A perfect storm brewing

Buffeted by the coronavirus pandemic and shockwaves from the Ukraine war, an already fragile global economy faces the combined threat of inflation, recession and financial crisis.

Lim Mah Hui

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THE COVID-19 pandemic is the most serious since the Spanish flu of 1918. Worldwide, close to half a billion people have been infected and 6.2 million deaths have been officially reported as of March 2022. The actual numbers could be much higher. The economic costs are enormous, estimated at $16 trillion or 17% of 2021 world gross domestic product (GDP); not to mention the social costs of lost education, mental depression and suicide.

        This is not the first pandemic, nor will it be the last. It is also not simply a health crisis. It has a web of relationships in problems that have been building up in the environment, health, economy, finance and politics. A zoonotic pandemic is bound up with an environmental crisis that results from humans’ relentless and ruthless encroachment on nature and the environment, upsetting the precarious ecological balance and the distance between wild animals and the human population. It should have been expected, but we were not well prepared.

        COVID-19 has laid bare many fractures and flaws in society: inability of health systems to cope with health calamities; huge socio-economic disparities that widen as the pandemic hits the poor and lower working class harder than the rich; increasing fragility of an inherently unstable financial system; and political polarisation between those who are economically left behind and the privileged minority who continue to benefit disproportionately from growth.

        The pandemic landed on a wobbly financial stage. It hit the world economy hard when it was still struggling to emerge from the catastrophic 2008 Global Financial Crisis (GFC). The GFC, the most serious financial crisis since the 1932 Great Depression, resulted from four decades of excessive financialisation – the buildup of an inherently unstable and parasitic financial system – abetted by financial deregulation and neoliberal economic policies. Financialisation meant the economic centre of gravity shifted from production to financial circulation, from value creation to value extraction. Finance not only came to dominate the real economy but whipsawed it like the proverbial tail wagging the dog. Growth is driven more by debt than productivity and income gains. Speculation and investment in financial assets fanned repeated booms and busts. Financialisation breeds inequality, and inequality contributes to financial crisis, the two mutually reinforcing each other. The complex interplay of all these factors produces an unstable financial system that lunges from one financial crisis to the next, as happened in the US savings-and-loans crisis in the early 1980s, the Latin American financial crisis of the 1980s, the Asian financial crisis of 1997, and the Global Financial Crisis of 2008.

        To get out of the GFC, central banks lowered interest rates and unleashed massive liquidity into the financial system through quantitative easing. While these policies bailed out banks, they were less effective in reviving the real economy. It took 11 years after the GFC for the world output gap to become marginally positive before plunging into negative territory again in 2020. Corporations borrowed cheap money for financial activities such as mergers and acquisitions and share buybacks rather than for investing in production. Cheap money also enabled the wealthy to borrow at low interest rates to invest and speculate in financial markets, pushing up stock and bond markets to new heights surpassing the pre-GFC levels. The results were higher levels of inequality and debt, the very mix that led to booms and busts and the recession in 2008. By 2019, world debt had reached $253 trillion (320% of world GDP), 70% higher than before the GFC. Inequality was also at a historic peak, with the top 1% of households owning over 50% of the world’s wealth.

        The pandemic has brought the sharpest decline in economic growth since the Great Depression. Governments in most countries pulled out all the stops to rescue the economy through unprecedented fiscal and monetary measures. By May 2020, the G10 industrial countries plus China had spent $15 trillion in fiscal and monetary packages to rescue their economies. Fiscal expenditure in the form of government grants and subsidies to businesses forced to shut down and individuals who lost their jobs or had income cut cushioned the negative impact. Central banks resorted to their knee-jerk reaction cutting interest rates to near zero and ramping up quantitative easing, this time purchasing not only government securities but also mortgage-backed securities and corporate bonds.

        Repeating the same monetary policies that were used to fight the last financial crisis serves to sow the seeds for the next financial crisis. Ultra-low interest rates and massive liquidity again tempted corporations to binge on debt, propped up zombie companies, misallocated capital and disadvantaged savers and people who depend on wage or fixed income in favour of financial investors and speculators who profited handsomely. Global debt doubled after the Global Financial Crisis from $150 trillion in 2007 to $296 trillion at the end of June 2021. Global financial markets soared to historic highs, stretching valuations to dangerous levels.

        The monumental rescue plans made for a quick rebound in the first half of 2021 mainly due to the low-base effect. But a full recovery is still tentative. It is also highly skewed, being K-shaped rather than V-shaped, with large swaths of the economy and population still very much underwater.

        Policymakers are now stuck between the Scylla of inflation and Charybdis of rising interest rates. As late as the second half of 2021, the US Federal Reserve, insistent that inflation was transitory and would taper out by 2022, continued its loose monetary policies. By late 2021, however, supply chain disruptions appeared more serious and persistent, new variants of the coronavirus emerged delaying health and economic recovery, and absenteeism and labour shortages became more prevalent – all these put pressure on prices, which crept higher. By October 2021, the US monthly inflation rate had more than tripled to 6.2% from 1.7% in February 2021, and it reached 7.9% by February 2022, the steepest monthly increase in over 40 years.

        The outbreak of the Ukraine war in late February added fuel to the fire, changing the ballgame and elevating inflation to a new level. The war and the sanctions imposed by the West on Russia, a major supplier of oil and gas, wheat, fertilisers and vital minerals, sent energy and food prices through the roof. These are basic commodities with extensive downstream effects on the rest of the economy. The impact is felt most keenly in Europe, which is highly dependent on Russia for energy supply, and by non-oil-producing developing economies reliant on energy and food imports. While European countries may have the fiscal policy space to blunt some of the rising costs to consumers, poorer countries are more constrained. Food shortages and huge spikes in food prices have ignited protests and riots in several Middle Eastern countries highly dependent on wheat imports. The sanctions also severely disrupted world trade and upended financial flows (remittances and payment systems). They have also prompted a rethink on the real risks for countries with vast US dollar reserves holdings and spurred their search for alternative payment and settlement systems. Some commentators have termed these financial sanctions as financial weapons of mass destruction.

        We are now staring not just at inflation, but stagflation and probable recession – a nightmare scenario for central bankers. Today’s conditions are reminiscent of the early 1970s when the 1973 Arab-Israeli war and the Arab oil embargo tripled the price of oil, pushing the US and other major economies into recession. In today’s scenario, the chief economist of Goldman Sachs estimated that a European Union ban on Russian energy imports would cause a 2.2% hit to production and trigger a eurozone recession.

        Again, today’s conditions are more complicated and serious owing to the mountain of debt weighing on governments and corporations. Raising interest rates to fight inflation would not only court recession but, worse still, could trigger a financial crisis as over-leveraged companies default on their debt. It is estimated that 20% of US companies are zombie companies, i.e., whose earnings are inadequate to service debt, kept afloat only by lenders rolling over their debt when due. What about the potential losses to institutional investors like insurance companies and pension funds who hold $16 trillion of negative bonds worldwide when interest rates climb?

        Central banks, trying to find an exit strategy from extraordinary monetary and fiscal liquidity injections without plunging the world into another financial crisis, no longer have the luxury of a rider trying to leisurely dismount from a tiger’s back. The geopolitical conditions of the war have forced them to slam the brakes by aggressively hiking interest rates to bring inflation under control.

How we can ride out the perfect storm is anyone’s guess.           

Dr Lim Mah Hui, Chair of the Board of the Third World Network, has been a university professor and banker, in the private sector and with the Asian Development Bank. He is the lead author of COVID-19 and the Structural Crises of Our Time.

*Third World Resurgence No. 350, 2022, pp 5-6