Home / Opinion / Columns /  From the Great Moderation to anxiety over Great Stagflation

The world economy is undergoing a radical shift. The decades-long Great Moderation is over. Coming after the stagflation of the 1970s and early 1980s, it was characterized by low inflation in rich economies, relatively stable and robust economic growth, with short and shallow recessions, low and falling bond yields, thanks to a secular fall in inflation, and sharply rising values of risky assets. This period is usually explained by central banks’ move to credible inflation-targeting policies after the loose monetary policies of the 1970s and governments’ adherence to relatively conservative fiscal policies. But, more important than demand-side policies were positive supply shocks that upped potential growth and reduced production costs, thus keeping inflation in check.

During the post-Cold War era of hyper-globalization, China and other emerging economies integrated with the world economy, supplying it with low-cost goods, services, energy and commodities. Large-scale migration from the global south to the north kept a lid on wages in advanced economies, technological innovations reduced costs and relative geopolitical stability allowed for an efficient and secure allocation of production to low-cost locations.

But the Great Moderation started to crack during the Great Recession and was then hit by covid. In both cases, inflation initially remained low, given demand shocks, and loose monetary, fiscal and credit policies prevented deflation. But inflation is back, rising sharply, owing to a mix of both demand and supply factors. On the supply side, the backlash against globalization has gained momentum. Public anger over stark inequalities also has been rising, leading to more policies to support workers that are now contributing to a spiral of wage-price inflation. Making matters worse, renewed protectionism has restricted trade and the movement of capital. Political tensions are driving a process of re-shoring. Political resistance to immigration has curtailed the global movement of people, putting upward pressure on wages. Strategic considerations have further restricted flows of technology, data and information. And new labour and environmental standards, important as they may be, have hampered production.

This balkanization of the global economy is deeply stagflationary, and it is coinciding with demographic ageing, not just in developed countries, but also in large emerging economies such as China. Because young people tend to produce and save, whereas older people spend down their savings, this trend also is stagflationary.

The same is true of today’s geopolitical turmoil. Now that the US dollar has been fully weaponized for strategic purposes, its position as the main global reserve currency may begin to decline, and a weaker dollar would add to the inflationary pressures. A frictionless world trading system requires a frictionless financial system. But sweeping sanctions have thrown sand in this well-oiled machine, making trade costlier.

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Climate change is also stagflationary. Apart from its disruptive effects, the drive for decarbonization has led to underinvestment in fossil-fuel capacity before investment in renewables has reached the point where they can make up the difference. Pandemics caused by zoonotic viruses will also be a persistent threat.

Finally, cyberwarfare remains an underappreciated threat to economic activity and even public safety. Firms and governments will either face more stagflationary disruptions to production, or they will have to spend a fortune on cybersecurity. Either way, costs will rise.

On the demand side, loose and unconventional monetary, fiscal and credit policies have become not a bug, but rather a feature of the new regime. Between today’s surging stocks of private and public debts and the huge unfunded liabilities of pay-as-you-go social-security and health systems, both the private and public sectors face growing financial risks. Central banks are thus locked in a ‘debt trap’: any attempt to normalize monetary policy will cause debt-servicing burdens to spike, leading to massive insolvencies, cascading financial crises, and fallout in the real economy. With governments unable to reduce high debts and deficits by spending less or raising revenues, those that can borrow in their own currency will increasingly resort to the ‘inflation tax’: relying on unexpected price growth to wipe out long-term nominal liabilities at fixed rates.

As in the 1970s, persistent and repeated negative supply shocks will combine with loose monetary, fiscal and credit policies to produce stagflation. Moreover, high debt ratios will create the conditions for stagflationary debt crises. During the Great Stagflation, both components of any traditional asset portfolio—long-term bonds and equities—will suffer, potentially incurring massive losses. ©2022/Project Syndicate

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’.

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