Commentary: Warning signs show a coming stagflation is unavoidable

Such shocks could follow from renewed protectionism; demographic ageing in advanced and emerging economies; immigration restrictions in advanced economies; the reshoring of manufacturing to high-cost regions; or the balkanisation 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.

CAN CENTRAL BANKS MAKE A DIFFERENCE?

Making matters worse, central banks have effectively lost their independence, because they have been given little choice but to monetise massive fiscal deficits to forestall a debt crisis. 

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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 fixed-rate 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.

COULD GOVERNMENTS BECOME INSOLVENT?

To be sure, real long-term 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. 

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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 1980-1982, 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.

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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.

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