The West's wild crises

Inflation, interest rates, the coming banking crisis and the political shakeup that will follow

I had said in my first piece on Ukraine that this war will bring about the end of neoliberalism. I thought I should expand on this. I argue that interest rates will have to rise dramatically throughout the West to break out of stagflation, which is either already here or is around the corner. There will be extreme political resistance to this. Higher interest rates will intensify the cost of living crisis that much of the world faces. They will limit governments’ ability to refinance their debts, as well as placing a far greater burden on mortgage holders. This risks triggering a banking crisis in the West. Combined with Russia’s gradual military victory in Ukraine, the expansion of the BRICS, the willingness of third countries to trade with Russia in roubles using its alternative to SWIFT and the economic crisis the West is facing, this risks undermining the position of the dollar. All of these factors will have political implications, especially in Europe, where an increase in populism and in government instability is inevitable.

Historic comparison: The current energy crisis, brought about by attempts to impose green energy and by the sanctions that followed Russia’s invasion of Ukraine, is being compared to the 1973 crisis. It’s worth noting that the inflation that began with the energy crisis of the 1970s was not tamed until the 1980s. No one had the heart to make the tough political decisions needed to address it. It is impossible to assume that the current energy-driven inflationary wave is transitory – the cost of living crisis is going to lead to demands for higher wages and is going to force governments to spend to support companies and consumers, until the situation becomes so bad that the political cost of severe action becomes lower than the political cost of evasion. Even now, the Federal Reserve continuing with quantitative easing, meaning that the global supply of dollars is increasing.

Scope: I view the Euro, the pound, the Australian dollar, the yen, the Canadian dollar and the American dollar as inseparable, for the simple reason that in every major economic crisis in recent memory, the Fed has to engage in currency swaps with these countries’ central banks to bail them out. Furthermore, US sanctions end up impacting all these countries – if the US says you cannot do business, banks in these countries will follow the US’ diktats. The combination of bailout power and regulatory power that the US has over these countries means that we can think about the Western bloc holistically, though I appreciate that there are many nuances and differences that I am not aware of.

Inflation: The 1973 crisis triggered double digit inflation in most of the developed world. Inflation calculations in much of the West have changed, with the cost of electronic goods, for example, being assessed against the supposed improvements in technology. Essentially, the bean counters claim that your enjoyment of your mobile phone has doubled due to better technology, but prices have only risen by half, and so the net effect is lower inflation. It is very likely that if Western bean counters were using proper methodology, inflation today would be in the mid to high teens.

Interest rates: For most of the 1970s US and UK interest rates were in the double digits. Interest rates must be raised above the level of inflation if there is any hope of reducing inflation. Anything else makes inflation last for longer. Negative real interest rates also disincentivise saving – your dollar consumed today is worth more than your dollar saved for tomorrow. The reduction in savings reduces the pool of available investment, hobbling the economy in the long term and reducing the future supply of goods, also raising future inflation. With lower output and higher prices, the West is entering a period of stagflation that will last as long as the low interest rate regime is maintained

Interest rates will rise, dramatically, to levels well above inflation before this wave of inflation is tamed. It is not a transitory wave. However, there are political constraints on the ability to raise interest rates in the West. Firstly, the number and value of mortgages in the economy are today far greater than they were in the 1970s. A large increase in interest rates would make many borrowers unable to stay in their homes. Given the expansion in the number of people with mortgages, this is political suicide. Furthermore, with debt to GDP levels where they are in the West post the 2008 crisis and post COVID, it is very likely that many states with large deficits would be unable to afford to refinance their debts if interest rates were considerably higher. Western states are also under pressure to increase military spending as they are now in a full blown confrontation with Russian and China. Finally, states will find that they are under pressure to significantly raise wages and pensions to keep pace with inflation, which they also cannot afford due to the impact this would have on inflation and on fiscal deficits. The West is facing a perfect storm.

Banking crisis: We are heading towards a situation where governments cannot print more money, individual borrowers cannot afford their mortgages and already overextended governments cannot afford their debts. This is a recipe for a banking crisis that will be considerably worse than the 2008 crisis, when at least the system had both some fiscal and monetary options. With so much fiscal and monetary ammunition expended to deal with the 2008 crisis, COVID and the current crisis, there will be far less room for government action. Already, there is a wide number of European banks that are insolvent and highly vulnerable. My gut instinct is that some banks need to be destroyed for a stable and strong banking sector to emerge.

The dollar’s position: Already, most developing countries have rejected Western sanctions on Russia (it is safe to say that they will reject sanctions on China even more vigorously). The African Union sent a delegation to meet with President Putin and find a way to continue to obtain Russian food and energy. The BRICS are talking about adding new countries, building a shared banking infrastructure, establishing a ratings agency and doing what is necessary to be able to trade fully independently of the US and its auxiliary, the EU. What underpins the dollar’s position is a combination of factors: the size of the US economy, the US’ ability to maintain high deficits, the depth of the US’ capital markets, the petrodollar and the perception of US military might. The ongoing crushing defeat that the Ukraine is facing, the willingness of the world to pay for Russian energy and food in roubles, and the coming economic crises that the US faces all challenge the dollar’s position and with it challenge the US’ economic and political model. Any move away from the dollar will be gradual, and then sudden. The gradual part has already begun.

Political impact: The 2008 crisis birthed the Tea Party, which eventually gave us Donald Trump. It ended or mortally wounded many political parties in Europe, and European politics are still unsettled. Now what? Now, Europe faces a situation where the US is offering it more neoliberalism – as in, the combination of free trade, de-industrialisation, financialisaton and gig economy work – and where Russia is offering cheap energy and food, military prowess and social sanity (see my two pieces in the links to understand what I mean by that). Russia has the means to support populist parties in Europe and will almost certainly do so. Any attempt to bailout the banks and not the consumers will be met with public rage that gets fuelled by Russian media, but that will be very genuinely felt by European citizens. There will be a political price to pay for what will be the first response of various Western governments, which is to try to impose on the whole of Europe what was imposed on Greece in 2008. I expect this crisis to topple many governments, trigger many early elections, and force a rethink of how we have run our affairs for the past generation. Already, the government in Bulgaria has fallen, and the UK’s Boris Johnson is in an untenable position. The governing coalition in Germany also looks vulnerable. The political turmoil will continue until a movement that is seen as a clean break with the past, and that offers hard but necessary solutions, emerges. I also expect that there will be an increase in support for various countries exiting the European Union, though it is impossible to say which will go first. For the US, if there is a global loss of confidence in the dollar, this will generate an enormous populist backlash which may pull Europe along with it.

Energy policy impact: It is not unrealistic to assume that a political change in Europe and the US will come with a reversal on renewable energy policy. The key risk is that political parties could emerge that openly oppose renewable energy, while sanctions against Russia and opposition to hydrocarbons remains within the establishment. This could lead to a situation where investors find it unsafe to invest in both renewable energy and in hydrocarbons, while some public opposition to nuclear power continues. This would ensure energy starvation.

Call for feedback: I wrote this piece in rather general terms to appeal to a wide audience. I’d be most interested in hearing about the specifics of your country and in any views you may have.