Dr. Doom: Stagflationary Debt Crisis Looms Ahead
Nouriel Roubini earned the nickname “Dr. Doom” during the housing bubble of the early 2000s, when he predicted a crash in housing prices would blow up into a larger financial crisis and deep recession. He is one of the few economists who can honestly claim to have predicted the major events that came to pass.
Writing at Project Syndicate, Roubini considers how the ocean of red ink being unleashed by the Biden administration and enabled by the Federal Reserve’s pandemic stimulus policies threaten another economic catastrophe.
In April, I warned that today’s extremely loose monetary and fiscal policies, when combined with a number of negative supply shocks, could result in 1970s-style stagflation (high inflation alongside a recession). In fact, the risk today is even bigger than it was then.
After all, debt ratios in advanced economies and most emerging markets were much lower in the 1970s, which is why stagflation has not been associated with debt crises historically. If anything, unexpected inflation in the 1970s wiped out the real value of nominal debts at fixed rates, thus reducing many advanced economies’ public-debt burdens.
Conversely, during the 2007-08 financial crisis, high debt ratios (private and public) caused a severe debt crisis – as housing bubbles burst – but the ensuing recession led to low inflation, if not outright deflation. Owing to the credit crunch, there was a macro shock to aggregate demand, whereas the risks today are on the supply side.
We are thus left with the worst of both the stagflationary 1970s and the 2007-10 period. Debt ratios are much higher than in the 1970s, and a mix of loose economic policies and negative supply shocks threatens to fuel inflation rather than deflation, setting the stage for the mother of stagflationary debt crises over the next few years.
What Makes Today’s Inflation Worse Than the 1970s?
A simple shopping trip is all it takes to find the effects of undesirable inflation these days as the monetary mistakes of the 1970s are repeated. But as Roubini notes, national debts around the world are much higher today, which makes the problem worse. He describes how:
Making matters worse, central banks have effectively lost their independence, because they have been given little choice but to monetize massive fiscal deficits to forestall a debt crisis. 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.
You can see why he earned the “Dr. Doom” nickname! Roubini concludes his piece by observing “this slow-motion train wreck looks unavoidable” and that “the question is not if but when”.
If there’s good news in this, it’s that it’s a slow-motion train wreck. There’s still time to take steps to mitigate the worst of the outcomes if only today’s policymakers would choose to do so. Perhaps the right question to ask is in who’s interest do they serve?