The author is Professor of Economics and Public Policy at Harvard University and former Chief Economist of the IMF.
The Fed’s sweeping actions to prevent the collapse of Silicon Valley banks from becoming systemic, followed by Credit Suisse’s massive lifeline embattled by Suisse National Bank, left little doubt this week that financial leaders are determined to act decisively when fears strike. Let’s leave the moral hazard for another day.
But even if the risks of a 2023 financial armageddon are contained, not all the differences with 2008 are so reassuring. At that time, inflation was a non-issue and deflation – falling prices – quickly became one. Today, core inflation is still tepid in the US and Europe, and one would really have to strain the definition of “temporary” to argue that it is not a problem. Global debt, both public and private, has also skyrocketed. This would not be such an issue if long-term real interest rates were to plunge as deeply as they did in the years of secular stability prior to 2022.
Unfortunately, however, ultra-low borrowing rates are not something that can be counted on at this time. First and foremost, I would argue that if one looks at long-term historical patterns in real interest rates (as Paul Schmelzing, Barbara Rossi, and I have), large shocks — for example, the large drop after the 2008 financial crisis — tend to is Fade over time. There are also structural reasons: for one thing, 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 that are pushing up long-term real rates include the large costs of the green transition and the impending increase in defense spending around the world. A rise in populism will likely help reduce inequality, but a higher tax trend will still reduce growth even as it increases upward pressure on higher tax rates.
This means that even after inflation declines, central banks may need to keep interest rates higher than they have been in the past decade to keep inflation stable.
Another important difference between now and after 2008 is China’s weak position. Beijing’s fiscal stimulus after the financial crisis played a key role in maintaining global demand, particularly for commodities but also for German manufacturing and European luxury goods. Much of that went into real estate and infrastructure, the country’s massive growth sector.
Today, however, after years of building at breakneck speed, China is running into the same sort of diminishing returns that Japan began to experience in the late 1980s (the famous “bridge to nowhere”) and the former Soviet Union saw in the late 1960s. was . Combine that with hyper-centralization of decision-making, extraordinarily unfavorable demographics and expanding deglobalization, and it becomes clear that China will not be able to play such a large role in sustaining global growth during the next global recession.
Last, but not least, the 2008 crisis came during a period of relative global calm, which is now rare. The Russian war in Ukraine has been a persistent supply shock that accounts for a significant part of the inflation problem that central banks are now trying to deal with.
Looking at the banking stress of the last two weeks, we should be thankful that this did not happen sooner. With the central bank raising rates sharply, and with an uneasy underlying economic backdrop, it is inevitable that there will be many business casualties, and so will emerging market borrowers in general. So far, many lower-middle-income countries have defaulted, but more are likely to follow. Certainly there will be other problems besides tech, for example the commercial real estate sector in the US, which has been affected by rising interest rates, even though the big city office business remains only 50 percent. Of course the financial system, including the lightly regulated “shadow banks”, must be housing some losses.
Governments of advanced economies are not necessarily all immune. They may have “graduated” from a long-overdue sovereign debt crisis, but not from a partial default through staggeringly high inflation.
How should the Federal Reserve weigh all these issues in deciding its rate policy next week? After the banking shock, it certainly won’t go ahead with a 50 basis point (half a percent) hike as the European Central Bank surprised markets on Thursday. But then the ECB is playing catchup for the Fed.
If nothing else, the optics of tightening the screws on Main Street and bailing out the financial sector once again are not good. Yet, like the ECB, the Fed cannot lightly rule out sustained core inflation above 5 percent. Presumably, if the banking sector seems calm again it would prefer an increase of 25 basis points, but if there is still some noise it can absolutely say that the direction of travel is still up, but it needs to take a break.
Political pressure is easier to contain in an era of downward global interest rate and price pressures. Not now. Those days are over and things are about to get tougher for the Fed. The trade-offs he faces next week could be just the beginning.