Brexit-Like Populist Pressure May Spawn ’70s-Style Stagflation

(Bloomberg) -- It's practically become conventional wisdom among the economic pundit class that central bankers have been playing far too big a role in managing the global economy. If only other policy makers came off the sidelines and joined in from the fiscal side, all would be right with the world.

Well, maybe not. Following Britain's vote to leave the European Union, the odds are growing that governments will be jolted into action by mounting populist pressures worldwide. The danger, though, is that the steps they take end up being inimical to growth -- think protectionism and severe curbs on immigration -- rather than supportive of it.

The danger, as countries turn inward and inefficiencies proliferate, could be a return to the bad old days of the 1970s and early 1980s, when economies suffered from a toxic mix of stagnant output and elevated inflation, some analysts say.

“Longer-term, there is a rising risk of a stagflationary scenario,” Joachim Fels, global economic adviser for Pacific Investment Management Co., said in an e-mail.

Protectionism “raises import prices and benefits less efficient” and more expensive domestic producers, said Fels, whose company manages $1.5 trillion in assets. “Greater barriers to immigration reduce competition for domestic workers and thus lead to higher wage growth than otherwise” that fuels unwanted inflation.

Bond market investors are buying into the “stag” part of the Fels scenario as they push yields down to record lows in anticipation of an even weaker global economy post-Brexit. They're skeptical though of the “flation” forecast, as shown by the lagging performance of inflation-protected securities.

Fels agreed that both global growth and inflation will be held down over the next six to 12 months as depressed demand and a stronger dollar cap price pressures. Over a longer period, though, inflation could accelerate as a result of populist-driven policy changes, he argued.

Former Federal Reserve Chairman Alan Greenspan pinpointed a key economic characteristic common to both the 1970s and today: poor productivity. That constrains how fast economies can grow without generating inflationary pressures.

“What it's doing is creating a general stagnation in the developed countries which is causing desperation on the part of their electorate,” as exemplified by the June 23 U.K. vote to leave the EU, he said in an interview with Bloomberg Surveillance on June 27 in Washington.

In a follow-up e-mail, Greenspan said the U.S. is eventually heading toward stagflation if money-supply growth continues at its recent, stepped-up pace. But he added that he had no time frame on when that might occur.

Inflation Risk

“I would not be surprised to see the next unexpected move to be on the inflation side,” the former Fed chairman said.

Prices in that instance would be driven higher by self-imposed limits on supply -- through import barriers and the like -- as well as via excess demand, said Allen Sinai, chief executive officer of Decision Economics Inc. in New York.

Presumptive Republican presidential candidate Donald Trump recently threatened to slap punitive tariffs on products from China and other U.S. trading partners to level a playing field that he argues is heavily tilted toward America's competitors.

His likely rival, Democrat Hillary Clinton, has also promised to take a tougher stance on trade, saying she would appoint a chief prosecutor to represent U.S. interests.

In Europe, mounting disillusionment with the EU isn't limited to Great Britain, according to an opinion survey published last month by the Washington-based Pew Research Center.

Globalization Backlash

While the opposition has been turbocharged by a flood of refugees into the region, it's also been driven by a backlash against globalization, said Jacob Funk Kirkegaard, a senior fellow at the Peterson Institute for International Economics in Washington.

Mohamed El-Erian, whose 2016 book “The Only Game in Town” crystallized the argument that central banks can't do it all on their own, said the Brexit vote has accelerated the world economy's journey to a fork in the road.

On one spur, governments finally swing into action, lifting global growth and enhancing financial stability by increasing infrastructure investment and reducing income inequality and indebtedness. On the other, already-stretched central bankers remain left on their own, increasing the risk of recessions and market disruptions.

El-Erian, who's chief economic adviser at Allianz SE, said in response to an e-mail that there was a third option: Governments do act, but they adopt protectionist and other economically-damaging policies.

“The result would be recession, severe market instability, worsening inequality” and the risk of greater social polarization, said El-Erian, who's also a Bloomberg View columnist. Inflation “could go either way” should that occur.

Pundits haven't been the only ones pining for more fiscal action by governments. Central bankers have been too.

“We've had seven or eight years where monetary policy” has been the primary economic policy, Federal Reserve Bank of Dallas President Robert Kaplan said in an interview on June 30. “We're now at the end of that phase, and I think we need to broaden how we think about economic policy.”

He brushed off suggestions that governments might take actions that hurt rather than help growth, saying he had “faith” that they would do the right thing.

Europe's initial response to the Brexit vote might provide the region's economy with some support. Kirkegaard said the EU could spend more on border control and forgo sanctioning Portugal and Spain for bigger budget deficits.

Bigger Deficits

U.S. budget shortfalls probably will also be boosted no matter who wins the presidential election in November, according to Andy Laperriere, a partner at Cornerstone Macro LLC in Washington.

In the longer run, though, there's a danger that the anti-elitist backlash exemplified by Brexit could end up being economically corrosive, said Hung Tran, executive managing director for the Institute of International Finance in Washington.

“If the Brexit vote symbolizes a deeper malaise and a deeper push-back against the post-war trade, investment and financial architecture, the impact will be gradual, long-term but quite negative,” he said. “It will cause world trade to decelerate” and “will also impact business confidence and therefore capital expenditures and investment.

“Overall growth will be slower than otherwise could be the case,” he said.

--With assistance from Lisa Du To contact the reporter on this story: Rich Miller in Washington at rmiller28@bloomberg.net. To contact the editors responsible for this story: Carlos Torres at ctorres2@bloomberg.net, Vince Golle, Scott Lanman