A new debt crisis is ahead of us

Posted July 14, 2022 at 17:23

The global financial and economic outlook for the rest of the year has rapidly deteriorated in recent months. Political leaders, investors and households are wondering how they are going to have to change their behavior. And how long. This will depend on the answers to six questions.

First, inflation. The debate is now largely resolved: the sustained inflation camp has won, while the transitional inflation camp – which yesterday included most central banks and budgetary authorities – can only admit its mistake.

Second question: was the rise in inflation more caused by excessive aggregate demand (accommodating monetary, fiscal and credit policies) or by the various negative aggregate supply shocks (lockdowns, supply chain strangulation bottlenecks, war in Ukraine and China’s zero zero ‘policy); ? It is now widely accepted that the former has played a crucial and growing role, which has increased fears of a hard landing (rising unemployment and potential recession) as monetary policy tightens.

Possible recession

This leads us directly to the third question: will the tightening of monetary policy by the US Federal Reserve and other major central banks result in a hard landing or a soft landing? Consensus, which until now leaned on a soft landing, has changed recently. In the US and Europe, forward-looking indicators related to business and economic activity clearly point to a decline. And Fed Chairman Jerome Powell himself admits the possibility of a recession.

The fourth question is whether a hard landing would weaken central banks’ decision on inflation. If they decide to stop their political tightening when a hard landing becomes very likely, we should expect a sustained rise in inflation and either overheating of the economy or stagflation (inflation over target and recession), depending on whether demand or supply shock dominates .

Most market analysts seem to believe that central banks will remain firm. I’m not sure. I think they will retreat and accept inflation – followed by stagflation – because they fear the damage of a recession and a debt trap, given an excessive accumulation of private and public debt after years of low interest rates.

A crisis that cannot be compared to 2008

As the hard landing becomes the base scenario for more and more analysts, a fifth and new question arises: will the coming recession be mild and short, or more severe and marked by deep economic difficulties? Most of those who have too late and reluctantly accepted the idea of ​​a hard landing scenario argue that the recession will be small and short, given that the current financial imbalances are not as severe as those of 2008. This view is , however dangerously naive.

There are many reasons to believe that the next recession will be marked by a severe debt crisis of a stagflationary nature. As a share of global GDP, the level of private and public debt is now very high, rising from 200% in 1999 to 350% today. Under these conditions, a rapid normalization of monetary policy and a rise in interest rates will push heavily indebted and already struggling households, companies, financial institutions and governments into bankruptcy and default.

The next crisis will not be comparable to the previous ones. In the 1970s, we experienced stagflation without a major debt crisis as debt levels remained low. After 2008, we experienced a debt crisis followed by low inflation or deflation, as the credit crunch led to a negative demand shock.

Today, we are facing several supply shocks against the background of much higher debt levels, which means that we are heading towards a combination of stagflation in 1970s style and 2008-like debt crises, ie. against a stagflationary debt crisis.

Everywhere the bubbles are emptied

In the face of stagflationary shocks, a central bank must tighten its political stance even as the economy is heading into a recession. Moreover, the potential for fiscal expansion will also be limited this time. Most of the budget ammunition has already been used up and public debt is becoming unsustainable.

And to the extent that central banks are tightening at the same time, they are increasing the likelihood of a synchronized global recession. This tightening is already having an effect: bubbles are being emptied everywhere – in public and private capital, real estate, housing, cryptocurrencies, SPACs, bonds and even credit instruments. Real and financial wealth are declining, while debt and debt service ratios are rising.

This brings us to the last question: will stock markets rise or dive even deeper? They are likely to crumble further. Typically during recessions, US and global equities tend to fall around 35%. However, as the next recession looks set to become both stagflationary and accompanied by a financial crisis, the stock market crash could be around 50%.

This text has been published in collaboration with Project Syndicate.

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