We Can Delay but not Escape the Global Economic Crisis Brewing : Daily Current Affairs

Date: 07/12/2022

Relevance: GS-3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.

Key Phrases: World economy, finance consumption with debt, private- and public-sector debt, quantitative easing (QE), negative nominal interest rates, borrowing costs near zero, Stagflation, Russia’s war in Ukraine, financial crisis.

Why in News?

  • The world economy is lurching toward an unprecedented confluence of economic, financial and debt crises, following the explosion of deficits, borrowing and leverage in recent decades.
  • In the private sector, the mountain of debt includes that of households, businesses and corporations, and the financial sector.
  • In the public sector, it includes central, provincial and local government bonds and other formal liabilities, as well as implicit debts such as unfunded liabilities from pay-as-you-go pension schemes and healthcare systems—all of which will continue to grow as societies age.

Staggering figures:

  • Globally, total private- and public-sector debt as a share of GDP rose from 200% in 1999 to 350% in 2021.
  • The ratio is now 420% across advanced economies and 330% in China.
  • In the US, it is 420%, which is higher than during the Great Depression and after World War II.

Unsustainable expenditure:

  • Finance consumption with debt:
    • Debt can boost economic activity if borrowers invest in new capital that yields returns higher than the cost of borrowing.
    • But much borrowing goes simply to finance consumption spending above one’s income on a persistent basis, and that is a recipe for bankruptcy.
    • The democratization of finance has allowed income-strapped households to finance consumption with debt.
  • Capital investment:
    • Investments in ‘capital’ can also be risky, whether the borrower is a household buying a home at an artificially inflated price, a corporation that’s trying to expand too quickly regardless of returns, or a government spending the money on white elephants (extravagant but useless infrastructure projects).
  • Tax policies:
    • Centre-right governments have persistently cut taxes without also cutting spending, while centre-left governments have spent generously on social programmes that aren’t funded with sufficient higher taxes.
    • Tax policies that favour debt over equity, abetted by central banks’ ultra-loose monetary and credit policies, fuelled a borrowing spike in the private and public sectors.

Low cost of borrowing:

  • Years of quantitative easing (QE) and credit easing kept borrowing costs near zero and in some cases even negative.
  • By 2020, negative-yielding dollar-equivalent public debt was $17 trillion, and in some Nordic countries, even mortgages had negative nominal interest rates.
  • The explosion of unsustainable debt ratios implied that many borrowers were insolvent ‘zombies’ that were being propped up by low-interest rates (which kept debt-service costs manageable).
  • During both the 2008 global financial crisis and the covid pandemic crisis, many insolvent agents that would have gone bankrupt were rescued by zero- or negative-interest-rate policies, QE, and outright fiscal bailouts.

Inflation:

  • Inflation—fed by the same ultra-loose fiscal, monetary and credit policies—has ended this financial Dawn of the Dead.
  • With central banks forced to increase interest rates in an effort to restore price stability, zombies are experiencing sharp increases in their debt-servicing costs.
  • For many, this represents a triple whammy, because inflation is also eroding real household incomes and reducing the value of household assets.
  • The same goes for fragile and over-leveraged corporations, financial institutions and governments.

Stagflation:

  • Stagflation is a combination of the words stagnation and inflation. It describes an economic condition characterized by slow growth and high unemployment (economic stagnation) mixed with rising prices (inflation).

Why is it dangerous?

  • The situation is dangerous mainly because in a normal low-growth situation the government or the central bank can provide economic stimulus via higher public spending and cut interest rates.
  • But the catch is that when inflation is already running high, the fiscal and monetary stimulus can make it worse as that puts more money in the hands of the consumer.

Return of Stagflation:

  • These present developments are coinciding with the return of stagflation.
  • The last time advanced economies experienced such conditions was in the 1970s. But at least back then, debt ratios were very low.
  • Today, we are facing the worst aspects of the 1970s (stagflationary shocks) alongside the worst aspects of the global financial crisis. And this time, we cannot simply cut interest rates to stimulate demand.
  • Reasons for stagflation:
    • The global economy is being battered by persistent short- and medium-term negative supply shocks that are reducing growth and increasing prices and production costs.
    • These include the pandemic’s disruptions to the supply of labour and goods; the impact of Russia’s war in Ukraine on commodity prices; China’s increasingly disastrous zero-covid policy; and a dozen other shocks that will add to stagflationary pressures.

Leading towards financial crisis:

  • Unlike in the 2008 financial crisis and the early months of covid, simply bailing out private and public agents with loose macro policies would pour more gasoline on the inflationary fire.
  • That means there will be a hard landing—a deep, protracted recession—on top of a severe financial crisis.
  • As asset bubbles burst, debt-servicing ratios spike and inflation-adjusted incomes fall across households, corporations and governments, the economic crisis and a financial crash will feed on each other.

Conclusion:

  • To be sure, advanced economies that borrow in their own currency can use a bout of unexpected inflation to reduce the real value of some nominal long-term fixed-rate debt.
  • With governments unwilling to raise taxes or cut spending to reduce their deficits, central-bank deficit monetization will once again be seen as the path of least resistance.
  • But you can’t fool all the people all the time. Once the inflation genie gets out of the bottle—i.e., when central banks abandon their fight in fear of a looming economic and financial crash—interest rates will surge.
  • The mother of all stagflationary debt crises can be postponed but not averted unless the world moves towards the sustainable expenditure, a rational tax structure, and strong fiscal and monetary policies.

Source: Live Mint

Mains Question:

Q. What are the reasons for slow global economic growth, and what steps do the governments and central banks need to take to avoid the next global financial crisis?