The author is professor of economics and public policy at Harvard University and former chief economist at the IMF.
The Fed’s far-reaching actions to prevent the Silicon Valley Bank meltdown from becoming systemic, followed by the Swiss National Bank’s massive lifeline to struggling Credit Suisse, left little doubt this week that that financial leaders are determined to act decisively when fear begins to set in. leave moral hazard for another day.
But even if the risks of a financial Armageddon in 2023 have been contained, not all the differences with 2008 are so reassuring. At the time, inflation was not a problem and deflation – falling prices – quickly became one. Today, underlying inflation in the United States and Europe is still going strong, and you really have to force the definition of “transient” to say that it is not a problem. Global debt, both public and private, has also exploded. It wouldn’t be such a problem if forward-looking real long-term interest rates were to take a deep dive, as they did during the years of secular stagnation before 2022.
Unfortunately, however, ultra-low borrowing rates are not something to be relied upon this time around. First of all, I would say that if you look at long-term historical models of real interest rates (like Paul Schmelzing, Barbara Rossi and myself), major shocks – for example, the sharp drop after the financial crisis of 2008 – tend to fade over time. There are also structural reasons: on the one hand, global debt (public and private) exploded after 2008, partly as an endogenous response to low rates, partly as a necessary response to the pandemic. Other factors pushing up real long-term rates include the massive costs of green transition and the upcoming increase in defense spending around the world. Rising populism will likely help reduce inequality, but higher taxes will reduce trend growth even as higher spending adds upward pressure on rates.
This means that even after inflation falls, central banks may need to keep the general level of interest rates higher over the next decade than they have over the last. simply to keep inflation stable.
Another significant difference between now and after 2008 is China’s much weaker position. Beijing’s fiscal stimulus after the financial crisis has played a key role in sustaining global demand, especially for raw materials, but also for German manufacturing and European luxury goods. Much of it went into real estate and infrastructure, the country’s massive growth sector.
Now, however, after years of construction at breakneck speed, China is facing the same kind of diminishing returns that Japan began to experience in the late 1980s (the so-called “bridges to nowhere”) and the former Soviet Union experienced in the late 1960s. Combine this with excessive centralization of decision-making, extremely unfavorable demographics and creeping de-globalization, and it becomes clear that China will not be able to play such an outsized role in sustaining global growth in the next global recession.
Last but not least, the 2008 crisis occurred during a period of relative global peace, which is hardly the case today. The Russian war in Ukraine has been a continuous supply shock that explains a large part of the inflation problem that central banks are currently trying to deal with.
Looking back on the last two weeks of banking strains, we should be grateful that it didn’t happen sooner. With central bank rates rising sharply and a troubled underlying economic backdrop, it is inevitable that there will be many losses from businesses and, normally, debtors from emerging markets. So far, several low- and middle-income countries have defaulted, but there are likely to be more to come. Surely there will be issues other than technology, for example the commercial real estate sector in the United States, which is being hit by rising interest rates even as office occupancy in major cities does not remains only about 50%. Of course, the financial system, including the loosely regulated “shadow banks,” has to bear some of the losses.
Governments in advanced economies are not all necessarily immune. They may have long since emerged from sovereign debt crises, but not from partial default following surprise high inflation.
How should the Federal Reserve weigh all these issues in deciding its rate policy next week? After the bank jolts, it certainly won’t go ahead with a 50 basis point hike (half a percent) like the European Central Bank did on Thursday, surprising markets. But then the ECB catches up with the Fed.
At least the optics of once again bailing out the financial sector while tightening the screws on Main Street are not good. Yet, like the ECB, the Fed cannot lightly dismiss persistent underlying inflation above 5%. He’ll probably go for a 25 basis point hike if the banking sector looks calm again, but if there’s still some jitters he could perfectly say the direction is still up, but he has to to make a break.
It is much easier to resist political pressures at a time when global pressures on interest rates and prices are pushing down. No more. Those days are over and things are going to get tougher for the Fed. The trade-offs he faces next week may just be the start.
