The world economy is undergoing a radical regime shift. The decades-long Great Moderation is over.
Coming after the stagflation (high inflation and severe recessions) of the 1970s and early 1980s, the Great Moderation was characterized by low inflation in advanced economies; relatively stable and robust economic growth, with short and shallow recessions; low and falling bond yields (and thus positive returns on bonds), owing to the secular fall in inflation; and sharply rising values of risky assets such as US and global equities.
This extended period of low inflation 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 (with meaningful stimulus coming only during recessions). But, more important than demand-side policies were the many positive supply shocks, which increased potential growth and reduced production costs, thus keeping inflation in check.
During the post-Cold War era of hyper-globalization, China, Russia, and other emerging-market economies became more integrated in 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 the costs of producing many goods and services, and relative geopolitical stability allowed for an efficient allocation of production to the least-costly locations without worries about investment security.1
But the Great Moderation started to crack during the 2008 global financial crisis and then during the 2020 COVID-19 recession. In both cases, inflation initially remained low given demand shocks, and loose monetary, fiscal, and credit policies prevented deflation from setting in. But now inflation is back, rising sharply, especially over the past year, owing to a mix of both demand and supply factors.
On the supply side, the backlash against hyper-globalization has been gaining momentum, creating opportunities for populist, nativist, and protectionist politicians. Public anger over stark income and wealth inequalities also has been building, leading to more policies to support workers and the “left behind.” However well-intentioned, these policies are now contributing to a dangerous spiral of wage-price inflation
Making matters worse, renewed protectionism (from both the left and the right) has restricted trade and the movement of capital. Political tensions (both within and between countries) are driving a process of reshoring (and “friend-shoring”). Political resistance to immigration has curtailed the global movement of people, putting additional upward pressure on wages. National-security and strategic considerations have further restricted flows of technology, data, and information. And new labor and environmental standards, important as they may be, are hampering both trade and new construction.
This balkanization of the global economy is deeply stagflationary, and it is coinciding with demographic aging, 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. Russia’s war in Ukraine, and the West’s response to it, has disrupted the trade of energy, food, fertilizers, industrial metals, and other commodities. The Western decoupling from China is accelerating across all dimensions of trade (goods, services, capital, labor, technology, data, and information). Other strategic rivals to the West may soon add to the havoc. Iran crossing the nuclear-weapons threshold would likely provoke military strikes by Israel or even the United States, triggering a massive oil shock; and North Korea is still regularly rattling its nuclear saber.
Now that the US dollar has been fully weaponized for strategic and national-security purposes, its position as the main global reserve currency may begin to decline, and a weaker dollar would of course add to the inflationary pressures. A frictionless world trading system requires a frictionless financial system. But sweeping primary and secondary sanctions have thrown sand in this well-oiled machine, massively increasing the transaction costs of trade.
On top of it all, climate change, too, is stagflationary. Droughts, heat waves, hurricanes, and other disasters are increasingly disrupting economic activity and threatening harvests (thus driving up food prices). At the same time, demands for decarbonization have led to underinvestment in fossil-fuel capacity before investment in renewables has reached the point where they can make up the difference. Today’s large energy-price spikes were thus inevitable.
Pandemics will also be a persistent threat, lending further momentum to protectionist policies as countries rush to hoard critical supplies of food, medicines, and other essential goods. After two and a half years of COVID-19, we now have monkeypox. And owing to human encroachments on fragile ecosystems and the melting of Siberian permafrost, we may soon be dealing with dangerous viruses and bacteria that have been locked away for millennia.
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 (as a share of GDP) 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.
Thus, 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 US and global equities – will suffer, potentially incurring massive losses.
