NEW YORK (Project Syndicate) – The global financial and economic outlook for the coming year has deteriorated rapidly in recent months, with policymakers, investors and households now asking how much and for how long to revise their expectations.
That depends on the answers to six questions.
First, will the rise in inflation in most advanced economies be temporary or more persistent? This debate has been raging for the past year, but now it’s largely resolved: “Team Persistent” won, and “Team Transitory” — which previously involved most central banks and fiscal authorities — admits they were mistaken.
† Regardless of whether the recession is mild or severe, history suggests that the stock market has a lot more room to fall before bottoming out. †
The second question is whether the rise in inflation was driven more by excessive aggregate demand (easy monetary, credit and fiscal policies) or by stagflation negative aggregate supply shocks (including the initial COVID-19 lockdowns, supply chain bottlenecks, a reduced labor supply, the impact of the Russian war in Ukraine on commodity prices and China’s “zero-COVID” policy).
While both supply and demand factors played a role, it is now widely recognized that supply factors have played an increasingly decisive role. This matters because supply-driven inflation is stagnant and so increases the risk of a hard landing (higher unemployment and possibly a recession) if monetary policy is tightened.
Hard or soft landing?
That leads directly to the third question: Will monetary policy FF00,
hard or soft landing by the Federal Reserve and other major central banks? Until recently, most central banks and most of Wall Street occupied ‘Team Soft Landing’. But the consensus has quickly shifted, with even Fed Chair Jerome Powell recognizing that a recession is possible and that a soft landing will be “challenging.”
In addition, a model from the Federal Reserve Bank of New York shows a high probability of a hard landing, and the Bank of England has expressed similar views. Several prominent Wall Street institutions have now decided that a recession is their base case (the most likely outcome if all other variables are held constant). In both the United States and Europe, forward-looking indicators of economic activity and business and consumer confidence are moving sharply south.
The fourth question is whether a hard landing would weaken the central banks’ aggressive decision on inflation. If they stop their policy tightening as soon as a hard landing becomes likely, we can expect a continued rise in inflation and either economic overheating (above target and above potential growth) or stagflation (above target inflation and recession), depending on whether demand shocks or supply shocks are dominant.
Most market analysts seem to think that central banks will continue to be aggressive, but I’m not so sure. I have argued that they will eventually pass out and accept higher inflation – followed by stagflation – once a hard landing is imminent, because they will worry about the damage of a recession and a debt trap from an excessive private sector build-up. and public liabilities after years of low interest.
As a hard landing becomes the basis for more analysts, a new (fifth) question arises: will the coming recession be mild and short-lived, or will it be more severe and marked by deep financial problems?
Dangerously naive vision
Most of those who have been late and reluctantly reached the baseline of a hard landing still argue that a recession will be shallow and short. They argue that today’s financial imbalances are not as severe as those leading up to the 2008 global financial crisis and that the risk of a recession with a severe debt and financial crisis is therefore low. But this view is dangerously naive.
There is ample reason to believe that the next recession will be marked by a severe stagflationary debt crisis. As a share of global GDP, private and public debt is much higher today than in the past, from 200% in 1999 to 350% today (with a particularly strong increase since the start of the pandemic).
Under these circumstances, rapid normalization of monetary policy and rising interest rates TMUBMUSD10Y,
Zombie households, corporations, financial institutions and governments with a high debt burden will lead to bankruptcies and defaults.
The next crisis will not be like its predecessors. In the 1970s we had stagflation, but no massive debt crises, because debt levels were low. After 2008, we had a debt crisis followed by low inflation or deflation, as the credit crisis had caused a negative demand shock.
Today, we are faced with supply shocks in a context of much higher debt, meaning we are heading for a combination of 1970s-style stagflation and 2008-style debt crises – that is, a stagflationary debt crisis.
No help from monetary or fiscal policy
When faced with stagflationary shocks, a central bank must tighten its policy stance, even as the economy heads for recession. So the current situation is fundamentally different from the global financial crisis or the early months of the pandemic, when central banks were able to loosen monetary policy aggressively in response to falling aggregate demand and deflationary pressures. The scope for fiscal expansion will also be more limited this time around. Most of the fiscal ammunition has been used up and government debt is becoming unsustainable.
In addition, because the current higher inflation is a global phenomenon, most central banks are tightening at the same time, increasing the likelihood of a synchronized global recession. This tightening is already having an effect: bubbles are deflating everywhere, including in public and private equity, real estate, housing, meme stocks, cryptocurrencies, SPACs (special acquisition companies), bonds and credit instruments. Real and financial wealth decreases and debt and debt repayment ratios increase.
Shares will fall 50%
Which brings us to the final question: will stock markets recover from the current bear market (down at least 20% from the last peak), or will they plunge even lower? Most likely they will dive lower.
After all, in typical regular recessions, US SPX,
and global stocks GDOW,
decrease by about 35%. But because the next recession will be both stagnant and accompanied by a financial crisis, the stock market crash could be closer to 50%.
Regardless of whether the recession is mild or severe, history suggests that the stock market has a lot more room to fall before bottoming out. In the current context, any rebound, such as those from the past two weeks, should be considered a dead-cat bounce, rather than the usual buy-the-dip opportunity.
While the current global situation presents us with many questions, there is no real riddle to solve. Things will get much worse before they get better.
Nouriel Roubini is Professor Emeritus of Economics at New York University’s Stern School of Business and author of the forthcoming “MegaThreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them” (Little, Brown and Company, October 2022).
This commentary is published with permission from Project Syndicate – A Stagflationary Debt Crisis Looms
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