Some fear the fire of inflation; others the ice of deflation
Martin Wolf
Some say the world will end in fire, Some say in ice.” These brilliant lines by the poet Robert Frost capture the world’s possible economic prospects.
Some warn that the world of high debt and low interest rates will end in the fire of inflation. Others prophesy that it will end in the ice of deflation. Others, such as Ray Dalio of Bridgewater, are more optimistic: the economy will be neither burnt nor frozen. Instead, it will be neither too hot nor too cold, like the baby bear’s porridge, at least in countries that have had the fortune and wit to borrow in currencies they create freely.
William White, former chief economist of the Bank for International Settlements, presciently warned of financial risks before the 2007-09 financial crisis. Last year, he warned of another crisis, pointing to the continuing rise in non-financial sector debt, especially of governments in high-income countries and corporations in high-income and emerging economies. Those in emerging countries are particularly vulnerable, because much of their borrowing is in foreign currencies. This causes currency mismatches in their balance sheets. Meanwhile, monetary policy fosters risk-taking, while regulation discourages it — a recipe for instability.
Start then with inflationary fire. Much of what is going on right now recalls the early 1970s: an amoral US president (then Richard Nixon) determined to achieve re-election, pressured the Federal Reserve chairman (then Arthur Burns) to deliver an economic boom. He also launched a trade war, via devaluation and protection. A decade of global disorder ensued. This sounds rather familiar, does it not?
In the late 1960s, few expected the inflation of the 1970s. Similarly, a long period of stable and low inflation has calmed fears of an upsurge, even though unemployment has fallen to low levels. (In the US, it is at its lowest level since 1969.) Some suggest that the Phillips curve — the short-term relationship between unemployment and inflation — is dead, because low unemployment has not raised inflation. More likely, it is sleeping. Inflation expectations may now be anchored. But a strong surge of demand might still sweep them away.
In some ways, a rise in inflation would be helpful. A sudden jump in inflation would reduce debt overhangs, notably of public debt, just as the inflation of the 1970s did. Moreover, central banks know what to do in response to a surge in inflation. Yet higher inflation would also lead to a rise in long-term nominal interest rates, which tend to front-load the real burden of debt service. Short-term rates would also jump as they did in the early 1980s. Risk premia would rise. High-flying stock markets might collapse. Labour relations would become more strife-prone, as would politics. This disarray would hit unevenly, causing currency disorder. The loss of confidence in public institutions, notably central banks, would be severe. In the end, the likely stagflation would end in severe recession, as in the 1980s.
Now turn to deflationary ice. This might begin with a sharp negative economic shock: a worsening trade war, a war in the Middle East or a crisis in private or public finance, possibly in the eurozone, where the central bank is relatively constrained. The result could be a deep recession, even a lurch into deflation, so worsening the debt overhang.
The big difficulty would be knowing how to respond given that interest rates are already so low. Conventional policy (lower short-term rates) and conventional unconventional policy (asset purchases) might be insufficient.
A range of other possibilities exist: negative rates from the central bank; lending to banks at lower rates than the central bank pays on their deposits; purchase of a much wider range of assets, including foreign currencies; monetisation of fiscal deficits; and “helicopter drops” of money. Much of this would be technically or politically problematic, and would require close co-operation with the government. Meanwhile, if governments acted too slowly (or not at all) a depression might ensue, as in the 1930s, via mass bankruptcy and debt deflation. Many fools recommended that in 2008.
Yet none of these disasters is at all inevitable. They would be chosen catastrophes. As Mr Dalio argues, a golden mean is possible. Fiscal and monetary policy would then co-operate to generate non-inflationary growth. Changes in fiscal incentives would discourage debt and encourage equity. Government policy would shift income towards spenders, reducing our current reliance on debt-fuelled asset bubbles for sustaining demand. Still more debt would be moved out of the balance sheets of financial intermediaries directly on to the balance sheets of households.
Even if real interest rates rose, perhaps because productivity growth strengthened durably, the impact of robust non-inflationary growth on the debt burden would almost certainly outweigh a move to somewhat higher interest rates. We would, above all, be moving out of “secular stagnation” into something less bad. That shift might be tricky. But it would be to a better world.
It is not necessary to repeat the mistakes of either the 1930s or the 1970s. But we have made enough mistakes already and are, collectively, making enough more right now to risk either outcome, possibly both.
A breakdown of the global economic and political order seems conceivable. The impact on our debt-encumbered world economy and increasingly fraught global politics is impossible to calculate. But it could be horrendous. Above all, nationalistic strongmen would be unable to co-operate if things went seriously wrong, as they might, perhaps even soon.
That is the most worrying feature of our world.
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