a large negative aggregate demand shock, the next recession is likely to be
caused by permanent negative supply shocks from the Sino-American trade and
technology war. And trying to undo the damage through never-ending monetary and
fiscal stimulus will not be an option.
NEW YORK – There are three negative supply shocks that could
trigger a global
recession by 2020. All of them reflect political factors affecting
international relations, two involve China, and the United States is at the
center of each. Moreover, none of them is amenable to the traditional tools of
countercyclical macroeconomic policy.
The first potential shock stems from the Sino-American trade
and currency war, which escalated
earlier this month when US President Donald Trump’s administration threatened
additional tariffs on Chinese exports, and formally labeled China a currency
manipulator. The second concerns the slow-brewing cold war between the US and
China over technology. In a rivalry that has all the hallmarks of a “Thucydides
Trap,” China and America are vying for dominance over the industries of the
future: artificial intelligence (AI), robotics, 5G, and so forth. The US has
placed the Chinese telecom giant Huawei on an “entity list” reserved for
foreign companies deemed to pose a national-security threat. And although
Huawei has received temporary exemptions allowing it to continue using US
components, the Trump administration this week announced that it was adding an additional 46 Huawei
affiliates to the list.
The third major risk concerns oil supplies. Although oil
prices have fallen in recent weeks, and a recession triggered by a trade,
currency, and tech war would depress energy demand and drive prices lower,
America’s confrontation with Iran could have the opposite effect. Should that
conflict escalate into a military conflict, global oil prices could spike and
bring on a recession, as happened during previous Middle East conflagrations in
1973, 1979, and 1990.
All three of these potential shocks would have a
stagflationary effect, increasing the price of imported consumer goods,
intermediate inputs, technological components, and energy, while reducing
output by disrupting global supply chains. Worse, the Sino-American conflict is
already fueling a broader process of deglobalization, because countries and
firms can no longer count on the long-term stability of these integrated value
chains. As trade in goods, services, capital, labor, information, data, and
technology becomes increasingly balkanized, global production costs will rise
across all industries.
Moreover, the trade and currency war and the competition
over technology will amplify one another. Consider the case of Huawei, which is
currently a global leader in 5G equipment. This technology will soon be the
standard form of connectivity for most critical civilian and military
infrastructure, not to mention basic consumer goods that are connected through
the emerging Internet of Things. The presence of a 5G chip implies that
anything from a toaster to a coffee maker could become a listening device. This
means that if Huawei is widely perceived as a national-security threat, so
would thousands of Chinese consumer-goods exports.
It is easy to imagine how today’s situation could lead to a
full-scale implosion of the open global trading system. The question, then, is
whether monetary and fiscal policymakers are prepared for a sustained – or even
permanent – negative supply shock.
Following the stagflationary shocks of the 1970s, monetary
policymakers responded by tightening monetary policy. Today, however, major
central banks such as the US Federal Reserve are already pursuing
monetary-policy easing, because inflation and inflation expectations remain
low. Any inflationary pressure from an oil shock will be perceived by central
banks as merely a price-level effect, rather than as a persistent increase in
inflation.
Over time, negative supply shocks tend also to become
temporary negative demand shocks that reduce both growth and inflation, by
depressing consumption and capital expenditures. Indeed, under current
conditions, US and global corporate capital spending is severely depressed,
owing to uncertainties about the likelihood, severity, and persistence of the
three potential shocks.
In fact, with firms in the US, Europe, China, and other
parts of Asia having reined in capital expenditures, the global tech,
manufacturing, and industrial sector is already in a recession. The only reason
why that hasn’t yet translated into a global slump is that private consumption
has remained strong. Should the price of imported goods rise further as a
result of any of these negative supply shocks, real (inflation-adjusted)
disposable household income growth would take a hit, as would consumer
confidence, likely tipping the global economy into a recession.
Given the potential for a negative aggregate demand shock in
the short run, central banks are right to ease policy rates. But fiscal
policymakers should also be preparing a similar short-term response. A sharp
decline in growth and aggregate demand would call for countercyclical fiscal
easing to prevent the recession from becoming too severe.
In the medium term, though, the optimal response would not
be to accommodate the negative supply shocks, but rather to adjust to them
without further easing. After all, the negative supply shocks from a trade and
technology war would be more or less permanent, as would the reduction in
potential growth. The same applies to Brexit: leaving the European Union will
saddle the United Kingdom with a permanent negative supply shock, and thus
permanently lower potential growth.
Such shocks cannot be reversed through monetary or fiscal
policymaking. Although they can be managed in the short term, attempts to
accommodate them permanently would eventually lead to both inflation and
inflation expectations rising well above central banks’ targets. In the 1970s,
central banks accommodated two major oil shocks. The result was persistently
rising inflation and inflation expectations, unsustainable fiscal deficits, and
public-debt accumulation.
Finally, there is an important difference between the 2008
global financial crisis and the negative supply shocks that could hit the
global economy today. Because the former was mostly a large negative aggregate
demand shock that depressed growth and inflation, it was appropriately met with
monetary and fiscal stimulus. But this time, the world would be confronting
sustained negative supply shocks that would require a very different kind of
policy response over the medium term. Trying to undo the damage through
never-ending monetary and fiscal stimulus will not be a sensible option.
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