavishly on social programs that are not fully financed with sufficiently higher taxes.

And fiscal policies that favor debt over equity, encouraged by central banks’ extremely accommodative monetary and credit policies, have fueled a surge in borrowing in both the private and public sectors.

Years of quantitative easing (QE) and credit easing kept borrowing costs close to zero TMUBMUSD10Y,
and in some cases even negative (as in Europe and Japan until recently). By 2020, the negative-yielding dollar-equivalent government debt was $17 trillion, and in some Nordic countries even mortgages had negative nominal interest rates.

Insolvent zombies

The explosion of unsustainable leverage meant that many borrowers – households, corporations, banks, shadow banks, governments and even entire countries – were insolvent “zombies” who were propped up by low interest rates (which kept their service costs manageable debt).

During the 2008 global financial crisis and the COVID-19 crisis, many would-be defaulted agents were bailed out by zero or negative interest rate policies, QE, and outright tax bailouts.

But now, inflation, fueled by the same extremely accommodative fiscal, monetary and credit policies, has ended this financial Dawn of the Dead. With central banks forced to raise interest rates FF00,

in an effort to restore price stability, zombies are experiencing sharp increases in their debt service costs.

For many, this represents a triple whammy, because inflation is also eroding real household incomes and reducing the value of household assets, such as houses and SPX stocks.
The same is true for overleveraged and fragile corporations, financial institutions and governments: They are simultaneously dealing with soaring financing costs, falling incomes and revenues, and declining asset values.

The worst of both worlds

Worse, these developments coincide with the return of stagflation (high inflation alongside weak growth). The last time advanced economies experienced such conditions was in the 1970s. But at least then, debt-to-GDP ratios were very low. Today we are facing the worst aspects of the 1970s (stagflationary shocks) alongside the worst aspects of the global financial crisis. And this time we can’t just cut interest rates to stimulate demand.

After all, the global economy is being hit by persistent short- to medium-term negative supply shocks that are reducing growth and raising prices and input costs.

These include pandemic disruptions in the supply of jobs and goods; the impact of Russia’s war in Ukraine on commodity prices; China’s increasingly disastrous zero-COVID policy; and a dozen other medium-term shocks, from climate change to geopolitical developments, that will create further stagflationary pressures.

Unlike the 2008 financial crisis and the early months of COVID-19, simply bailing out private and public agents with loose macroeconomic policies would have added more fuel to the inflationary fire. This means that there will be a hard landing, a deep and protracted recession, as well as a major financial crisis. As asset bubbles burst, debt service rates rise, and inflation-adjusted incomes fall for households, corporations, and governments, the economic crisis and financial meltdown will feed into each other.

Indeed, advanced economies that borrow in their own currency can exploit an unexpected surge in inflation to reduce the real value of some nominal long-term fixed-rate debt. With governments reluctant to raise taxes or cut spending to reduce their deficits, central bank deficit monetization will once again be seen as the path of least resistance.

But you can’t fool all the people all the time. Once the inflation genie comes out of the bottle – which is what will happen when central banks abandon the fight in the face of impending economic and financial collapse – nominal and real borrowing costs will soar. The mother of all stagflationary debt crises can be postponed, not avoided.

Nouriel Roubini, professor emeritus of economics at New York University’s Stern School of Business, is the author of “MegaThreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them” (Little, Brown and Company, 2022).

This comment was posted with the permission of Project Syndicate — The Inevitable Crash

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