Market Watch: The Looming Stagflationary Debt Crisis Will Deliver a One-two Punch to Markets and Economies

Article by Nouriel Roubini in Market Watch

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.

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.

Worst of both worlds

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.

For now, loose monetary and fiscal policies will continue to fuel asset and credit bubbles, propelling a slow-motion train wreck.

At some point, this boom will culminate in a Minsky moment (a sudden loss of confidence), and tighter monetary policies will trigger a bust and crash.

But meanwhile, the same loose policies that are feeding asset bubbles will continue to drive consumer price inflation, creating the conditions for stagflation. 

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.

The Volcker Moment

When former Fed Chair Paul Volcker hiked rates to tackle inflation in 1980-82, the result was a severe double-dip recession in the United States and a debt crisis and lost decade for Latin America. But now that global debt ratios are almost three times higher than in the early 1970s, any anti-inflationary policy would lead to a depression, rather than a severe recession.

Under these conditions, central banks will be damned if they do and damned if they don’t, and many governments will be semi-insolvent and thus unable to bail out banks, corporations, and households.

As matters stand, this slow-motion train wreck looks unavoidable. The Fed’s recent pivot from an ultra-dovish to a mostly dovish stance changes nothing. The Fed has been in a ......

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