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Stagflation, debt distress, financial innovation

Professor Emeritus of Economics at New York University, Nouriel Roubini speaks to Project Syndicate (PS) on that and more.

 Project Syndicate: In your latest PS commentary, you reaffirmed your expectation that monetary authorities’ efforts to rein in inflation will “cause both an economic and a financial crash,” and that “regardless of their tough talk,” central banks “will feel immense pressure to reverse their tightening” once that crash materialises. What would the impact of such a reversal be? Do monetary policymakers in the United States and Europe have any good – or less bad – options?

Nouriel Roubini: Central banks are in both a stagflation trap and a debt trap. Amid negative aggregate supply shocks that reduce growth and increase inflation, they are damned if they do and damned if they don’t. If they increase interest rates enough to bring inflation down to 2%, they will cause a severe economic hard landing. And if they don’t – attempting instead to protect growth and jobs – they will be left increasingly far behind the curve, leading to a de-anchoring of inflation expectations and a wage-price spiral.

Very high debt ratios (both private and public) complicate the dilemma further. Raising interest rates enough to crush inflation causes not only an economic crash, but also a financial crash, with highly leveraged private and public debtors facing severe distress. The resulting financial turmoil that intensifies the recession, creating a vicious cycle of deepening recession and escalating financial pain and debt distress.

In these circumstances, central banks will blink. They will wimp out in the fight against inflation, in an effort to avoid an economic and financial crash. But that will lead to a higher permanent inflation rate, while only postponing the arrival of stagflation and debt crises. In other words, central banks in the United States, Europe, and other advanced economies have only bad options.

As you put it in your new book, `MegaThreats: Ten Dangerous Trends That Imperil Our Future and How to Survive Them’, we are headed toward the “Mother of All Debt Crises,” and none of the potential solutions is without costs. We must “choose our poison.” But does more noxious mean more effective? For developing economies, in particular, are innovative proposals like debt-for-climate swaps examples of policies that recognise the interconnected nature of today’s megathreats?

Solutions for debt distress are never easy or costless. There are always trade-offs. Monetising the debt and wiping out its real value with unexpected inflation works only for countries that borrow in their own currencies, and relying on the inflation tax to wipe out debts causes a persistent increase in the inflation rate. For debt denominated in a foreign currency, the only feasible option is a default and restructuring when the debt has become unsustainable – processes that can be messy and protracted, and that can cost a country access to capital markets. Imposing taxes on wealth or capital to reduce unsustainable debt levels is not only politically difficult; it can also undermine investment, capital accumulation, and growth.

Debt-for-equity or debt-for-climate swaps convert the debt claims of creditors into equity claims or claims to reduce greenhouse-gas emissions. But they are not large enough in scope to resolve severe debt problems, and debtors may feel that converting debt into equity on emissions-reduction claims erodes sovereignty by effectively transferring the ownership of a country’s natural resources and assets to foreign entities. Debt-for-climate swaps can neither resolve debt distress nor contribute much to combating climate change.

One example of the “slow-motion negative supply shocks” that will characterise the “Great Stagflation” is “fiscal policies to boost wages and workers’ power.” One of the ten “megathreats” you highlight in your book is the rise in income and wealth inequality, which is fueling a backlash against democracy. What policies or interventions would help counter the distributional effects of the current crisis, without inadvertently exacerbating it?

Income and wealth inequality have been rising within countries for many reasons. Notable factors include trade and globalisation, technological innovation (which is capital-intensive, skill-biased, and labour-saving), the self-reinforcing political power of economic and financial elites, the concentration of oligopolistic power in the corporate sector, and the declining power of labour and unions. Together, these factors have triggered a backlash against liberal democracy.

Fiscal policies that support workers, unions, the under- and unemployed, and disadvantaged groups (such as women and racial minorities) can help to reduce inequality, but they also lead to higher inflation by increasing wage inflation. And given corporations’ disproportionate pricing power (compared to labour), prices rise more than wages, as has occurred in 2021 and 2022. The result is a decline in real wages, which exacerbates inequality.

Historically, fiscal policies – including progressive taxation – have had only a modest impact on inequality. And the rise of artificial intelligence, robotics, and automation mean that labour is set to become even weaker over time, as humans lose many jobs – routine, cognitive, and increasingly even creative jobs – to software and robots.

By the Way…

You indicate in MegaThreats that whoever leads in AI may become the leading global power, and you suggest that China may get there first. But the recent government crackdown on tech companies has raised fears that China is crushing the sector’s “animal spirits,” and Xi’s recent consolidation of power implies that the ruling Communist Party’s commitment to central control will only strengthen. How do you view China’s high-tech ambitions – and its economic prospects more broadly – under Xi?

 The U.S. and China are in a race not only to become the leading geopolitical and military power of this century, but also to dominate the industries of the future, including AI, machine learning, robotics, automation, the Internet of Things, big data, 5G (tomorrow, 6G), and quantum computing. Both are subsidising these technologies, but China takes a more heavy-handed command-and-control approach.

True, China’s recent crackdown on the private sector, including tech firms, does not bode well for the country’s ability to devise truly innovative technologies and applications. But the sheer force of China’s continued top-down investment in leading-edge sectors – which the government continues to shower with massive financial incentives and subsidies – may yet enable the country to dominate the technologies underlying the industries of the future.

America’s more nuanced approach may succeed in the long term. But China’s command-and-control model has been proven to affect dynamically the economy’s comparative advantage. That is why the U.S. needs the right industrial policies. A purely laissez-faire approach will not be enough to enable the U.S. to dominate in strategic technologies.

That said, China’s state-capitalist model does appear to be running out of steam, causing a sharp reduction in potential growth. And, given Xi’s statist approach, it is likely that this growth slowdown will continue and deepen.

Yet another threat you identify is destabilising financial innovation, which may lead to the debasement of fiat currencies. Each chapter of your book includes possible solutions. What steps should policymakers be taking to mitigate this threat?

Historically, financial innovation without proper regulation and supervision has led to asset inflation, which fuels bubbles that eventually burst. Today, we are also facing goods and services inflation, owing to negative aggregate supply shocks and the effects of fiscal and monetary policies that were too loose for far too long. With high inflation, the debasement of fiat currencies is a rising risk.

But the solution is not cryptocurrencies, which are neither currencies nor assets; in fact, crypto has turned out to be the Mother of All Scams, and its bubbles have now gone bust. Instead, the solution is proper supervision and regulation of the financial system, including steps to curb toxic innovations that, like crypto, have no use or benefit but fuel financial instability.

In addition, the moral hazard of loose monetary and credit policies that feed bubbles and deepen debt traps needs to be addressed. But there is no easy solution to debt traps, which are driven by deep political biases toward private and public over-leveraging.

You famously predicted the 2008 global financial crisis, earning you the moniker Dr. Doom. In MegaThreats, you make what is arguably an even bleaker prediction: that a “dystopian” future of “chaos, crises, instability, and domestic and global conflict” is more likely than a “utopian” one of sound policymaking and international cooperation. Are economists, investors, and policymakers more willing to take such warnings seriously nowadays, or do you get the sense that those with the power to make a difference still have their heads buried in the sand?

 We need to distinguish between normative statements, about how the world should ideally or desirably be, and positive statements, about how the world is likely to be. Unfortunately, I don’t see any reason to think that we have moved meaningfully beyond our preferred strategy of kicking the can down the road – not least because of the sheer number of barriers to implementing the right policies.

Consider global warming. Half of the U.S. – the Republican Party – denies the reality of human-induced climate change and actively blocks policies intended to address it when in power. There is also an inter-generational conflict: older generations are unwilling to bear the costs of action to prevent a future they will never see, while younger generations are smaller and often don’t even vote.

At the international level, we have a free-rider problem: even if a country makes all the sacrifices needed to achieve net-zero emissions, it will benefit only if the rest of the world does the same. And the advanced economies, which created most of the stock of atmospheric greenhouse gases, are unwilling to fork over the trillions of dollars in subsidies that developing economies need to achieve net-zero emissions and adapt to a warmer climate. Meanwhile, the emerging economies that produce most of the flow of new emissions today – such as China and India – may resist cutting their emissions until they are richer, perhaps in another decade or two. Finally, the geopolitical rivalry between the U.S. and China is severely hampering efforts to advance global public goods. The same is true for the solutions to many other megathreats. That is why the dystopian future is more likely than the utopian one.

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Nouriel Roubini, Professor Emeritus of Economics at New York University’s Stern School of Business, is Chief Economist at Atlas Capital Team and the author of `MegaThreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them’ (Little, Brown and Company, 2022).

 Copyright: Project Syndicate, 2022.

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