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Leaders | After the chaos
A new macroeconomic era is emerging. What will it
look like?
A great rebalancing between governments and central banks is under way
Oct 6th 2022 Save Share Give
F or months there has been turmoil in financial markets and growing evidence of stress in the world
economy. You might think that these are just the normal signs of a bear market and a coming
recession. But, as our special report this week lays out, they also mark the painful emergence of a new
regime in the world economy—a shift that may be as consequential as the rise of Keynesianism after the
second world war, and the pivot to free markets and globalisation in the 1990s. This new era holds the
promise that the rich world might escape the low-growth trap of the 2010s and tackle big problems such as
ageing and climate change. But it also brings acute dangers, from financial chaos to broken central banks
and out-of-control public spending.
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The ructions in the markets are of a magnitude not seen for a generation. Global inflation is in double
digits for the first time in nearly 40 years. Having been slow to respond, the Federal Reserve is now
cranking up interest rates at the fastest pace since the 1980s, while the dollar is at its strongest for two
decades, causing chaos outside America. If you have an investment portfolio or a pension, this year has
been gruesome. Global shares have dropped by 25% in dollar terms, the worst year since at least the 1980s,
and government bonds are on course for their worst year since 1949. Alongside some $40trn of losses there
is a queasy sense that the world order is being upended as globalisation heads into retreat and the energy
system is fractured after Russia’s invasion of Ukraine.
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All this marks a definitive end to the age of economic placidity in the 2010s. After the global financial crisis
of 2007-09 the performance of rich economies assumed a feeble pattern. Investment by private firms was
subdued, even at those making monster profits, while governments did not take up the slack: the public
capital stock actually shrank around the world, as a share of gdp, in the decade after Lehman Brothers
collapsed. Economic growth was sluggish and inflation was low. With the private and public sectors doing
little to stimulate more activity, central banks became the only game in town. They held interest rates at
rock-bottom levels and bought huge volumes of bonds at any sign of trouble, extending their reach ever
further into the economy. On the eve of the pandemic central banks in America, Europe and Japan owned a
staggering $15trn of financial assets.
The extraordinary challenge of the pandemic led to extraordinary actions which helped unleash today’s
inflation: wild government stimulus and bail-outs, temporarily skewed patterns of consumer demand and
lockdown-induced supply-chain tangles. That inflationary impulse has since been turbocharged by the
energy crunch as Russia, one of the largest exporters of fossil fuels along with Saudi Arabia, has isolated
itself from its markets in the West. Faced with a serious inflation problem the Fed has already raised rates
from a maximum of 0.25% to 3.25% and is expected to take them to 4.5% by early 2023. Globally, most
monetary authorities are tightening too.
What on earth comes next? One immediate fear is of a blow-up, as a financial system that has become
habituated to low rates wakes up to the soaring cost of borrowing. Although one mid-sized lender, Credit
Suisse, is under pressure, it is unlikely that banks will become a big problem: most have bigger safety
buffers than in the past. Instead the dangers lie elsewhere, in a new-look financial system that relies less
on banks and more on fluid markets and technology. The good news is that your deposits are not about to
go up in smoke. The bad news is that this system for financing firms and consumers is opaque and
hypersensitive to losses.
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You can already see this in the credit markets. As firms that buy debt shy away from risk, the interest rate
on mortgages and junk bonds is soaring. The marketReplay
for “leveraged loans” used to finance corporate buy-
outs has seized up—if Elon Musk buys Twitter the resulting debts may become a big problem. Meanwhile
investment funds, including pension schemes, face losses on the portfolios of illiquid assets they have
accumulated. Parts of the plumbing could stop working. The Treasury market has become more erratic (see
Buttonwood) while European energy firms have faced crushing collateral calls on their hedges. Britain’s
bond market has been thrown into chaos by obscure derivatives bets made by its pension funds.
If markets stop working smoothly, impeding the flow of credit or threatening contagion, central banks may
step in: already the Bank of England has done a u-turn and started buying bonds again, cutting against its
simultaneous commitment to raise rates. The related belief that central banks will not have the resolve to
follow through on their tough talk is behind the other big fear: that the world will return to the 1970s, with
rampant inflation. In one sense this is alarmist and over the top. Most forecasters reckon inflation in
America will fall from the present 8% to 4% in 2023 as energy price-rises ebb and higher rates bite. Yet
while the odds of inflation going to 20% are tiny, there is a glaring question about whether governments
and central banks will ever bring it back down to 2%.
A moving target
To understand why, look beyond the hurly-burly to the long-term fundamentals. In a big shift from the
2010s, a structural rise in government spending and investment is under way. Ageing citizens will need
more health care. Europe and Japan will spend more on defence to counter threats from Russia and China.
Climate change and the quest for security will boost state investment in energy, from renewable
infrastructure to gas terminals. And geopolitical tensions are leading governments to spend more on
industrial policy. Yet even as investment rises, demography will weigh ever more heavily on rich
economies. As people get older they save more, and this excess of savings will continue to act to depress
the underlying real rate of interest.
As a result the fundamental trends in the 2020s and 2030s are for bigger government but still-low real
interest rates. For central banks this creates an acute dilemma. In order to get inflation down to their
targets of roughly 2% they may have to tighten enough to cause a recession. This would incur a high
human cost in the form of job losses and trigger a fierce political backlash. Moreover, if the economy
deflates and ends up back in the low-growth, low-rate trap of the 2010s, central banks may once again lack
enough stimulus tools. The temptation now is to find another way out: to ditch the 2% inflation targets of
recent decades and raise them modestly to, say, 4%. That is likely to be on the menu when the Fed begins
its next strategy review in 2024.
This brave new world of somewhat higher government spending and somewhat higher inflation would
have advantages. In the short run it would mean a less severe recession or none at all. And in the long run
it would mean that central banks have more room to cut interest rates in a downturn, reducing the need for
bond-buying and bail-outs whenever anything goes wrong, which cause ever-greater distortion of the
economy.
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Yet it also comes with big dangers. Central banks’ credibility will be damaged: if the goalposts are moved
once, why not again? Millions of contracts and investments written on the promise of 2% inflation would
be disrupted, while mildly higher inflation would redistribute wealth from creditors to debtors.
Meanwhile, the promise of moderately bigger government could easily spiral out of control, if populist
politicians make reckless spending pledges or if state investments in energy and industrial policy are
poorly executed and morph into bloated vanity projects that drag down productivity.
These opportunities and dangers are daunting. But it is time to start weighing them and their implications
for citizens and businesses. The biggest mistakes in economics are failures of imagination that reflect an
assumption that today’s regime will last for ever. It never does. Change is coming. Get ready.7
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This article appeared in the Leaders section of the print edition under the headline "What next?"
Leaders
October 8th 2022
→ A new macroeconomic era is emerging. What will it look like?
→ To win Brazil’s presidency, Lula should move to the centre
→ Britain’s Conservatives do not understand how much things have
changed
→ Do McKinsey and other consultants do anything useful?
→ How worried should you be about Elon Musk’s superpowers?
From the October 8th
2022 edition
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