For four decades after World War II, climate change and job-displacing artificial intelligence were not on anyone’s mind, and terms like “deglobalization” and “trade war” had no purchase. But now we are entering a new era that will more closely resemble the tumultuous and dark decades between 1914 and 1945.
NEW YORK – Severe megathreats are imperiling our future – not just our jobs, incomes, wealth, and the global economy, but also the relative peace, prosperity, and progress achieved over the past 75 years. Many of these threats were not even on our radar during the prosperous post-World War II era. I grew up in the Middle East and Europe from the late 1950s to the early 1980s, and I never worried about climate change potentially destroying the planet. Most of us had barely even heard of the problem, and greenhouse-gas emissions were still relatively low, compared to where they would soon be.
Moreover, after the US-Soviet détente and US President Richard Nixon’s visit to China in the early 1970s, I never really worried about another war among great powers, let alone a nuclear one. The term “pandemic” didn’t register in my consciousness, either, because the last major one had been in 1918. And I didn’t fathom that artificial intelligence might someday destroy most jobs and render Homo sapiens obsolete, because those were the years of the long “AI winter.”
Similarly, terms like “deglobalization” and “trade war” had no purchase during this period. Trade liberalization had been in full swing since the Great Depression, and it would soon lead to the hyper-globalization that began in the 1990s. Debt crises posed no threat, because private and public debt-to-GDP ratios were low in advanced economies and emerging markets, and growth was robust. No one had to worry about the massive build-up of implicit debt, in the form of unfunded liabilities from pay-as-you-go social security and health-care systems. The supply of young workers was rising, the share of the elderly was still low, and robust, mostly unrestricted immigration from the Global South to the North would continue to prop up the labor market in advanced economies.
Against this backdrop, economic cycles were contained, and recessions were short and shallow, except for during the stagflationary decade of the 1970s; but even then, there were no debt crises in advanced economies, because debt ratios were low. The kind of financial cycles that lead to crises were contained not just in advanced economies but even in emerging markets, owing to the low leverage, low risk-taking, solid financial regulation, capital controls, and various forms of financial repression that prevailed during this period. The advanced economies were strong liberal democracies that were free of extreme partisan polarization. Populism and authoritarianism were confined to a benighted cohort of poorer countries.
GOODBYE TO ALL THAT
Fast-forward from this relatively “golden” period between 1945 and 1985 to late 2022, and you will immediately notice that we are awash in new, extreme megathreats that were not previously on anyone’s mind. The world has entered what I call a geopolitical depression, with (at least) four dangerous revisionist powers – China, Russia, Iran, and North Korea – challenging the economic, financial, security, and geopolitical order that the United States and its allies created after WWII.
There is a sharply rising risk not only of war among great powers but of a nuclear conflict. In the coming year, Russia’s war of aggression in Ukraine could escalate into an unconventional conflict that directly involves NATO. And Israel – and perhaps the US – may decide to launch strikes against Iran, which is on its way to building a nuclear bomb.
With Chinese President Xi Jinping further consolidating his authoritarian rule, and with the US tightening its trade restrictions against China, the new Sino-American cold war is getting colder by the day. Worse, it could all too easily turn hot over the status of Taiwan, which Xi is committed to reuniting with the mainland, and which US President Joe Biden is apparently committed to defending. Meanwhile, nuclear-armed North Korea has once again been seeking attention by firing rockets over Japan and South Korea.
Cyberwarfare occurs daily between these revisionist powers and the West, and many other countries have adopted a non-aligned posture toward Western-led sanctions regimes. From our contingent vantage point in the middle of all these events, we don’t yet know if World War III has already begun in Ukraine. That determination will be left to future historians – if there are any.
Even discounting the threat of nuclear Armageddon, the risk of an environmental Apocalypse is becoming increasingly serious, especially given that most of the talk about net-zero and ESG (environment, social, and governance) investing is just greenwashing – or greenwishing. The new greenflation is already in full swing, because it turns out that amassing the metals needed for the energy transition requires a lot of expensive energy.
There is also a growing risk of new pandemics that would be worse than biblical plagues, owing to the link between environmental destruction and zoonotic diseases. Wildlife, carrying dangerous pathogens, are coming into closer and more frequent contact with humans and livestock. That is why we have experienced more frequent and virulent pandemics and epidemics (HIV, SARS, MERS, swine flu, bird flu, Zika, Ebola, COVID-19) since the early 1980s. All the evidence suggests that this problem will become even worse in the future. Indeed, owing to the melting of Siberian permafrost, we may soon be confronting dangerous viruses and bacteria that have been locked away for millennia.
Moreover, geopolitical conflicts and national-security concerns are fueling trade, financial, and technology wars, and accelerating the deglobalization process. The return of protectionism and the Sino-American decoupling will leave the global economy, supply chains, and markets more balkanized and fragmented. The buzzwords “friend-shoring” and “secure and fair trade” have replaced “offshoring” and “free trade.”
But on the domestic front, advances in AI, robotics, and automation will destroy more and more jobs, even if policymakers build higher protectionist walls in an effort to fight the last war. By both restricting immigration and demanding more domestic production, aging advanced economies will create a stronger incentive for companies to adopt labor-saving technologies. While routine jobs are obviously at risk, so, too, are any cognitive jobs that can be unbundled into discrete tasks, and even many creative jobs. AI language models like GPT-3 can already write better than most humans and will almost certainly displace many jobs and sources of income. In due course, some scientists believe that Homo sapiens will be rendered entirely obsolete by the rise of artificial general intelligence or machine super-intelligence – though this is a highly contentious subject of debate.
Thus, over time, economic malaise will deepen, inequality will rise even further, and more white- and blue-collar workers will be left behind.
HARD CHOICES, HARD LANDINGS
The macroeconomic situation is no better. For the first time since the 1970s, we are facing high inflation and the prospect of a recession – stagflation. The increased inflation in advanced economies wasn’t “transitory.” It is persistent, driven by a combination of bad policies – excessively loose monetary, fiscal, and credit policies that were kept in place for too long – and bad luck. No one could have anticipated how much the initial COVID-19 shock would curtail the supply of goods and labor and create bottlenecks in global supply chains. The same goes for Russia’s brutal invasion of Ukraine, which caused a sharp spike in energy, food, fertilizers, industrial metals, and other commodities. Meanwhile, China has continued its “zero-COVID” policy, which is creating additional supply bottlenecks.
While both demand and supply factors were in the mix, it is now widely recognized that the supply factors have played an increasingly decisive role. This matters for the economic outlook, because supply-driven inflation is stagflationary and thus increases the risk that monetary-policy tightening will produce a hard landing (increased unemployment and potentially a recession).
What will follow from the US Federal Reserve and other major central banks’ current tightening? Until recently, most central banks and most of Wall Street belonged to “Team Soft Landing.” But the consensus has rapidly shifted, with even Fed Chair Jerome Powell recognizing that a recession is possible, that a soft landing will be “very challenging,” and that everyone should prepare for some “pain” ahead. The Federal Reserve Bank of New York’s model shows a high probability of a hard landing, and the Bank of England has expressed similar views about the United Kingdom. Several prominent Wall Street institutions have also now made a recession their baseline scenario (the most likely outcome if all other variables are held constant).
History, too, points to deeper problems ahead. For the past 60 years in the US, whenever inflation has been above 5% (it is above 8% today), and unemployment has been below 5% (it is now 3.5%), any attempt by the Fed to bring inflation down toward its 2% target has caused a recession. Thus, a hard landing is much more likely than a soft landing, both in the US and across most other advanced economies.
In addition to the short-term factors, negative supply shocks and demand factors in the medium term will cause inflation to persist. On the supply side, I count eleven negative supply shocks that will reduce potential growth and increase the costs of production. Among these is the backlash against hyper-globalization, which has been gaining momentum and creating opportunities for populist, nativist, and protectionist politicians, and growing public anger over stark income and wealth inequalities, which is leading to more policies to support workers and the “left behind.” However well-intentioned, such measures will contribute to a dangerous wage-price spiral.
Other sources of persistent inflation include rising protectionism (from both the left and the right), which has restricted trade, impeded the movement of capital, and heightened political resistance to immigration, which in turn has put additional upward pressure on wages. National-security and strategic considerations have further restricted flows of technology, data, and talent, and new labor and environmental standards, as important as they may be, are hampering both trade and new construction.
This balkanization of the global economy is deeply stagflationary, and it is coinciding with demographic aging, not just in developed countries but also in large emerging economies such as China. Because young people tend to produce and save more, whereas older people spend down their savings and require many more expensive services in health care and other sectors, this trend, too, will lead to higher prices and slower growth.
Today’s geopolitical turmoil further complicates matters. The disruptions to trade and the spike in commodity prices following Russia’s invasion were not just a one-off phenomenon. The same threats to harvests and food shipments that arose in 2022 may well persist in 2023. Moreover, if China does finally end its zero-COVID policy and begin to restart its economy, a surge in demand for many commodities will add to the global inflationary pressures. There is also no end in sight for Sino-Western decoupling, which is accelerating across all dimensions of trade (goods, services, capital, labor, technology, data, and information). And, of course, Iran, North Korea, and other strategic rivals to the West could soon contribute in their own ways to the global havoc.
Now that the US dollar has been fully weaponized for strategic and national-security purposes, its position as the main global reserve currency could eventually begin to decline, and a weaker dollar would of course add to inflationary pressures in the US. More broadly, a frictionless world trading system requires a frictionless financial system. But sweeping primary and secondary sanctions have thrown sand in what was once a well-oiled machine, massively increasing the transaction costs of trade.
On top of it all, climate change, too, will create persistent stagflationary pressures. Droughts, heat waves, hurricanes, and other disasters are increasingly disrupting economic activity and threatening harvests (thus driving up food prices). At the same time, demands for decarbonization have led to underinvestment in fossil-fuel capacity before investment in renewables has reached the point where they can make up the difference. Today’s large energy-price spikes were inevitable.
The increased likelihood of future pandemics also represents a persistent source of stagflation, especially considering how little has been done to prevent or prepare for the next one. The next contagious outbreak will lend further momentum to protectionist policies as countries rush to close borders and hoard critical supplies of food, medicines, and other essential goods.
Finally, cyberwarfare remains an underappreciated threat to economic activity and even public safety. Firms and governments will either face more stagflationary disruptions to production, or they will have to spend a fortune on cybersecurity. Either way, costs will rise.
THE WORST OF ALL POSSIBLE ECONOMIES
When the recession comes, it will not be short and shallow but long and severe. Not only are we facing persistent short- and medium-term negative supply shocks, but we are also heading into the mother of all debt crises, owing to soaring private and public debt ratios over the last few decades. Low debt ratios spared us from that outcome in the 1970s. And though we certainly had debt crises following the 2008 crash – the result of excessive household, bank, and government debt – we also had deflation. It was a demand shock and a credit crunch that could be met with massive monetary, fiscal, and credit easing.
Today, we are experiencing the worst elements of both the 1970s and 2008. Multiple, persistent negative supply shocks have coincided with debt ratios that are even higher than they were during the global financial crisis. These inflationary pressures are forcing central banks to tighten monetary policy even though we are heading into a recession. That makes the current situation fundamentally different from both the global financial crisis and the COVID-19 crisis. Everyone should be preparing for what may come to be remembered as the Great Stagflationary Debt Crisis.
While central banks have been at pains to sound more hawkish, we should be skeptical of their professed willingness to fight inflation at any cost. Once they find themselves in a debt trap, they will have to blink. With debt ratios so high, fighting inflation will cause an economic and financial crash that will be deemed politically unacceptable. Major central banks will feel as though they have no choice but to backpedal, and inflation, the debasement of fiat currencies, boom-bust cycles, and financial crises will become even more severe and frequent.
The inevitability of central banks wimping out was recently on display in the United Kingdom. Faced with the market reaction to the Truss government’s reckless fiscal stimulus, the BOE had to launch an emergency quantitative-easing (QE) program to buy up government bonds. That sad episode confirmed that in the UK, as in many other countries, monetary policy is increasingly subject to fiscal capture.
Recall that a similar turnaround occurred in 2019, when the Fed, after previously signaling continued rate hikes and quantitative-tightening, stopped its QT program and started pursuing a mix of backdoor QE and policy-rate cuts at the first sign of mild financial pressures and a growth slowdown. Central banks will talk tough; but, in a world of excessive debt and risks of an economic and financial crash, there is good reason to doubt their willingness to do “whatever it takes” to return inflation to its target rate.
With governments unable to reduce high debts and deficits by spending less or raising revenues, those that can borrow in their own currency will increasingly resort to the “inflation tax”: relying on unexpected price growth to wipe out long-term nominal liabilities at fixed interest rates.
How will financial markets and prices of equities and bonds perform in the face of rising inflation and the return of stagflation? It is likely that, as in the stagflation of the 1970s, both components of any traditional asset portfolio will suffer, potentially incurring massive losses. Inflation is bad for bond portfolios, which will take losses as yields increase and prices fall, as well as for equities, whose valuations are hurt by rising interest rates.
For the first time in decades, a 60/40 portfolio of equities and bonds suffered massive losses in 2022, because bond yields have surged while equities have gone into a bear market. By 1982, at the peak of the stagflation decade, the average S&P 500 firm’s price-to-earnings ratio was down to eight; today, it is closer to 20, which suggests that the bear market could end up being even more protracted and severe. Investors will need to find assets to hedge against inflation, political and geopolitical risks, and environmental damage: these include short-term government bonds and inflation-indexed bonds, gold and other precious metals, and real estate that is resilient to environmental damage.
THE MOMENT OF TRUTH
In any case, these megathreats will further contribute to rising income and wealth inequality, which has already been putting severe pressure on liberal democracies (as those left behind revolt against elites), and fueling the rise of radical and aggressive populist regimes. One can find right-wing manifestations of this trend in Russia, Turkey, Hungary, Italy, Sweden, the US (under Donald Trump), post-Brexit Britain, and many other countries; and left-wing manifestations in Argentina, Venezuela, Peru, Mexico, Colombia, Chile, and now Brazil (which has just replaced a right-wing populist with a left-wing one).
And, of course, Xi’s authoritarian stranglehold has given the lie to the old idea that Western engagement with a fast-growing China would ineluctably lead that country to open itself up even more to markets and, eventually, to democratic processes. Under Xi, China shows every sign of becoming more closed off, and more aggressive on geopolitical, security, and economic matters.
How did it come to this? Part of the problem is that we have long had our heads stuck in the sand. Now, we need to make up for lost time. Without decisive action, we will be heading into a period that is less like the four decades after WWII than like the three decades between 1914 and 1945. That period gave us World War I; the Spanish flu pandemic; the 1929 Wall Street crash; the Great Depression; massive trade and currency wars; inflation, hyperinflation, and deflation; financial and debt crises, leading to massive meltdowns and defaults; and the rise of authoritarian militarist regimes in Italy, Germany, Japan, Spain, and elsewhere, culminating in WWII and the Holocaust.
In this new world, the relative peace, prosperity, and rising global welfare that we have taken for granted will be gone; most of it already is. If we don’t stop the multi-track slow-motion train wreck that is threatening the global economy and our planet at large, we will be lucky to have only a repeat of the stagflationary 1970s. Far more likely is an echo of the 1930s and the 1940s, only now with all the massive disruptions from climate change added to the mix.
Avoiding a dystopian scenario will not be easy. While there are potential solutions to each megathreat, most are costly in the short run and will deliver benefits only over the long run. Many also require technological innovations that are not yet available or in place, starting with those needed to halt or reverse climate change. Complicating matters further, today’s megathreats are interconnected, and therefore best addressed in a systematic and coherent fashion. Domestic leadership, in both the private and public sector, and international cooperation among great powers is necessary to prevent the coming Apocalypse.
Yet there are many domestic and international obstacles standing in the way of policies that would allow for a less dystopian (though still contested and conflictual) future. Thus, while a less bleak scenario is obviously desirable, a clear-headed analysis indicates that dystopia is much more likely than a happier outcome. The years and decades ahead will be marked by a stagflationary debt crisis and related megathreats – war, pandemics, climate change, disruptive AI, and deglobalization – all of which will be bad for jobs, economies, markets, peace, and prosperity.
Nouriel Roubini is Professor Emeritus at the Stern School of Business, NYU and author of the recently released book Megathreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them.