Is the World Heading Towards a ‘Polycrisis?’

Analysis

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Corporate finance columnist Les Nemethy takes a high-level view of the potential drivers of a “polycrisis” and how individual countries are placed to cope.

According to historian Adam Tooze, we are currently potentially facing a “polycrisis:” several smaller to medium-sized crises in the world that have the potential to combine and reinforce each other. Think of many small and medium-sized fires combining to form one magnificent conflagration. Historian Niall Ferguson talks of a crisis shaping up in the 2020s that could be significantly worse than the 1970s. 

Debt is always associated with fragility. Whereas during the 1970s crisis, global debt was hovering around 100% of global GDP, today it is in the range of 350%. 

For a long time, the U.S. Federal Reserve was in denial about inflation, then labeled it as “transitory.” 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 started raising interest rates.

Over the past months, the Fed has pushed through several 75 basis point increases (and the ECB a few relatively minor increases), but it has proven too little, too late, to stop inflation.

The taming of inflation typically requires positive real interest rates. Even after many interest rate hikes, real interest rates in the United States remain in the range of negative 4-5%, and in Europe, 8 to 10% as of the beginning of October 2022. Because of significantly higher debt levels, the pain inflicted by raising interest rates is, by definition, much higher than in the late 1970s. Something will break.

Another driver is that climate change has been pushing an agenda of substituting green energy for fossil fuels. The planning for this was done poorly, particularly in Europe. Even if we look beyond the colossal error of reliance on Russian hydrocarbons, fossil fuels were phased out faster than green fuels could be brought on stream, particularly with respect to satisfying base load capacity. The nuclear industry, a carbon-free source of such capacity, was virtually shut down in Germany and curtailed in other European countries. 

In the 1970s, the world enjoyed a number of favorable tailwinds, including good demographics and rising productivity; globalization was just beginning. These factors now constitute headwinds. Most of the world faces a demographic cliff, and globalization is stalling or reversing, resulting in diminishing efficiency and productivity.

The above drivers were in place even pre-COVID and the war in Ukraine, although both have served to accelerate and aggravate matters.

Is the World Ready?

So, how is the world poised to face down this polycrisis? China is losing its locomotive effect on the world economy due to an imploding real estate sector (which accounted for almost one-quarter of GDP), aggravated by the demographic cliff China is now facing. COVID lockdowns further diminish GDP growth and create supply chain havoc. The government’s insistence on recentralizing power to the Communist Party is also likely to dampen growth.

Continental Europe faces multiple challenges, the cessation of Russian gas supplies perhaps being the greatest. Meanwhile, Italy’s newly-elected right-wing government could well bring havoc to debt markets in Europe and put stress on the European banking system: at least half a dozen major European banks see share prices collapsing and have price-to-book ratios of less than 40%. The bankruptcy of a globally systemically important bank (G-SIB) such as CSFB is not inconceivable.

Emerging markets worldwide are in tough shape due to higher U.S. interest rates and global crises sucking up liquidity. Much of emerging market sovereign and corporate debt is denominated in U.S. dollars, and with the appreciation of the dollar, is becoming increasingly difficult to service. Turkey and Argentina are approaching hyperinflation. Sri Lanka and Pakistan are basket cases. Russia, Iran and Venezuela all face sanctions.

The United Kingdom is in crisis due to markets reacting poorly to giant tax cuts announced by the relatively new Liz Truss government (a controversial cut for the highest earners was dropped in an embarrassing u-turn on October 3). The Bank of England had to suddenly reverse gear from quantitative tightening to quantitative easing in a quest to re-establish stability, likely accelerating inflation. 

The United States seems to be the only real economic locomotive of the world today; its job market remains surprisingly strong. Even the U.S. economy is decelerating, thanks to ever-higher interest rates. Yet inflation in America remains robust at over 8%, meaning that the Fed will likely continue increasing interest rates until something breaks. And then the world’s last economic locomotive will lose traction.

Might that be the moment that triggers a “polycrisis?” Think again of various fires coalescing. Might it be the emergence of a new strain of COVID? Or the bankruptcy of a G-SIB creating a Lehman moment? The trigger or 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 firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.

This article was first published in the Budapest Business Journal print issue of October 7, 2022.

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