October 17, 2018

Elites throughout the West are grappling with the rise of populist parties and figures challenging the turn of the century consensus. They haven’t seen the half of it. The sober fact is the entire West is just one financial crisis away from chaos.

If that seems exaggerated, consider the facts. Extreme economic hardship almost always produces dramatic political changes. The economic collapse following the Great Depression ushered in fascism throughout Central and Southern Europe and social democracy in most other states.

The stagflation of the 1970s gave rise to Margaret Thatcher and Ronald Reagan, whose apparent political and economic successes nudged the rest of the West toward some form of neoliberal economics. Even in the late 1990s, nations that experienced extreme deprivation because of the collapse in the price of oil, such as Venezuela and Russia, overthrew their established political orders in favour of undemocratic authoritarian regimes.

This pattern even held true following the Great Financial Crisis of 2008. The economies of Greece, Ireland, Iceland, and Spain essentially collapsed under the strain. Each has since either elected a populist-led government (Greece), or seen the share of the vote of the pre-crisis established parties drop by between one-quarter and one-third. The slow-growth countries of France and Italy have both ended the domination of their politics by traditional Right-Left parties; elsewhere the old duopoly is hanging on by a thread, often in coalition with one of the new, populist parties.

The events of 2008 also upended politics in the Anglosphere. The United States and Great Britain were hardest hit, each experiencing large increases in unemployment and expensive bank bailouts. Each has seen the Right challenged by anti-immigration and anti-globalist forces, and each seen the Left rise to obtain or battle for control of the leading centre-Left party. Even placid Australia, whose economy declined after 2008 but never dropped into recession, is seeing record numbers of voters embracing anti-immigrant or other protest parties.

All of this is well known, but the role of economics in these developments is still under-appreciated. According to the OECD, 28 of the 32 member countries on which it has data increased their debt-to-GDP ratio between 2007 and 2018. Countries that experienced deep downturns dramatically increased their debt, even to the point of doubling it (Great Britain, Iceland) or nearly tripling it (Ireland, Spain).

Virtually every major economy now has debt-to-GDP ratios at the level that, pre-2008, would have sent alarm bells ringing in financial markets. Among wealthy economies, only Germany, Switzerland, and a couple of Nordic countries are close to pre-Crisis debt levels. As rich as they are, they cannot bail out the world should another crash occur.

In essence, wealthy countries throughout the world bought off political convulsion the old-fashioned way, by borrowing massive amounts of money to fund high levels of government consumption. Individual nations might have the financial capacity to address mild or local downturns, but the free world does not have the cash to bail itself out again. Given what we know from history and recent experience, the political reaction to a combination of crash and austerity will be swift and severe.

There is an alternative to a financial crash followed by political upheaval, but it carries its own political risks. China’s economy is now the largest in the world, and while its household and business debt is high, its formal government debt is not. China’s central bank holds over $3 trillion in hard currency reserves. Assuming that a financial crash in the West does not completely crush the Chinese economy, one can easily imagine Beijing absorbing some of its own domestic debt defaults while bailing out strategic countries that are now part of the Western alliance.

Does anyone think that newly-elected populist governments – or even pre-crash established ones who see the writing on the wall – would turn down offers of low-interest loans from China to avert total collapse? Does anyone think that the longer-term ramifications of that would stop those nations from signing on the dotted line if an equivalent offer were not forthcoming?

These considerations should cause Western governments to sit up. They need to start serious economic reforms now if they want to avoid the risk of everything blowing up.

There are only three ways to get a debt problem under control. The first is devaluation – if the currency is worth less, then the value of the debt held by creditors would be reduced. Devaluation also can spur growth, as the costs in the devaluing country are suddenly cheaper in terms of the purchasing country’s currency.

The second is inflation – again, with high rates of inflation, the dollar amount of the debt held drops in real terms, making it in theory more affordable if all else remains equal. The problem with both of those remedies is that all else rarely remains equal. Inflation in particular erodes confidence in the future, which erodes investment. That in turn reduces growth, which reduces nominal GDP in future years and thus undermines a country’s ability to service its debt.

Devaluation only works if one is a first-mover country, gaining a relative advantage over other countries that do not devalue and thus spurring growth. If all major countries devalue, or if a small country’s devaluation is then followed by a very large country’s move, the advantage is cancelled and the expected future growth does not occur.

The third option, increasing economic growth without currency debasement, is hard to implement. Orthodox prescriptions from the Right – labour deregulation, lower marginal tax rates, and so forth – always either worsen the debt problem initially, prove politically difficult to pass in the face of opposition from vested interests, or both.

Orthodox prescriptions from the Left – higher levels of public spending and, often, increasing taxes on capital – also produce initially worse financial results and resistance from special interest groups. The solution the Italian populist government has just hit upon – to do both simultaneously – is even riskier financially, as the doubling of Italian government bond yields since the government was formed in May demonstrates.

And so the West slouches on, hoping the centre will hold. It might: one can never predict the future with any certainty. But the warning sounds are present, and growing more urgent, for all who have ears to hear.

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