The Post-Covid Global Economy: Could Negative Supply Shocks Disrupt Other Fragile Systems?

Possible repercussions of economic crisis on the stability of democracies that already show significant signs of fragility

There is a reasonable likelihood that the next global economic crisis could threaten the future of our democratic political systems. The global economic system is a complex, adaptive system, like many others in nature and in society, and shares their basic characteristics. Underlying stresses can result in crises which, moreover, can feed through to destabilize other systems. There is a growing understanding of the damage that can be done to the economy by health pandemics and environmental degradation. In contrast, this new INET Working Paper focuses on interactions working in the opposite direction: more specifically the possible repercussions of economic crisis on the stability of democracies already showing significant signs of fragility.

The global economic system is already showing worrisome signs of stress. Ratios of debt to GDP have been rising for decades and in many jurisdictions are now at record levels. Debt exposes debtors to default in both good times (when interest rates rise) and in bad (when revenues shrink). Moreover, due to low investment and declining productivity growth in recent years, a huge, inverted pyramid of measured “assets” is now supported by a narrowing base of real production. While the “everything asset price bubble” has recently shrunk, the scope for further declines still seems significant. The migration of credit from regulated banks to less well-regulated financial institutions and markets also implies that the good health of less transparent entities cannot be assumed. Finally, in recent years, many financial markets have been showing signs of malfunctioning, including the market for US Treasuries.

The global economy has recently been subject to two negative supply shocks; the covid pandemic and the Russian invasion of Ukraine. The macroeconomic authorities in advanced economies initially underestimated the magnitude of the inflationary effects and then erred in assuming they would be only of short duration. In combination with massive demand-side support for the economy, this led to an unexpected upsurge in inflation. In turn, this led to a belated and unprecedentedly aggressive monetary response from an equally unprecedented number of countries. As of early 2023, credible arguments are being advanced for both further aggressive tightening and for some moderation of these policy actions.

Looking forward, a number of negative supply shocks can be identified that will intensify or prolong inflationary pressures. While the short-run effects of the two recent shocks have clearly abated, longer-run effects (for example, long covid and supply chain restructuring) will continue. For various reasons, there also seems likely to be secular upward pressure on commodity prices, especially metals, food, and energy. Demographic evolution will reduce the number of workers while increasing the number of pensioners with adequate means to maintain their consumption. Environmental change will constrain output in a variety of important ways, while time will increasingly reveal the effects of “malinvestments” encouraged by expansionary monetary policy over many years. Adding to all these negative supply effects, there are many reasons to anticipate the need for higher investment levels; to mitigate and adapt to climate change and replace scarce workers, and for other purposes. Combined, these forces imply a future of higher inflation and higher real interest rates. This could potentially lead to problems of private debt distress, leading towards debt/deflation, or public debt distress, leading towards much higher inflation.

This raises the issue of how economic distress might affect political developments in democratic countries. Democracies are also CAS and inherently fragile. Many requirements must be met for them to work properly. As well, there exists a natural tension in such systems between individual rights and concern for the common good. Historical experience indicates that such tensions can lead to excesses in both directions and an eventual rupture with the democratic order.

Today, ordinary citizens in many countries are legitimately concerned about the rise of inequality of income, wealth, and opportunity for their children. This disquiet is being fanned by vested interests, both internal and external, and is further amplified by the “echo chambers’ of social media. Many objective measures show that the underpinnings of democracy are breaking down with the nationalist right seemingly the biggest beneficiary. As happened in Germany in the 1920s and 1930s, and as seen on numerous other occasions, successive economic shocks can contribute to a change in the political order.

Before trying to identify policies that might contribute to economic and political stability, it will be necessary to adopt a new analytical framework based on the reality of interacting complex, adaptive systems. Within systems, this implies focussing on the longer-run effects of suggested policies. Between systems, it implies avoiding spillover effects that might support stability in one system while undermining it in another.

Restructuring debt levels in an orderly way would contribute to economic stability while reducing tensions between creditors and debtors. Recognizing the joint reality of lower economic potential and the need for greater investment underlines the need to moderate consumption over time. It would serve both economic and political ends if those more capable of exercising such moderation could be induced to do so. Direct measures to reduce inequality should also be contemplated. Private sector initiatives, like greater attention to stakeholder Interests, should be encouraged. Similarly, government measures to alter tax incentives (e.g., interest rate deductibility and other tax expenditures) and to improve educational and health outcomes would also be welcome.

None of the above recommendations will be easy to sell politically. Citizens and voters will instinctively react negatively to the suggestion that future consumption might have to be constrained, even in the interest of species survival. The intellectual and business elites will resist giving up power in the interests of greater equality. Political leaders will have to put the common good ahead of their immediate chances of re-election. Overcoming these incentive problems is a necessary first, if not sufficient, step toward resolving the prospective economic and political problems facing our democracies.

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