From Economic Crisis to World War III

The response to the 2008 economic crisis has relied far too much on monetary stimulus, in the form of quantitative easing and near-zero (or even negative) interest rates, and included far too little structural reform. This means that the next crisis could come soon – and pave the way for a large-scale military conflict.

BEIJING – The next economic crisis is closer than you think. But what you should really worry about is what comes after: in the current social, political, and technological landscape, a prolonged economic crisis, combined with rising income inequality, could well escalate into a major global military conflict.

The 2008-09 global financial crisis almost bankrupted governments and caused systemic collapse. Policymakers managed to pull the global economy back from the brink, using massive monetary stimulus, including quantitative easing and near-zero (or even negative) interest rates.

But monetary stimulus is like an adrenaline shot to jump-start an arrested heart; it can revive the patient, but it does nothing to cure the disease. Treating a sick economy requires structural reforms, which can cover everything from financial and labor markets to tax systems, fertility patterns, and education policies.

Policymakers have utterly failed to pursue such reforms, despite promising to do so. Instead, they have remained preoccupied with politics. From Italy to Germany, forming and sustaining governments now seems to take more time than actual governing. And Greece, for example, has relied on money from international creditors to keep its head (barely) above water, rather than genuinely reforming its pension system or improving its business environment.

The lack of structural reform has meant that the unprecedented excess liquidity that central banks injected into their economies was not allocated to its most efficient uses. Instead, it raised global asset prices to levels even higher than those prevailing before 2008.

In the United States, housing prices are now 8% higher than they were at the peak of the property bubble in 2006, according to the property website Zillow. The price-to-earnings (CAPE) ratio, which measures whether stock-market prices are within a reasonable range, is now higher than it was both in 2008 and at the start of the Great Depression in 1929.

As monetary tightening reveals the vulnerabilities in the real economy, the collapse of asset-price bubbles will trigger another economic crisis – one that could be even more severe than the last, because we have built up a tolerance to our strongest macroeconomic medications. A decade of regular adrenaline shots, in the form of ultra-low interest rates and unconventional monetary policies, has severely depleted their power to stabilize and stimulate the economy.

If history is any guide, the consequences of this mistake could extend far beyond the economy. According to Harvard’s Benjamin Friedman, prolonged periods of economic distress have been characterized also by public antipathy toward minority groups or foreign countries – attitudes that can help to fuel unrest, terrorism, or even war.

For example, during the Great Depression, US President Herbert Hoover signed the 1930 Smoot-Hawley Tariff Act, intended to protect American workers and farmers from foreign competition. In the subsequent five years, global trade shrank by two-thirds. Within a decade, World War II had begun.

To be sure, WWII, like World War I, was caused by a multitude of factors; there is no standard path to war. But there is reason to believe that high levels of inequality can play a significant role in stoking conflict.

According to research by the economist Thomas Piketty, a spike in income inequality is often followed by a great crisis. Income inequality then declines for a while, before rising again, until a new peak – and a new disaster.

This is all the more worrying in view of the numerous other factors stoking social unrest and diplomatic tension, including

  • technological disruption, a
  • record-breaking migration crisis,
  • anxiety over globalization,
  • political polarization, and
  • rising nationalism.

All are symptoms of failed policies that could turn out to be trigger points for a future crisis.

.. Voters have good reason to be frustrated, but the emotionally appealing populists to whom they are increasingly giving their support are offering ill-advised solutions that will only make matters worse. For example, despite the world’s unprecedented interconnectedness, multilateralism is increasingly being eschewed, as countries – most notably, Donald Trump’s US – pursue unilateral, isolationist policies. Meanwhile, proxy wars are raging in Syria and Yemen.

Against this background, we must take seriously the possibility that the next economic crisis could lead to a large-scale military confrontation. By the logicof the political scientist Samuel Huntington , considering such a scenario could help us avoid it, because it would force us to take action. In this case, the key will be for policymakers to pursue the structural reforms that they have long promised, while replacing finger-pointing and antagonism with a sensible and respectful global dialogue. The alternative may well be global conflagration.

Who Will Be Trump’s Pick to Lead the Fed? We Asked Experts to Rate the Odds

Ms. Yellen has a possibility of being renominated, according to this consensus, but it is only 22 percent; experts think that Kevin Warsh, a former Fed governor with deep Republican ties, has a slightly better chance at 23 percent.

.. The case for renominating Ms. Yellen is straightforward.

She has presided over four years of steady economic expansion and rising financial markets. She moved cautiously toward raising interest rates even though the economy seemed to be approaching full employment. By contrast, some more conservative contenders for the job have indicated they want to raise rates more quickly, which could endanger the economy as President Trump approaches midterm elections in 2018 and a potential re-election battle in 2020.

.. Moreover, as President Trump dabbles in making deals with Democrats, reappointing Ms. Yellen could serve as an expression of good faith to Democratic senators. As administration officials focus on tax legislation and other priorities on Capitol Hill, it might be helpful to them to nominate someone who might sail through confirmation, rather than demand a bruising, time-consuming battle.

.. The case against Ms. Yellen is similarly straightforward: She is a liberal economist in a government dominated by conservatives. She is a cerebral academic serving during the presidency of a bombastic businessman. And she is a staunch defender of the work the Fed and other bank regulators have done to try to limit risk in the financial system — including in a high-profile speech last month — amid an administration focused on deregulation.

Kevin Warsh: well connected, but with baggage

He has a law degree, but no advanced degree in economics.

.. Mr. Warsh has been a skeptic of the Fed’s efforts to boost the economy through quantitative easing and has advocated raising interest rates more quickly. He also has a regulatory philosophy more in line with the administration’s.

.. Mr. Warsh’s father-in-law is Ronald Lauder, of the Estée Lauder cosmetics fortune, a major Republican donor with longstanding ties to Mr. Trump.

.. If Mr. Warsh is nominated, expect significant blowback during the confirmation process from Democrats, who are likely to accuse the 47-year-old Mr. Warsh of being underqualified, of being responsible for the 2008 bank bailouts and inclined to regulate banks too lightly now, and of being too overtly political for the traditionally nonpartisan Fed chairmanship.

.. Democrats would be eager to criticize the administration for naming a recent top executive at Goldman Sachs to be the nation’s most powerful financial regulator. Some populist Republicans might join them.
.. Foremost among them are several of the names we would probably be hearing about if a conventional Republican president were in the White House
.. John B. Taylor is a respected economist at Stanford who worked in the George W. Bush administration and has been an influential voice among congressional Republicans who want to see the Fed bound by stricter rules governing its actions.

Glenn Hubbard was a top economic adviser to Mr. Bush who is dean of Columbia Business School.

Larry Lindsey was another top adviser to Mr. Bush and a former Fed governor with an economics doctorate from Harvard.

.. Their doctorates and affiliations with top universities may actually be downsides in an administration that has shown disdain for academic expertise.

.. other names has emerged in various reports, including the F.D.I.C. vice chairman Thomas Hoenig and John Allison