Simmering tensions are a necessary but not sufficient condition for conflict. I have stressed in Accidental Conflict that it will take a spark to ignite the high-octane fuel of US-China conflict escalation. Over the past few months, I have written about several potential sparks — especially Taiwan, the South China Sea, and the increasingly militaristic, anti-China bluster of Washington.
Another possibility could be a global recession. As central banks hike interest rates amid war and mounting inflation, such an outcome is hardly idle conjecture. Global recessions, of course, don’t appear out of thin air. Most recently, they have been outgrowths of financial crises. While crises are almost impossible to predict, they are always worth thinking about — especially now.
There is usually a distinct warning sign before every financial crisis. That was true of the capital outflows that presaged the Asian Financial Crisis of the late 1990s, the speculative surge of dotcom stocks in the late 1990s, as well as the bursting of the subprime mortgage bubble before the Global Financial Crisis. Could the astonishing recent failure of Silicon Valley Bank hint at yet another crisis?
Perspective is important in trying to answer this question. No two crises are alike. But they all inevitably reflect the interplay of greed, fear, and policy blunders. That is, indeed, the case today. There can be little question about the greed of a major financial institution that was unwilling to accept the risks of the Fed’s belated exit from near-zero interest rates.
SVB is most certainly not alone in having made that mistake. Signs of spreading collateral damage are already evident — not just among domestic institutions (such as Signature Bank and First Republic Bank) and but also in the international arena (for example, Credit Suisse). As is typical in major crises, firewalls end up being more porous than we thought, unable to prevent contagion. This time is no different.
But there is a new and important risk today that was not evident in earlier crises: a serious outbreak of inflation. Since the late 1990s, financial crises have occurred in era of sharp and prolonged disinflation — America’s CPI-based inflation averaged just 2.1% from 1997 to 2020. That provided inflation-targeting central banks with ample leeway to respond to crises by opening their liquidity spigots and slashing policy rates to zero. Those circumstances do not exist today. Inflation is stubbornly sticky and well above target, and policy rates remain too low to address that problem.
If central banks flinch on interest rate hikes, as financial markets are now expecting, the odds of a return to price stability will fall. As a result, far more monetary tightening will ultimately be required to contain inflation. Recession will then be unavoidable.
Sound familiar? SVP could well be that proverbial canary in the coal mine. If so, that could have a major destabilizing impact on the ever-escalating US-China conflict. More on that next week.
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