While central banks have the tools to reduce inflation, high debt levels will make it impossible to raise interest rates without triggering a financial crisis, he says.
“Central banks are not credible when they say they will fight inflation at all costs,” he says. “If you want to raise interest rates enough to get inflation back to 2 percent, you have to cause a recession. And for many reasons, this mantra today that it’s going to be a short, shallow recession of the plain, vanilla, garden variety is nonsense. It’s going to be very bad and long-term.”
Keeping economies out of recession is one thing. But that’s not the only problem. Roubini says there is so much debt in the world that making it harder to borrow has big consequences.
Borrowing increased during the pandemic, as governments massively subsidized wages during the quarantine. Global debt levels currently stand at $290 trillion (£240 trillion). The Institute of International Finance says rising interest rates could trigger a “dangerous increase in debt servicing costs”.
The UK’s public debt has grown from 40 per cent of gross domestic product (GDP) in 2006 to almost 100 per cent today. In the US, it rose from 65 percent of GDP to 140 percent of GDP. The pandemic has forced many to save, but household debt also remains at a high level, amounting to 133.9 percent of household disposable income, according to official data. That’s not too far from a peak of 155.6 percent just before the collapse of Lehman Brothers.
“There is so much private and public debt in the system that if you raise interest rates to fight inflation, it not only causes a recession, it causes a financial meltdown.”
Roubini says higher interest rates in the UK have already caused financial turmoil. A sudden jump in borrowing costs, triggered by former chancellor Kwasi Kwarteng’s mini-budget, brought several pension funds to their knees, forcing the Bank of England to step in and buy government debt.
This creates doom loops, says Roubini. Central banks will always come to the rescue to save the day, but they also have their limitations. “And so you have an ugly financial crash that worsens the economic crash and so on. It’s a vicious cycle.”
Roubini warned at the mini-budget that the UK would end up begging the International Monetary Fund for help. He disputed that forecast but insists the best the UK can hope for is “average growth”, adding that policymakers have “shot themselves in the foot with Brexit”.
Central banks will have to “blink and accept higher inflation,” he said, adding: “If you’re not willing to raise taxes or cut spending to reduce debt and deficits, the path of least resistance is dealing with unexpected inflation because inflation reduces the real value of debt with fixed interest.”
This “inflation tax” may help reduce Britain’s debt pile relative to the size of the economy, but it also means permanently higher price growth. Roubini believes inflation rates will stabilize at around 5% for the foreseeable future.
“I think 5% to 6% is the new normal. If inflation goes from 2% to 6%, gilt yields will have to be at least 8% and mortgage rates between 10% and 12%.”
This will cause permanent damage to the central bank’s credibility. “What became of the central banks when the fig leaf of their independence was torn away, as debts rose?”
Roubini says they “moved away from a strict focus on the long-term big picture. Instead, they look to politicians and leveraged investors to cater to every wind of change.”