The Globalization of Inflation

The progeny of these successive shocks was inflation. Among economists, a debate ensued on whether these price movements constituted “inflation” as traditionally understood, that is to say whether they were one-off, transitory, and supply-driven as opposed to being persistent, broad-based, and wage- and expectations-driven. The war rendered this debate moot: soaring energy, commodity, and food prices are effectively forcing the hand of the world’s central bankers, who were already under pressure to “normalize” monetary policy by hiking interest rates that had been at record lows for over a decade.

Resorting to interest rate hikes to fight inflation exacts huge social costs, however. Increasing rates puts pressure on firms, now faced with higher financing and debt-servicing costs, to cut their operating expenditures by increasing unemployment and lowering real incomes. There is no historical example of a cycle of tighter monetary policy not resulting in a recession.

But nowhere are the effects of the US Federal Reserve’s response to inflation felt more severely than in the developing world. And this is due to its precarious existence in the global dollar system.

Historically, the surest way for developing countries to secure economic growth for their citizens was by gaining a share of global demand — that is to say, by turning to export-led growth and by attracting foreign capital. But for the trading system to be stable, it requires a stable currency in which to denominate trade. In emerging markets, roughly 80 percent of trade is invoiced in dollars. Since none of these countries actually issue dollars, transactions are financed by offshore pools of dollar-denominated credit, or eurodollars.

Since most trade is invoiced in dollars and since most countries cannot amass significant debts in their own currencies, they are incentivized to acquire dollar reserves. A country’s central bank will use these reserves — usually held in the form of dollar-denominated benchmark assets such as Treasury bonds — to finance trade and prop up the value of its currency (by buying large amounts of it). In the case of a downturn, investors seeking a safer haven in more stable markets will sell assets denominated in the local currency.

This is precisely what has been happening during the current downturn: a sudden stop of capital flows to emerging markets was followed by a massive sell-off. Developing countries suffered over $61 billion in outflows by mid-May, driven by concerns over inflation and its economic consequences. With depreciating currencies, countries without “fortress balance sheets” (that is, a very large number of reserves) struggled to find dollars to import key goods and to service their debt.

The Mother of All Debt Crises

The era of cheap money made many of the poorest countries more vulnerable to this situation. When rates were low, emerging market economies ramped up their borrowing, issuing more dollar-denominated debt. This debt is serviced with their foreign exchange earnings. Now, they find themselves in a situation in which those earnings are dwindling and in which the Federal Reserve is tightening monetary policy. And when interest rates go up, so too do debt-servicing costs.

The extent to which higher interest rates increase the repayment burden of vulnerable economies depends on the structure of their debt. Unfortunately, in addition to owing a lot of private lenders, the share of developing countries’ debt that is variable — that is to say exposed to increases in interest rates — has risen sharply, to over 30 percent since the Global Financial Crisis. As a result, debt distress has increased throughout the developing world, and the stock of debt has soared to 250 percent of government revenues, a fifty-year high.

The Fed’s rate hikes and the “tapering” off of its quantitative easing program has had another, even more consequential effect: a stronger dollar. A weaker local currency relative to the dollar raises a country’s import bill and worsens the problems of rising prices. But an appreciation of the dollar not only makes the relative foreign-exchange positions of emerging markets more precarious — since the currency they need to bolster their reserves and service their debt now comes at a greater price — but also instantly stifles credit and investment growth. This is due to the effects of a stronger dollar and a depreciating local currency affecting bank balance sheets: as the dollar appreciates and the cost of servicing dollar debt rises as a result, the value of those liabilities in the domestic currency expands relative to a bank’s assets. On the basis of this asset-liability mismatch, the banking system will extend less credit to firms and individuals to finance investment and consumption.

These tighter financial conditions domestically add to the unemployment already created by general economic conditions: the flight of foreign capital, the collapse in exports, and the reduction in public spending. A terrible, self-reinforcing spiral is setting in for many countries, with monetary tightening and runs on their currencies leading to higher debt-servicing costs, forcing them to draw down their reserves, depressing investor confidence further, and precipitating further sell-offs and further currency depreciations.

In the coming months, it is not unlikely that we might witness a transition from balance-of-payments crises to debt crises, and from these economic events could emerge global social unrest and, in the worst cases, famine — all while stocks of the three agricultural staples — rice, wheat, and maize — are apparently at historic highs.

“If you think we’ve got hell on earth now, you just get ready,” United Nations World Food Program director David Beasley warned in late March. Meanwhile, a World Bank study estimated that “for each one percentage point increase in food prices, 10 million people are thrown into extreme poverty worldwide.”

The first major casualty of the debt crisis was Sri Lanka. Subject to economic mismanagement for years and badly hit by the pandemic, the country quickly ran out of dollar reserves. With over 58 percent of Sri Lanka’s government debt denominated in dollars, the government was not able to roll over or repay its outstanding loans. In late May, it defaulted on its entire $51 billion stock of external debt. The move came after months-long violent protests had resulted in the death of a ruling party lawmaker and in the resignation of disgraced prime minister Mahinda Rajapaksa.

The Solutions Are There, but the Politics Aren’t

According to textbook macroeconomic orthodoxy, a stronger dollar, by way of its effects on trade, is a net gain for the emerging world, as described by the so-called Mundell-Fleming model. This gain in export competitiveness, however, is greatly outweighed by terrible financial spillover effects in the dollar system. In fact, when the global reserve currency on which trade invoicing and financing depends strengthens in times of crisis, world trade and cross-border lending shrink, and balance sheets of developing nations and their private actors suffer — with life-altering consequences for hundreds of millions of people. Economist Branko Milanovic described recent events as the “largest setbacks to global poverty and inequality reduction since the end of Second World War.”

What are the prospects of reforming this system? Despite recent proclamations that its status as the world’s key currency is in jeopardy (following the weaponization of the dollar-based financial system against Russia), the dollar has never been more entrenched. This is largely due to the absence of any real alternatives, Europe not having an equivalent safe asset and China maintaining capital controls.

The important question does not concern the future status of the dollar system — no alternative is on the horizon —  but whether responsible economic actors are capable of improving the lot of countries within this system now.

A massive, synchronized slowdown requires a collective response of equal proportions. The architects of the postwar economic order devised a set of international monetary institutions for this purpose, chief among them the International Monetary Fund (IMF) and the World Bank. It has become abundantly clear, however, these institutions in their current form are not equipped to handle crises of this scope. Put simply, the problems that poor countries are facing are big, but the institutions are small. That is, they don’t have enough financial firepower, relative to the size of cross-border capital flows and the stock of global debt, to provide the liquidity to the countries that need it most. Due to this massive mismatch between the political and economic weight of the institutions and the problems they are called upon to deal with, they are slowly becoming irrelevant to a subset of emerging market economies.

To take one prominent example: the IMF does have the ability to issue costless reserve assets of equivalent quality to dollar assets, the so-called special drawing rights (SDRs). These can supplement a country’s foreign reserves and can be used to service debt and finance domestic spending. Since the SDR system was created in 1969, however, it has only been used on four occasions — 1970–72, 1979–1981, and two allocations in 2009. None of these proved to be particularly impactful, however, largely due to how the SDRs are allocated by way of a quota system based largely on the size of a member country’s economy. The result is that a lot of the SDRs end up with the largest economies that have least use for them.

There are promising plans to reform this system — for instance by making SDRs act as automatic stabilizers during crises and rechanneling them to poorer countries via a standing trust. But these reforms require political solutions at the multilateral level or parliamentary arithmetic (at the level of the US Congress) that simply isn’t present at the moment. The same is true for ambitious plans to suspend debt payments, to devise a sovereign debt restructuring mechanism for affected countries, or to increase the lending power of multilateral development banks (MDBs).

For now, the developing countries depend on the informality of the Paris Club, officials representing major creditor nations, for debt negotiations and on the good will of US dollar swap lines to provide dollar liquidity. In the absence of either increased cooperation or of a stabilizing hegemon akin to the United States during the Bretton Woods era, the global economy remains essentially leaderless. And while it remains leaderless, it remains exploitative for everyone but a small set of financial elites.

Which Order?

To summarize the bleak reality of much of the Third World: escaping poverty and converging on advanced countries requires integration into the global trading system, which in turn requires access to Western capital markets. But developing countries in the dollar-based global financial system are exposed to the vagaries of short-term capital flows and to cycles of boom-and-bust driven by macroeconomic policies in advanced economies.

The pandemic and the war did not disrupt a functional system. What the crisis did do, however, was to reveal the structure of the system through which it is currently propagating — that is to say, it revealed the absence of a system. To speak of any “international economic order” belies the fact that the global economy remains an anarchic, self-help system, in which states are incentivized to engage in protectionist economic policies and are forced to rely on the “devil’s doughnut” that is the dollar system. This system is, of course, not the result of deliberate US statecraft, but the consequence of a globalized economy that privileges the preferences of financial elites for the free, international movement of capital.

Even during “normal times,” this nonsystem only works for a few well-positioned and well-governed countries. The high-powered incentives of developing countries to run persistent trade surpluses not only requires quasi-permanent wage repression to render exports cost-competitive. It also forces other countries, often other emerging markets, into deficits. This “hot potato of deficits” is passed around until, at the end of the next financial cycle, the weakest economies collapse in debt crises, are forced to enact socially incendiary and politically destabilizing internal devaluations to resuscitate their competitiveness, all while the financial elites shift their dollar assets into offshore jurisdictions.

The political inability to reform the international institutions, norms, and policy frameworks in ways that can guarantee growth and stability for the majority of humanity has been at the heart of major geopolitical conflicts over the last century. The grand quest for stable global economic governance that defined much of the twentieth century is fundamentally about making these events a thing of the past.