The three wildest years in modern economic history

Three years ago, the world was already holding its breath in the face of the rapid advance of the virus, but there was no foreshadowing that the economy was going to turn around like a sock in a matter of hours. That activity would be artificially hibernated. And that the planet, in short, would wait for months waiting for the end of the shutdown. The possibility of the greatest recession ever experienced in peacetime did not enter anyone’s head. Nor that peace was about to explode with the first war on European soil since the Balkans. That energy and commodities would hit record highs. That value chains would be stretched to unimaginable levels. And that globalization itself, unstoppable for decades, would be called into question.

A pandemic, a war and the onset of galloping inflation are strange episodes, the kind that, however improbable, remain in the collective memory for decades. Their confluence in such a short period is even rarer. “They have been the three wildest years in modern economic history,” sums up Gian Maria Milesi-Ferretti, now at the Brookings Institution after many at the IMF. “They have been such huge shocks that even the most dormant economic variable of all, inflation, has skyrocketed.”

Far from being a normal economic cycle, what happened is something “completely anomalous,” in the words of economist Angel Ubide: first an induced coma, then an acceleration never seen before, and then a war. “These are three events that occur once every 100 years, and all three in a very short period of time”. The result: a constellation of economic shocks and policies “that make this a completely unique situation”.

“Since 9-11, the Great Recession, Brexit and the arrival of Donald Trump to power, the black swans are not so black swans anymore. But the last three years have been the height of unpredictability: we have never seen so much volatility and dispersion in all economic variables,” says Leopoldo Torralba of Arcano Research. “There are several generations of us who have never experienced a succession of chained events like this,” says Rafael Doménech, head of Economic Analysis at BBVA.

To find a comparable period, according to Joan Roses, professor at the London School of Economics (LSE), one has to go back to the years immediately after World War I and the flu pandemic of 1918: “Now there has not been a destruction of capital and a contraction of the labor force as there was then, but we are seeing something similar: there was inflation for a lot of years and international trade networks were destroyed”.

“The global financial crisis [of 2008] was even more savage and harder to control,” disagrees Olivier Blanchard of the Peterson Institute. “It is understandable that we think what is happening now is worse, but in the 20th century we have lived through very turbulent times: two world wars, a depression and another pandemic [that of 1918],” recalls Leticia Arroyo, an economic historian at the City University of New York. “This is the worst global crisis that those of us who were born after 1952, when the rationing cards ended in Spain, have suffered. But, at least until now, it has been quite bearable,” synthesizes Francisco Comín, also a historian. “There have been other savage periods, but what has happened in the last three years is certainly unprecedented,” adds Anne Krueger, former number two and former head of analysis at the World Bank.

What follows is a brief account of the three years in which the global economy hung by a very thin thread that - fortunately - never ended up breaking:

From negative interest rates to the biggest rise in half a century. José García Montalvo of Pompeu Fabra used to begin his lectures by warning that “interest rates can never be negative”. That is no longer the case. The major economies, with Europe, the US and Japan at the forefront, sank the price of money to the subsoil in 2020 and flooded the markets with liquidity to get out of the hardship. The aim was to stimulate investment and demand. “The natural interest rate had already been falling for the last 30 to 40 years. But that period of negative rates completely distorted the fundamentals of the economy,” says the professor.

The pendulum swung from one extreme to the other in the blink of an eye. The end of the confinements freed up savings that had also reached historic proportions, boosted demand, disrupted logistics and laid the foundations for an inflationary escalation that was later aggravated by the Russian invasion of Ukraine. That not only ended the policy of ultra-low rates: central banks stepped on the accelerator in the biggest hike in a long time. In the case of the ECB, the steepest in its history: if its roadmap remains unchanged, in just nine months Frankfurt will have raised them from 0% to 3.5%.

Charles Wyplosz of the Graduate Institute in Geneva believes the era of ultra-low rates will have “massive implications.” “Public debts will be harder to service and this can be dangerous. Asset prices will have to come down in a lasting way and we can anticipate a big clean-up in financial markets. Central banks have created huge amounts of liquidity, which must be withdrawn,” he says. “There has never been a smooth transition from superabundant liquidity to less abundant liquidity.”

... And yet the economy is holding up. For almost a decade, the central banks threw as much wood as they could to prevent the economic fire from burning out. Now they are looking for just the opposite: high inflation has forced them to pull out the fire extinguisher. The ECB, says its president, Christine Lagarde, “will continue the course of significant hikes at a sustained pace and keep them at sufficiently restrictive levels to ensure a timely return of inflation to its 2% target”.

Still, the economy holds on. Brussels had warned countries of a harsh winter, with energy cuts and even the possibility of rationing. But gas prices have come down and nothing of the sort has happened. “The structural parameters of the economy are moving in a different direction than a few years ago,” says García Montalvo. The private sector’s balance sheets are much healthier than in previous upheavals. “Banks have been recapitalizing since 2010, families have savings and companies are less indebted. The starting position was better and the policies that have been taken have also been better,” Ubide adds.

The euro zone closed 2022 with an increase of 3.5% after the economy stagnated in the last quarter and employment grew by 0.3%. The United States, which started rate hikes earlier, grew by 2.1% for the year as a whole, with an increase of 0.7% in the final stretch of the year. The strength of the economy has led central banks to warn of a new round of tightening. Federal Reserve Chairman Jerome Powell threatened to step on the accelerator again. In Europe, the more orthodox wing of the ECB has already threatened to take interest rates to 5%.

While acknowledging that the guardians of monetary policy were slow to react, which now raises the risk that they will have to go too far, Alejandro Werner, a former IMF executive now at Georgetown, poses a question: “Would we rather live in a country that has an inflationary problem but has recovered precovid activity levels or in one where the opposite has happened? It is clear to me that it is the former”. The problem, countered Arroyo, of the City University of New York, is that “it is not easy to control inflation: inflationary inertia cannot be cut from one day to the next”. If rates had not been raised at this pace, he projects, “we would be at 15% inflation and accelerating”.

The question is whether there is a risk that these rate hikes will end up leading to the recession so often announced. “There is, but I continue to believe that, if there is, it will be short and mild, given the strength of economic fundamentals. And letting inflation become entrenched would be much worse: in that case, rates would have to stay high for even longer, which would end up hurting the economy even more,” says Berkeley’s Barry Eichengreen.

From short-circuiting supply chains to de-globalization? “Global gridlock”. The front page of this newspaper on October 24 reflected a collective mood. The pandemic was being left behind, but a new batch of problems was arriving in the form of an unprecedented breakdown in the global value chains that give consumers access to products manufactured thousands of miles away from home. That gear had seized up: chips were in short supply, the freight for a container from Rotterdam had increased fivefold in a year. Getting a new car or a washing machine in time was becoming a pipe dream.

The war would consummate the retreat of these global chains and change the business mentality: from producing in the cheapest corner of the world to producing in the most reliable. Globalization itself, the process that has most changed the world’s economic structure in recent decades, is under discussion. “Suddenly, we have realized that bringing a ship from Shanghai to Long Beach is more uncertain than taking a train from Chihuahua to San Antonio. Before, we didn’t consider the risks of the first route; now we do, and that’s a major change,” Werner notes. We are therefore moving towards a regionalized globalization in which China’s role has also been affected. “From being the country of choice for everyone, it has become almost a pariah. Its image has clearly suffered a setback,” says Alicia Garcia-Herrero, chief Asia-Pacific economist at Natixis.

“Although to a different degree than in the interwar period, there is now also a return to protectionism. And without political agreement between countries, there will be no globalization: if what happened then is repeated, globalization will collapse,” predicts the LSE’s Roses. The great lesson from then, he says, is that without international collaboration we could be facing a lost era. Eichengreen is more optimistic: “There is little evidence to support de-globalization. Rather, we are seeing a reorganization of the world economy, with shorter and more diversified supply chains. But that doesn’t mean they are being eliminated.”

“There will be temporary tensions and setbacks, and we may even see new regional trading blocs,” predicts Ugo Panizza, vice-president of CEPR, “but the world economy remains highly integrated. If globalization were to reverse, warns Diane Coyle of Cambridge, “the economic impact would be significant: that’s not to say it couldn’t happen, but it would put us in a scenario of conflict and potentially catastrophic outcomes.”

The weight of the public sector. In 2010, international institutions decided that the crisis could be cured with an overdose of austerity that weighed down European economies for years. The public response to the two consecutive blows to businesses and citizens in the wake of the pandemic and the energy crisis has been radically different. “After the financial crisis, the right policies were not implemented. It was later, with Mario Draghi’s whatever it takes, that the direction was corrected. But this time, fiscal and monetary policies have been on target,” says Bruegel researcher Gregory Claeys.

Last May, in the midst of the energy crisis, the EU was preparing to pull back after national treasuries had earmarked 1.3 trillion euros - 9% of GDP - in direct aid to stop the shock, according to the Independent Fiscal Institutions network. By then alone, more than 1,000 measures had been implemented by the capitals, taking advantage of temporary suspensions of tax and state aid rules.

This policy was accompanied by a 1.7 trillion euro bailout from the ECB, which injected liquidity in spades. The US followed suit through Joe Biden’s stimulus plans and massive debt purchases by the Federal Reserve. “That we avoided the worst-case scenario is mainly due to the effective and concerted steps taken by the monetary and fiscal authorities,” applauds Eichengreen. “In five years, when we look back, we may see the total change in the way we understand monetary and fiscal policy. The frameworks have changed.

Governments and central banks stopped acting in unison when the energy crisis erupted. With the exception of Japan, inflation led monetary authorities to begin their retreat. Washington began to reduce its balance sheet a year ago, while Frankfurt is starting to do so. On the fiscal front, stimulus remains. The EU-27 have earmarked 681 billion for measures to protect citizens and companies, according to Bruegel. Of this, 268 billion has been allocated to a single country: Germany, which has broken the deck. This spending has aroused a number of misgivings among central bankers, who believe it hampers their fight against inflation. Agencies, from the IMF to Brussels, are now beginning to tighten up and call for adjustments. But much, much more timidly than a decade ago.

A speeding up or slowing down of the energy transition? Although it had been simmering for a long time, the raw materials crisis broke out at the very moment when the Kremlin’s first shell hit Ukrainian soil: Russia is the world’s largest energy exporter. At the same time, there has been a sort of bellows effect in the ecological transition: more burning of fossil fuels - especially coal, the most polluting - in the short term, but also an unprecedented acceleration in the renewable revolution.

Carbon dioxide emissions grew by 1% last year, largely because of the switch from natural gas to coal for electricity generation in several areas of the world. Although lower than initially anticipated, the rise - “unsustainable,” according to the International Energy Agency - is bad news in the fight against climate change. In the future, however, the trajectory will be reversed: Europe’s desire for energy independence has increased the EU-27′s commitment to wind and solar power. And both the US Inflation Reduction Act and EU RepowerEU will add incentives for investment in both technologies.

“The energy transition will undoubtedly accelerate - at gunpoint, but it will accelerate,” says Francisco Blanch, head of commodities and derivatives at Bank of America. For two reasons: “Because high prices have led to a savings effort, they have taken away fat; and because a lot of progress has been made in renewables”.

Swings between the traditional and technology sectors. The last two downturns have been accompanied by tremendous volatility in the stock markets, with rapid shifts between the winners and losers of each shock. In 2020, tech giants emerged as the victors on the coattails of telecommuting, while the cryptocurrency bubble swelled. “In five months, we have lived through a five-year technological change,” Matt Brittin, president of Google in Europe, told EL PAÍS at the time. The change was not permanent. Only two years later, the tech companies have had to admit that they were too optimistic and have launched massive layoffs.

“I don’t know if that policy stimulated investment, but it did raise the risk of perpetuating zombie companies and forming bubbles,” said former US Treasury Secretary Larry Summers at a conference this week. In their place, two traditional sectors have emerged, which have benefited from the crisis with a sort of windfall profits: energy and banking, which have benefited from the rise in the cost of money.

Two unsolved puzzles: tax revenues and the labor market. Having recovered the global economic tone prior to the pandemic, tax collection has soared to unprecedented levels throughout the West. This is partly due to the emergence of underground activities -conditional aid to companies and workers; lower cash payments-; partly due to the rise in inflation. But there are still more elements missing to understand the puzzle in its full extent: it is one of the two black boxes of this crisis, on which only time will shed light.

The second is unemployment. Especially in the US, a country which, true to its idiosyncrasy, let the labor market do as it pleased and opted for paychecks -and not ERTE (Spain’s temporary furlough scheme)- to protect its citizens. In those fateful days of April 2020, when the economy was operating at 50% and the world was waiting at home for a reopening that seemed like it would never come, almost one in seven Americans - 14.7% - was unemployed, the highest since data has been available. Today, only one in 30 is out of work - 3.6% - the lowest level since May 1969.

Employment not only held up better than expected during the worst moments of the pandemic, but its recovery has been much faster than anyone could have predicted. Inertia - labor markets came into the Great Recession with minimal vacancy rates on both sides of the Atlantic - explains part of this recovery. In the US, Trump’s anti-immigration policies also offer an additional explanation. But much remains to be elucidated.

“We are still studying it,” admits BBVA’s Domenech. “If they told us three years ago that we were going to be where we are today, even with a war in Europe in between, we wouldn’t believe it. But beware, because this polycrisis is not yet completely over,” he warns. “The risk now is that, in their game of mirrors with the markets, the central banks will go too far,” warns Torralba, of Arcano.

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