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Corporate finance columnist Les Nemethy provides an overview of the potential drivers of a “polycrisis” and how countries are positioned to deal with it.
According to historian Adam Tooze, we are now potentially facing a “polycrisis”: several small to medium-sized crises around the world that have the potential to combine and reinforce each other. Think of many small to medium sized fires that combine to form a magnificent conflagration. Historian Niall Ferguson talks about a crisis looming in the 2020s that could be much worse than the 1970s.
Debt is always associated with fragility. While during the crisis of the 1970s, global debt hovered around 100% of global GDP, today it is around 350%.
For a long time, the US Federal Reserve denied inflation, then called it “transitional”. Quantitative tightening and interest rate hikes were postponed to the point where the genie was already out of the bottle by the time the Fed and European Central Bank began raising interest rates.
Over the past few months, the Fed has imposed several 75 basis point increases (and the ECB a few relatively minor increases), but that has proven to be too little, too late, to stop inflation.
Controlling inflation generally requires positive real interest rates. Even after numerous interest rate hikes, real interest rates in the United States remain in a negative range of 4-5%, and in Europe, 8-10% at the beginning of October 2022. Due to high levels of Much higher indebtedness, the pain inflicted by rising interest rates is, by definition, much higher than in the late 1970s. Something is going to snap.
Another factor is that climate change has pushed a program of substitution of green energy to fossil fuels. The planning for this was poorly done, especially in Europe. Even if we look beyond the colossal mistake of Russian hydrocarbon dependence, fossil fuels have been phased out faster than green fuels could be brought into use, especially in terms of satisfying the capacity of base load. The nuclear industry, a carbon-free source of this capacity, has been virtually shut down in Germany and curtailed in other European countries.
In the 1970s, the world benefited from a number of tailwinds, including good demographics and rising productivity; globalization was just beginning. These factors now constitute headwinds. Most of the world is facing a demographic cliff and globalization is stagnating or reversing, leading to reduced efficiency and productivity.
The above engines were in place even before COVID and the war in Ukraine, although both served to speed things up and make things worse.
Is the world ready?
So how is the world prepared to deal with this polycrisis? China is losing its driving effect on the global economy due to the implosion of the real estate sector (which accounted for nearly a quarter of GDP), compounded by the demographic cliff China is currently facing. COVID-related lockdowns are further diminishing GDP growth and creating havoc in the supply chain. The government’s insistence on recentralizing power to the Communist Party is also likely to dampen growth.
Continental Europe faces multiple challenges, with the shutdown of Russian gas supplies perhaps the most significant. Meanwhile, the newly elected right-wing government in Italy may well wreak havoc on Europe’s debt markets and put the European banking system under pressure: at least half a dozen major European banks are seeing share prices rise. collapse and have price-to-book ratios lower than 40%. The failure of a Global Systemically Important Bank (G-SIB) such as CSFB is not inconceivable.
Emerging markets around the world are in dire straits due to rising US interest rates and global crises sucking liquidity. Much sovereign and corporate debt in emerging markets is denominated in US dollars and, with the appreciation of the dollar, is becoming increasingly difficult to repay. Turkey and Argentina are approaching hyperinflation. Sri Lanka and Pakistan are hopeless cases. Russia, Iran and Venezuela face sanctions.
The UK is in crisis due to markets’ poor reaction to giant tax cuts announced by the relatively new government of Liz Truss (a controversial cut for top earners was scrapped in an embarrassing U-turn on October 3) . The Bank of England suddenly had to switch from quantitative tightening to quantitative easing in an effort to restore stability, which likely accelerated inflation.
The United States seems to be the only real economic engine in the world today; its labor market remains surprisingly strong. Even the US economy is slowing, thanks to ever-higher interest rates. Still, inflation in America remains robust at over 8%, which means the Fed will likely keep raising interest rates until something snaps. And then the world’s last economic locomotive will lose traction.
Could this be the moment that triggers a “polycrisis?” Think back to the merging of various fires. Could it be the emergence of a new strain of COVID? Or the bankruptcy of a G-SIB creating a Lehman moment? The trigger or the spark is almost irrelevant. We know there is a huge amount of combustible material around.
Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance company. He is a former global banker, author of Business Exit Planning (www.businessexitplanningbook.com) and former president of the American Chamber of Commerce in Hungary.
This article first appeared in the print issue of the Budapest Business Journal on October 7, 2022.