Most countries can avoid a deep recession
The inflationary surge following the Covid-19 pandemic eroded the real value of nominally denominated fixed-rate debt – a reminder that unanticipated inflation is always the debtors’ best friend
By Willem H. Buiter
Published: Wed 14 Dec 2022, 12:01 AM
Nouriel Roubini thinks the global economy is “lurching toward an unprecedented confluence of economic, financial, and debt crises, following the explosion of deficits, borrowing, and leverage in recent decades.” Is he right?
At the risk of sounding Panglossian, I do not regard such a disaster scenario as inevitable, or even as the most likely outcome. Turkey and a few other countries afflicted with severe macroeconomic and regulatory mismanagement will almost certainly suffer the fate Roubini describes, but most economies can still avoid a financial disaster and a deep recession.
Yes, private and public debt as a share of GDP is near a peacetime high. At 334% as of the third quarter of 2022, this ratio is down from its 2021 first-quarter peak (363%), but way up from its 1991 first-quarter level (227%). Moreover, the slight reduction since early 2021 is due primarily to (unanticipated) inflation, not real GDP growth. The inflationary surge following the Covid-19 pandemic eroded the real value of nominally denominated fixed-rate debt – a reminder that unanticipated inflation is always the debtors’ best friend.
Nonetheless, the risk-free real interest rate across most advanced economies is close to an 800-year low, and the consensus estimate of the risk-free neutral real interest rate is 0.5%. That is comfortably below the current underlying real GDP growth rate for most countries and the world as a whole. If the effective interest rate on the debt is persistently below the GDP growth rate, Ponzi finance remains feasible and worries about debt sustainability are moot.
The question is whether and how long these conditions will last. After all, the empirical drivers of global real interest rates – never mind the unobservable neutral real rate – are poorly understood. In a recent study of long-maturity real interest rates over the past 700 years, Kenneth Rogoff, Barbara Rossi, and Paul Schmelzing conclude that neither demographics (old cohorts saving less and driving up real rates) nor productivity (higher gains boosting real rates) are the causal drivers of global real rates.
Likewise, former US Secretary of the Treasury Lawrence H. Summers’s famous “secular stagnation” hypothesis never made much sense as an explanation for low global real interest rates since the early 1980s. There has been no global stagnation over the past 40 years. Moreover, it remains to be seen how investment demand will be affected by technological advances in artificial intelligence, machine learning, automation, robotics, biotechnology, fintech, and decentralized finance. The best we can do is to welcome the low neutral real rate without pretending to understand it.
Looking ahead, the component of inflation that is due to aggregate supply shocks (rather than to monetary and fiscal stimulus) is likely to be transitory. There also is not yet any evidence to suggest that medium- and long-term inflation expectations are becoming unanchored from the target rate of inflation. Russia’s war in Ukraine will end sooner or later, and most likely without a nuclear escalation. Whenever that happens, the subsequent easing of Western sanctions will produce a disinflationary shock.
In the United States, continued moderate monetary-policy tightening will slow the economy, but the likely effect will be a growth recession, rather than outright contraction. Similarly, although Europe has been hit harder than the US by the fallout from Russia’s war, the European Central Bank’s response to higher inflation has been even less aggressive than the US Federal Reserve’s, again leaving a growth recession as the most likely scenario. The big loser among advanced economies is the United Kingdom – an economic mess whose external problems have been exacerbated by self-inflicted wounds such as Brexit, various regulatory failures, and an absurd demonstration of fiscal irresponsibility by Liz Truss’s short-lived government.
As for Roubini’s warning about the likelihood of a financial crisis, it bears mentioning that banking-sector balance sheets in most advanced economies are in better shape than they were at the time of the 2007-09 global financial crisis, and that supervision over much of the non-bank financial sector is much improved. While regulation has failed miserably in the crypto world, that industry’s inevitable meltdown has been largely self-contained.
Across the advanced economies and China, monetary authorities are ready and able to monetize future deficit-financed fiscal stimulus should a recession become imminent. From February 2020 onward, central banks dealt effectively with what could have become a first-order financial crisis, by acting as lenders of last resort (including through liquidity swap lines) and market makers of last resort. That outstanding performance makes me confident of their readiness for the next potential crisis. Helicopter money – monetary financing – will work again.
Moreover, even fiscally challenged governments that don’t have access to monetary financing or external support are not completely without options. The balanced budget multiplier (higher public spending or a selective tax cut increases national income if paid for with appropriately selected higher taxation) can come to the rescue.
For example, because low-income households tend to spend a greater share of their incremental income than high-income households do, a tax cut benefiting the poor, and paid for with a tax increase on the rich, should boost total spending on goods and services. So, too, would an increase in public spending on real goods and services (such as a boost to green infrastructure investment – assuming sufficient shovel-ready projects are available), financed with a tax increase on the well-off. Resource utilization, broader socio-economic efficiency, and distributive fairness would all point in the same direction.
Almost everything is possible; but not everything is likely. I, for one, do not anticipate a Roubini-size global financial and macroeconomic disaster in the foreseeable future.
- Willem H. Buiter, a former chief economist at Citibank