Dark prospects

Image: Jorge Jesus


The party is over and there is a growing recognition that not only the global economy, but even humans are at risk

Since the publication of Megathreats, in October 2022, the themes that I emphasized there became mainstream. Everyone now recognizes that economic, monetary and financial threats are increasing and dangerously interacting with numerous other social, political, geopolitical, environmental, health and technological developments.

Thus, in December 2022, the Financial Times chose the term “polycrisis” as one of the keywords of the year. Whatever the preferred term (others have adopted “permacrises” or “confluent calamities”), there is a growing recognition that not only the global economy but even humans are at risk.

As I warned in that book, the “great moderation” (a long period of low macroeconomic volatility that occurred after the mid-1980s) gave way to “the great stagflation.” In 2022, we witnessed a rise in inflation in advanced economies and emerging markets, as well as a sharp slowdown in global growth that continued into 2023. Then, signs of serious debt problems in the public and private sectors appeared, as banks central banks increased interest rates to stabilize prices.

Due to this tightening of monetary policy, inflation fell across the world. Furthermore, the impact of short-term negative supply shocks – the pandemic, rising commodity prices following Russia's invasion of Ukraine and China's “zero COVID” policy – ​​has been gradually fading throughout 2023. But inflation remains well above the 2% target in advanced economies. However, a dozen other negative aggregate supply shocks – presented in the book as medium-term mega-threats – have become more severe.

For example, deglobalization has continued, with more countries moving from free trade to secure trade, as well as from economic integration to decoupling and “decoupling.” reshoring, near shoring and "friend shoring” imply a tradeoff between efficiency and resilience, with global supply chains just-in-time being replaced by arrangements “just-in-case".

Furthermore, social aging in Europe, Japan and China is reducing the supply of workers at a time when immigration restrictions are hampering the flow of labor from poor to rich countries – which increases labor costs. Climate change is already fueling energy and food insecurity. Rising energy and food costs continue, but the world has not yet done enough to prepare for future disasters, including pandemics.

In addition, there are the new underappreciated risks posed by cyberwarfare and disinformation now enhanced by Artificial Intelligence. Older problems also persist, such as increasing income and wealth inequality (which could lead to more fiscal policies to increase wages and support populist policies). Finally, as the United States leans more heavily on the dollar as a foreign policy tool, dedollarization remains an acute risk.

Thus, despite the near-term moderation of COVID-related shocks, the world still faces major risks of stagflation (lower growth and higher inflation), most of which are likely to become stronger over the next decade.

The party is over

I also warned previously that the high and growing proportions of public and private debt, which will reach 330% of GDP worldwide in 2022 (420% in advanced economies and more than 300% in China), mark a dramatic change compared to the pre- -2021, when these proportions were high but debt services were low.

The decade of secular stagnation following the global financial crisis was characterized by low aggregate demand growth, large private and public savings, and low investment rates. Slow growth has led to low inflation-adjusted interest rates. Near-zero or even negative interest rates, combined with quantitative and credit easing, have kept nominal and real rates very low – and often negative – at both the short and long ends of the yield curve.

But that easy-money environment is over. The negative supply shocks from the pandemic, coupled with the stimulus policies in response to it, led to a rise in inflation from 2021 onwards. Central banks responded by (eventually) raising nominal and real rates. But with the proportions of public and private debt so high, central banks are having difficulty reducing inflation to the 2% target. They are caught in a “debt trap”, facing not just a dilemma – how to achieve 2% inflation without causing an economic hard landing – but a “trilemma”: how to achieve price stability while avoiding a recession and a financial crisis.

Developments since the publication of Megathreats confirmed that this trilemma is a serious problem. If central banks continue to raise interest rates to reduce inflation to 2%, a recession and debt problems among highly leveraged public and private borrowers become more likely. But if policymakers blink and give up on their goal of price stability, inflation and inflation expectations could become unanchored, triggering a wage price spiral.

So far, central banks have not blinked. But if inflation remains above target – as seems likely, given high wage growth and rising house prices – commodities – they may eventually bend to the evidence to avoid causing an economic recession and financial crisis. The fact that they have already paused interest rate increases despite very high core inflation (which excludes volatile food and energy prices) suggests that they may be preparing to accept above-target inflation.

A few more wars

In addition to negative aggregate supply shocks, several aggregate demand trends also imply that inflation will be higher. As deficits grow, central banks may eventually be forced to monetize public debt. And deficits will increase because many key countries are involved in at least six battles (including some real wars) that will require higher levels of spending.

To begin with, we are now in a “geopolitical depression”, due to the intensifying rivalry between the West and revisionist (tacitly allied) powers such as China, Russia, Iran, North Korea and Pakistan. Russia's invasion of Ukraine could still expand and drag down NATO. Israel – and possibly the US – is on a collision course with Iran, which is on the threshold of becoming yet another nuclear weapons state.

Israel's horrific military operation in Gaza in response to Hamas' October 7 massacre of Israeli civilians risks fanning the flames of a broader regional conflict, which would cause another spike in energy prices. Meanwhile, the US and China continue to argue over influence in Asia and the fate of Taiwan. With the US, Europe, NATO and virtually everyone in the Middle East and Asia rearming, higher levels of spending on conventional and unconventional weapons (including nuclear, cyber, biological and chemical) are virtually guaranteed.

The battle against climate change will also be expensive. The cost of mitigation and adaptation is expected to be trillions of dollars per year in the coming decades. It is naive to think that all these investments will boost growth. Consider a real war that destroys much of the physical support of capital in a country. Although a wave of investment in reconstruction could produce an economic expansion, the country is still poorer for having lost a large part of its wealth. The same goes for climate investments. A significant part of the existing social capital will have to be replaced, either because it has become obsolete or because it has been destroyed by climate events.

There is also a costly battle to fight against future pandemics. For a variety of reasons – some of them related to climate change – disease outbreaks with the potential to become pandemics will become more frequent. Whether countries invest in prevention or deal with future health crises after the fact, higher costs on a perpetual basis will add to the growing burden associated with an aging society and pay-as-you-go healthcare systems and pension plans. These implicit unfunded liabilities are estimated to already be above the level of explicit public debt for most advanced economies.

We can also expect a military mobilization to deal with the disruptive effects of “globalized selves”: the combination of globalization and automation that is threatening a growing number of blue- and white-collar occupations, including creative and managerial jobs. Governments will be under increasing pressure to help those left behind, whether through basic income schemes, higher tax transfers or expanded public services.

These costs will remain high even if automation leads to an increase in economic growth. For example, the US would have to spend 20% of GDP just to support a meager universal basic income of $1.000 per month.

Then there is the related fight against rising income and wealth inequality. This battle is becoming increasingly urgent now that the malaise afflicting young people and many middle- and working-class families is fueling a backlash against liberal democracy and free-market capitalism. To prevent populist regimes from coming to power and pursuing reckless and unsustainable economic policies, liberal democracies will need to spend heavily to bolster their social safety nets – as many are already doing.

Finally, managing social aging will require herculean efforts. Health and pension systems will add to the explicit public debt (which has already reached a level of 112% of GDP, on average, in advanced economies) an implicit debt that is many times greater.

These battles are necessary, but they will be expensive. Now, economic and political restrictions will limit governments' ability to finance them with higher taxes. Tax-to-GDP ratios are already high in most advanced economies – especially in Europe; Tax evasion and arbitrage will further complicate efforts to raise taxes on high incomes and capital (assuming such measures can even get past lobbyists or gain support from center-right parties).

Inflation and spending

Greater government spending and transfers, without a commensurate increase in tax revenues, will cause structural budget deficits to grow even larger than they already are, potentially leading to unsustainable debt ratios that will increase borrowing costs and culminate in debt crises – with obvious adverse effects on economic growth. Of course, under these conditions, many emerging and developing countries with foreign currency-denominated debt will need to default or undergo coercive restructuring. But for countries that borrow in their own currencies, the convenient option will be to allow higher inflation as a means of eroding the real value of nominal debt under long-term fixed rates.

This approach, which functions as a tax on lenders and creditors and a subsidy on borrowers and debtors, can then be combined with other draconian measures such as financial repression or taxes on capital. Because many of these measures do not require explicit legislative or executive approval, they inevitably become the path of least resistance when deficits and debt prove unsustainable.

Bond markets have already begun to signal concerns about unsustainable fiscal deficits and rising public debt. And this is not just in poor countries and emerging markets, but also in advanced economies. A sharp rise in long-term bond rates in Europe and the US indicates that demand for bonds is shrinking as supply increases with growing budget deficits.

When central banks shift their policy from monetary easing to quantitative tightening, investors seek higher risk premiums and US rivals gradually reduce their dollar reserves. Furthermore, there will likely be even more upward pressure on  long-term rates in the US and other G-10 countries when Japan begins to normalize monetary policy and abandon the yield curve control policy it used to keep long-term rates near 0%.

And it's not just nominal bond yields that are rising; as well as real income. During the decade of secular stagnation, long-term real returns were close to zero or negative due to high savings and low investment rates. However, we are entering an era of negative public savings (rising fiscal deficits), lower private savings (driven by aging and lower income growth) and higher investment rates (due to climate change mitigation and adaptation, infrastructure spending and A.I. ).

So real rates are positive and are being pushed up by higher risk premiums on government bonds as debt increases. Some investment banks now estimate the long-term breakeven rate to be closer to 2,5%, while recent academic research puts it closer to 2%. In any case, the nominal and real cost of capital will be much higher in the future.

Given the aggregate supply and demand factors that drive up inflation, the new de facto (albeit unofficial) inflation target over the next decade could be closer to 4 or 5%. But accepting a higher inflation rate could undo inflation expectations – as happened in the 1970s – with serious consequences for economic growth and returns on financial assets.

After the bubble bubble

Until 2021, monetary, fiscal and credit easing inflated valuations of virtually everything: US and global stocks, real estate, and government and corporate bonds; technology, growth and venture companies; and speculative assets like cryptocurrencies, meme stocks and SPACs (special purpose acquisition companies). When this “bubble of bubbles” burst in 2022, speculative assets – starting with venture capital stocks, cryptocurrencies and memes – lost much more value than traditional stocks.

But safe assets like government bonds also lost money as higher long-term interest rates drove bond prices down. For example, the rise in US bond yields from 1% to 3,5% in 2022 has meant that ten-year Treasury bonds have lost more in price (-20%) than the S&P 500 (-18%). This year has brought additional losses in long-duration bonds (around -15% in price terms) as bond yields have risen further towards 5%. Traditional asset allocation models that balance stocks against bonds have therefore lost on both fronts.

This bloodbath is likely to continue. With inflation averaging 5% rather than 2%, long-term bond yields would need to be closer to 7,5% (5% for inflation and 2,5% for a real return). But if bond yields rise from the current 4,5% to 7,5%, this will cause bond prices (by 30%) and stocks (with a bear market) to fall because the dividend discount factor will be much greater. Globally, losses for bondholders and equity investors could reach tens of trillions of dollars over the next decade.

Admittedly, U.S. and global stocks rose through mid-2023 after the bear market of 2022. But most of that was driven by a small group of Big Tech stocks that benefited from the hope and hyping around generative artificial intelligence. If we exclude these high flyers, the markets were almost stable.

Furthermore, for most of 2023, investors were engaged in wishful thinking about the end of the rate hike cycle due to central bank decisions, with many even betting on rate cuts in the near future. But persistent inflation has dashed those hopes, prompting central banks to adopt a “higher for longer” policy, which will likely lead to economic contraction and additional financial stress. Last summer and fall, US bond yields rose from 3,7% to 5%, along with another significant correction in US and global equities.

When it comes to growth, the eurozone and the UK are already in a stagnant near-recession. China, for its part, is mired in a structural slowdown. Although the US has avoided a recession, it could still end up in a short, shallow recession. This will occur if Fed policy articulated as “a little more interest for a little while longer” causes high bond yields to persist.

geopolitical depression

Either way, the risk of a bear market in stocks is more secular than cyclical. If a significant set of mega-threats materialize in the next decade, their stagflationary impact will harm stocks in the medium term.

All the recent evidence suggests that the “geopolitical depression” is getting worse: Russia’s invasion of Ukraine has evolved into a war of attrition, with the Ukrainians mounting a grueling counteroffensive to regain the territory they lost in 2022. The war could easily escalate, attract other parties – such as NATO – or escalate with the use of unconventional weapons. Such scenarios would, of course, bring new spikes in energy prices and commodities.

In the Middle East, Iran is about to take the final step of enriching uranium to build a nuclear weapon. This leaves Israel faced with a fateful choice: accept a nuclear-armed Iran and hope that traditional deterrence works, or launch a military strike – which would cause a sharp rise in oil prices (among other things), potentially sending the global economy into a tailspin. a stagflationary recession. The conflict between Israel and Hamas over Gaza could well escalate into a regional conflict involving Iran and its Lebanese proxy Hezbollah.

In Asia, the cold war between the US and China is getting colder and could heat up if China decides to reunite Taiwan with the mainland by force. And while the world's attention is focused on Ukraine, Taiwan and Gaza, North Korea is becoming more aggressive with its missile launches into the waters around South Korea and Japan.

Of these risks, the greatest is an escalation of the Sino-American Cold War. After the May 7 G-2023 summit in Hiroshima, US President Joe Biden stated that he expected a “thaw” with China. However, despite some official bilateral meetings, relations remain frosty. Indeed, the G-7 summit itself confirmed Chinese fears that the US will adopt a strategy of “comprehensive containment, encirclement and suppression”.

Unlike previous meetings, when G-7 leaders offered mostly talk and little action, the Hiroshima summit may have been the most important in the group's history. The recent summit in San Francisco between Chinese President Xi Jinping and Joe Biden did not change anything structural in the collision between the US and China. Despite a short-term partial easing, the cold war is becoming colder still; Furthermore, it may eventually become heated over the Taiwan issue.

After all, the US, Japan, Europe and their friends and allies have made it clearer than ever that they intend to join forces to fight China. Japan, as host, will certainly invite top leaders from the Global South who want to enlist to contain China's rise. Chief among them was Indian Prime Minister Narendra Modi. Although India (which holds the G20 presidency in 2023) has taken a neutral stance on Russia's war in Ukraine, it has long maintained a strategic rivalry with China, in part due to the two countries' long shared border, parts of which remain disputed.

Even if India does not become a formal ally of Western countries, it will continue to position itself as an independent and rising power, whose interests are more aligned with the West than with China and its de facto allies (Russia, Iran, Korea North and Pakistan). Furthermore, India is a formal member of the Quadrilateral Security Dialogue (the Quad) with the US, Japan and Australia, the explicit aim of which is to deter China. Japan and India have long-standing friendly relations and a shared history of adversarial relations with China.

Japan also invited Indonesia, South Korea (with whom it seeks a diplomatic thaw, driven by common concerns with China), Brazil (another important power in the Global South) and Ukrainian President Volodymyr Zelensky to the G-7. In each case, the message was clear: “boundless” Sino-Russian friendship is having and will have serious consequences for the way other powers perceive China.

In its final statement, the G-7 explained in detail how it will confront and deter China in the coming years. He criticized Chinese “economic coercion” and expansionism in the East and South China Seas, emphasized the importance of an Indo-Pacific partnership, and issued a clear warning to China not to attack or invade Taiwan.

In taking steps to “de-risk” their relations with China, Western leaders have established language that is only slightly less aggressive than that of “decoupling.” But it wasn't just the diplomatic discourse that changed. According to the statement, Western containment efforts will be accompanied by major investments in clean energy and infrastructure across the Global South so that major middle powers are not drawn into China's sphere of influence through its Belt and Road Initiative. Route.

Meanwhile, the technological and economic war between the West and the Chinese continues to escalate. Japan recently imposed restrictions on semiconductor exports to China. And they are no less draconian than those introduced by the US. Furthermore, the Joe Biden administration has since pressured Taiwan and South Korea to follow suit. In response, China banned  semiconductors manufactured by US chipmaker Micron. Additionally, it has begun restricting exports of some critical metals over which it has a near-monopoly in production and refining.

Similarly, American chipmaker Nvidia – which is quickly becoming a corporate superpower due to growing demand for its advanced chips to power AI applications – is facing new restrictions on selling to China. US policymakers have made clear that they intend to keep China at least a generation behind in the race for AI supremacy. To this end, the US CHIPS and Science Act 2022 introduced massive incentives for the resumption of chip production.

The risk now is that China will take advantage of its dominant role in the production and refining of rare earth metals that are key inputs in the green transition. China has already increased its electric vehicle exports by about 700% in value terms since 2017. It is starting to produce commercial planes that could eventually compete with Boeing and Airbus. So, while the G-7 wants to deter China without escalating the cold war, Beijing's response suggests that the needle is still in the hole.

Of course, the Chinese would like to forget that their own aggressive policies contributed to the situation. In interviews marking his 100th birthday in May, Henry Kissinger – the architect of the 1972 “opening of the United States to China” – warned: Unless the two countries find a new strategic understanding, they will remain on a collision course that could end in total war. The deeper the freeze, the greater the risk of violent repression and military hostilities this decade.

Even without a true hot war between the US and China, a colder war will mean more fragmentation of the global economy. It will also imply more balkanization of global supply chains, more decoupling or decoupling and more restrictions on cross-border flows of goods, services, capital, people, data and knowledge. Neoliberal free trade is over. Industrial policies, “domestic economics”, subsidies and safe trade are already being implemented as the world increasingly divides into two economic domains, monetary, financial, currency, trade, investment and technology.

Other elephants in the room

At the same time, the costs of climate change will continue to rise rapidly. Scientists now expect global average temperatures to reach 1,5° Celsius above pre-industrial levels – the target of the Paris climate agreement – ​​within the next five years. To contain the rise in temperatures, greenhouse gas emissions would have to be halved by 2030 – which is basically impossible.

Even if all the commitments made at COP26 in Glasgow and COP27 in Sharm El-Sheikh were fulfilled – a big doubt remains – temperatures would still be on track to reach 2,4°C above pre-industrial levels by the end of the century . In the absence of real action, the greenwashing: greenwishing and greenflation are becoming rampant.

The good news is that there are many technology options that can accelerate decarbonization, helping to achieve net-zero emissions with limited impact on economic growth: renewable energy, carbon capture and storage, clean and green hydrogen, and nuclear fusion. The bad news is that fusion is still a long way from commercialization, as are many of the other options that remain expensive compared to fossil fuels. The way humanity deals with climate change is equivalent to a slow-motion shipwreck – but with gradual acceleration.

To make matters worse, poorer emerging markets and developing countries are facing dire economic prospects. After an anemic recovery from the COVID-19 pandemic, they bore the brunt of higher food and energy prices following Russia's invasion of Ukraine. Higher inflation eroded real incomes and their currencies weakened against the dollar. This, combined with higher interest rates, has left many with unsustainable debt. The International Monetary Fund and the World Bank estimate that around 60% of poor countries and 25% of emerging markets will be unable to pay their debts and will need to restructure them.

In this context, rising poverty, climate change, inequality and social conflicts could easily lead to internal political instability or even failed states, causing mass migration and fueling the trend towards economic populism. Most of Latin America is now governed by left-wing populists, while far-right authoritarian populism is on the rise in other parts of the world.

In the USA, Donald Trump is the clear favorite to be nominated as the Republican Party's candidate for next year's presidential elections; he will be able to come back and take back the White House. In the United Kingdom, demagogue Boris Johnson remains very popular. A party with fascist roots rules Italy; the ultra-rightist Marine Le Pen remains the de facto leader of the opposition in France. In Turkey, recently re-elected President Recep Tayyip Erdogan continues to consolidate an autocratic regime. Until the Hamas attack, Israel was governed by the most right-wing coalition in its history. And, of course, Russian and Chinese presidents Vladimir Putin and Xi Jinping have formed a new authoritarian axis.

Finally, in the year since the mega-threats, AI has become an even more important topic due to the public launch of generative AI platforms like ChatGPT. I had originally predicted that deep learning architectures (“transformative networks”) would revolutionize Artificial Intelligence; Now, it appears that this actually happened.

The potential benefits – and pitfalls – of generative AI are profound and are becoming increasingly clear. On the positive side, productivity growth could be sharply increased, considerably enlarging the economic pie. But, as with the first digital revolution and the creation of the internet and its applications, it will take time for such gains to emerge and reach scale.

The risks associated with Artificial Intelligence are also becoming clear. Many worry about permanent technological unemployment – ​​not just among low-skilled blue-collar workers, but also in all creative professions. In an extreme scenario, the economy two decades from now could be growing at a rate of 10% per year, but with unemployment at 80%. A related risk, then, is that artificial intelligence will be another winning industry that turbocharges income and wealth inequality. There remains both a contradictory prediction and a profound contradiction here.

Artificial Intelligence will also have a similar effect on misinformation, including through videos.”deep fake” and various forms of cyber warfare, especially around elections. And, of course, there is the small but dire risk that advances in Artificial Intelligence will lead to AGI (artificial general intelligence) and the obsolescence of the human species.

The debate over whether technology companies should be more strictly regulated – or even broken up – continues to intensify. But the obvious counter-argument is that the US needs big technology and artificial intelligence companies to ensure its global dominance and, in particular, over China. The latter – it should be noted – is doing everything it can to become a military superpower.

Fortunately, if artificial intelligence ushers in a world of 10% annual growth, a substantive income redistribution could well be possible. Furthermore, Artificial Intelligence can also help us deal with other mega-threats such as climate change and future pandemics. While none of these positive outcomes can be taken for granted, given the power and influence that ruling elites wield, distributional problems are always easier to address in a high-growth scenario than in a low-growth one.

While stagflationary forces weigh on growth and exacerbate megathreats in the medium term, the future could be bright if we can avoid a dystopian scenario in which megathreats destructively feed off one another. However, our first priority will be to survive the coming decades amidst instability and chaos.

* Nouriel Roubini is professor of economics at the Stern School of Business at New York University. Author, among other books, of Megathreats: ten dangerous trends that imperil our future (Little, Brown and Company).

Translation: Eleutério FS Prado.

Originally published on the portal Project Syndicate.

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