The Global Debt Overhang Condemns Central Banks Like the Fed To Pretend To Fight Inflation.
A sharp rise in interest rates would have devastating effects.
The road is straight but the slope will be rough. Central banks are now going to move twice as fast to raise interest rates. Officially to stop the acceleration in prices. But will they go that far?
In the past, the big money makers have not hesitated. They have even provoked recessions to keep inflation under control. The most famous episode was America's, forty years ago, to put an end to the stagflation of the 1970s. At the beginning of 1981, the then chairman of the US Federal Reserve, Paul Volcker, did not hesitate to push the key interest rate up to almost 20% to bring down inflation, which was then clinging to 13%, after having been close to 15%. In 1982, the consumer price index rose by less than 5%. And the GDP fell by 2%...
An unimaginable scenario today
Next to Volcker, the current central bankers are like friendly jokers. Joe Powell's Fed made its mark at the beginning of May 2022 by having the audacity to raise its key rate by 0.50% to 1%, while prices have jumped by 8.6% in one year!
Christine Lagarde's European Central Bank, on the other hand, is content to let us foresee a forthcoming increase in its key rate, currently at -0.5%, while prices have galloped by 7.5% in one year. A scenario unimaginable only three years ago. Why then such timidity to act on such a key price of the economy, and why such a difference with the policy implemented four decades ago?
Russia is the mine and the granary of the world
The most obvious answer is that inflation is not the same. In 1973, as in 2022, there was a shock in energy prices. But the 1973 shock was reflected in a very different economy, where rising prices mechanically raised wages through a series of indexation mechanisms. By breaking demand through a sudden increase in interest rates, the Fed broke this spiral.
This time, the problem is on the supply side. The outbreak of COVID-19 has blocked the production and delivery of a whole range of products. The outbreak of war in Ukraine has multiplied these blockages. Because if China is the world's factory, Russia is both the mine and the granary (first world exporter of wheat, titanium, oil, gas, and nitrogen fertilizer ...).
Investing massively
The shortages here affect the most important points. It is often possible to postpone the purchase of a cell phone or a pair of socks for a few months, but it is more complicated for a baguette or a full tank of gas. Faced with supply problems, raising interest rates is like hitting a fly with a hammer. Interest rates risk becoming too high to oxygenate growth ... and not high enough to break inflation.
To solve the problem, there is no short-term solution. One way is to invest massively in new supply capacities adapted to the ecological transition, as more and more economists are pointing out. These investments will be easier to finance at reasonable interest rates.
Catastrophic rise
But that's not the only reason for central banks to use rising rates sparingly. Because a rising cost of money can also have a devastating effect on the tenants. That is to say, the indebted economic actors.
At the end of the 1970s, the debt had risen little. Only the developing countries had heavy commitments. And the Fed-led rate hike was catastrophic for them. In the years that followed, there were more than a hundred debt restructurings. In Latin America, it is called La Década Perdida - “The Lost Decade”.
One point at 39 billion
Today, the debt has become colossal. This is of course true for governments, which have further increased their burden during the pandemic. In two years, the public debt of advanced countries, which had more or less stabilized after the two storms of the turn of the 2010s (financial crisis, eurozone crisis), has increased by 18 points of GDP to 131%.
The impact of a rise in interest rates will of course be felt little by little, as loans that have matured are refinanced. But the impact is significant: a single point increase in long-term interest rates translates into an additional public debt burden of 39 billion euros for a country like France after ten years, according to calculations by the Banque de France.
A new terra incognita
Another risk in the eurozone is that lenders may be more greedy for the most indebted countries, such as Italy. This could lead to the reappearance of deep rifts in the monetary union.
But it's not just public debt. On the household side, higher interest rates will weaken the real estate market after several decades of rising prices. On the corporate side, they will increase cash flow difficulties and limit investment. In the financial markets, they may threaten players who have sometimes borrowed fortunes to play the rising prices.
Raising interest rates sharply in such a world is like hitting a fly with a hammer, but a fly that would be on a tile. This is why, in all likelihood, central bankers will pretend to fight inflation. Exploring, once again, a terra incognita.
Some reading
Bitcoin Price Plunges Towards $30K: Is the Big One Imminent? Is It Time To Panic? My complete analysis of the current situation.
Fighting Inflation: Do the Fed and Other Central Banks Really Believe in Inflationary Risk? Central bankers try to pull the wool over our eyes with words rather than acting on rates.
Anybody Can Build a Crypto, but Not Bitcoin. The real revolution is Bitcoin, not cryptocurrencies.
Vladimir Putin’s Distrust of the West Comes From Very Far Away. The most worrying thing is that it now seems unmovable.