If we remain in a world marked by strong economic interdependencies, a producer of raw materials and semi-finished products as important as Russia cannot be excluded. Otherwise, we are moving towards a world where interdependencies are seen as vulnerabilities and over-dependence, and the break-up of the global economy into economic regions folded in on themselves is inevitable, writes Valdai Club expert Jacques Sapir.
What form could the “next economic crisis” take? This question arose after the Covid-19 epidemic, which had caused a major recession in many countries. It takes on a new dimension as inflation spikes and the consequences of the conflict in Ukraine begin to manifest themselves in international trade.
In fact, the world had not fully recovered from the subprime crisis of 2008-2010. The gradual reversal of the flows that characterised the “globalised” world, the fall in the share of international trade in world GDP, the rise of various forms of protectionism, but also of the political instrumentation of economic exchanges by the United States, signalled the end of globalisation. This context has obviously been exacerbated by recent events. IMF President Kristalina Georgieva speaks of a “crisis on top of a crisis”. She’s not wrong.
There are therefore many reasons to fear a new global crisis. Does this mean, however, that the risk of a new crisis can be clearly identified? As we verified in 2008, a global crisis always begins with an unforeseen event. However, between the crisis caused by the COVID-19 pandemic and chaotic subsequent recovery (due to shortages and inflation), and the geopolitical disorder resulting from the war in Ukraine, the risk of an unforeseeable event is naturally high. What, then, would be the unforeseen event that could cause a new global crisis?
Debt, inflation and insolvency
The first scenario is then that of a financial crisis caused by the general rise in State indebtedness and the general weakening of banking and financial systems in the aftermath of COVID-19. The unforeseen event would then be a systemic bank or government default.
Remember that debt, both public and private, has increased due to COVID-19 from levels that were already very high. Private debt, including household and corporate debt, increased by nearly 10% in developed countries and by 6.5% in China. It now amounts to 170% of GDP in the developed countries and 200% in China. Public debt has also increased sharply in developed countries, rising almost 23%. In total, both public and private debt reached 300% of GDP for these countries, and 270% for China. In developing countries (excluding China), overall debt has remained moderate, averaging 135% of GDP, although public debt has increased sharply, with an increase of 19% in 2020.
In this situation, a sharp rise in real interest rates (nominal rates less inflation) could cause risks of insolvency, or even default, whether of private actors or States. A massive rise in the insolvency of private players could cause so-called “systemic” bank crises and, step-by-step, trigger a global financial crisis, as in 2008. The International Monetary Fund has conducted a campaign of tests with a large panel of banks (257 in total, for 24 so-called “advanced” economies and 5 “emerging” economies). This campaign shows that the robustness of banks in “advanced” countries to insolvency problems has increased since the 2008 crisis. This seems to be less true for developing countries.
The risk of a crisis being induced by a sharp rise in interest rates, in the context of a sharp rise in inflation, therefore, seems moderate, but not zero. The main problem stems from the divergence of inflation rates within the so-called “advanced” countries. Thus, within the European Union, there is a significant difference between countries where inflation is currently (as of the beginning of April) very high, including Germany (7.1%), Spain (9.8%), and Italy (7.0%); and countries such as France (5.1%), Portugal (5.5%) and Finland (5.6%), where the inflation rate is more moderate. This also poses formidable problems for the European Central Bank, which must decide on a single interest rate for the countries of the eurozone, whose inflation rates are currently very different.
In this scenario, the critical players are indeed the Central Banks, which are facing the dilemma of having to raise their rates to deal with inflation, but must nevertheless be extremely cautious, as threats weigh on economic activity.
The risk of a recession induced by shortages of raw materials
The second scenario is much more directly related to the conflict in Ukraine and its consequences. The military operation, and the sanctions against Russia that it entails, have already caused a significant acceleration of the rise in the prices of raw materials, but also of certain manufactured products. If this movement continues, or even intensifies, we could end up with a shortage of key resources. This could cause a major recession in industrialised countries, as well as very serious social unrest in developing and low-income countries, particularly in the Maghreb and elsewhere in Africa.
This recession, combined with the inflation we are experiencing, could then cause insolvency crises even if central bank policy remains accommodating. The problem here does not come from the rates but from the flow of income that the turnover represents for the companies. Indeed, monetary policy has no effect when the problem is a shortage, or a form of retention, of resources. This scenario is therefore similar to the previous one. Insolvency would cause a cascade of banking crises, which, in turn, would result in more insolvency. Here, however, the starting point of the crisis is in the real sector, and in the interruption — or limitation — of critical trade flows. Note that the countries that would be the first to experience this crisis would not be the same. They would include countries which are very dependent on raw materials, particularly Germany, which could see its industrial production drop sharply. In fact, the insolvency crisis stems less from excessive indebtedness combined with an unbearable rise in interest rates than from the inability of companies to maintain sufficient turnover to meet their previous commitments, even if these were reasonable.
It should therefore be underscored that a total interruption of Russian gas supplies to the European Union, given the short-term impossibility of substituting LNG for Russian gas, would lead to the probable shutdown of 40% of German industry. This blockage would have immediate consequences for Germany’s neighbours. The decline in industrial production would therefore be significant, perhaps 30%. In addition to the social effects of this shutdown, with rising unemployment and a loss of income for employees, the ability of industrial companies to repay their debt would be seriously impacted. We would then witness either a collapse of the banking system or its “closing” by the governments concerned. However, this would result in an interruption of financial flows with other countries and would lead to new insolvency crises, in turn involving new government measures to protect and safeguard banking systems. The cumulative effect on the international financial and banking system would then be considerable.
Note that in this scenario, the key actor is no longer the Central Bank, making it quite different from previous financial crises, such as that of 2008. The key actor becomes the government, which is forced to take measures to safeguard the national economy in the face of the gravity of the situation, but in doing so spreads the crisis to other countries.
The resulting crisis, unlike the one in the first scenario, would be a long-term crisis, as it would be marked by a complete change in the economic model.
The Times They Are A-Changin’...
The range of potential crises is far from limited to these two scenarios. We could witness more localised crises, such as political uprisings in Arab countries or in Africa, which could also contribute to destabilising the world economy. Unfortunately, the rise in food prices that we have known for a year makes this risk very real. However, the question of whether such local crises could really destabilise the global economy must be asked. One-off aid measures for countries experiencing the most difficulties could be enough to allow them to survive the danger, if it doesn’t last too long. However, this would imply an international agreement between countries exporting food commodities. Is this possible, given the current circumstances? We are entitled to doubt it.
More generally, it is obvious — and this has been said by many officials, including Mrs. Carmen Reinhart, the chief economist of the World Bank — that we are experiencing the end of globalisation as we have known it since the end of the 1980s. This change is also accompanied by a change in the international balance of power, with a decline in the power of the G-7 countries and a rise in power of countries such as the BRICS. Such a change in the global economic panorama cannot but be associated with extremely significant disruptions in the economy. The crisis of the hegemony of the United States that we are experiencing brings us back to the crisis of the hegemony of Great Britain at the beginning of the 20th century. These tipping points are always periods conducive to major economic crises, but also — alas — to wars.
In fact, we face two alternatives: If we remain in a world marked by strong economic interdependencies, a producer of raw materials and semi-finished products as important as Russia cannot be excluded. Otherwise, we are moving towards a world where interdependencies are seen as vulnerabilities and over-dependence, and the break-up of the global economy into economic regions folded in on themselves is inevitable. If this hypothesis is confirmed in the years to come, it will be essential that the rules of exchange between these “regions” of the world economy are set in the least conflict-prone way possible. Here again, the maintenance of an inclusive political dialogue between the different States will prove necessary.
The conflict in Ukraine has dealt an additional blow to globalisation, which was dying to begin with. The risk of a global economic crisis has been multiplied. But, beyond that, it is indeed a profound change in the world that we are witnessing. This change does not necessarily imply major economic disruptions. However, it requires that a constructive spirit of dialogue be maintained, despite divergent interests between nations.
