A chance that we’ll face the greatest economic collapse in history

There’s a slight, but disquieting, chance that the globalized economic system of our time could collapse in a way never experienced before. Here’s how that could happen:

Globalization induced a tendency toward deflation. In manufacturing, for example, the American labor force that got paid at an average wage rate of around $20 per hour was largely replaced with a Chinese labor force that got paid at a much lower rate. It enabled the production of cheaper goods. That became a deflationary force in the world economy.

Central bankers got concerned that, one-by-one, the major economies could fall into deflation — as Japan started to during the 1990s. So the central banks decided to counter that tendency with stimulative monetary policies: low interest rates and bond purchases.

The low interest rates induced credit expansion. It became easy (and profitable) for corporations to take on more debt than previously would have been prudent. And it became easier for governments to support sovereign debt levels — so they increased.

It’s no wonder that the economic system is now awash in an unprecedented amount of debt.

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Debt deflation is the most pernicious kind of deflation. We started to fall into debt deflation during the Great Financial Crisis of 2008. Central bankers then lowered interest rates all the way to zero and instituted Quantitative Easing. It resulted in another round of credit expansion. It was like kicking the can down the road.

This year the monetary authorities started to try to “normalize” their policies. That meant raising interest rates back toward the historical norm (a range of between 3% and 6%) and ending Quantitative Easing. But the markets have reacted negatively. The plunge in the prices of stocks, bonds, crypto, etc. over the last six months has resulted in enormous wealth destruction. If we start to fall into recession the central banks might decide that they have to turn back to “easy money” policies.

The economy could collapse if bond buyers (corporations, governments, and rich people) decide too-easy money will lead to persistent inflation. If a bond yields 3% and inflation runs at 6%, the purchaser loses money in real terms. So bond buyers could start to shun bonds at the current low interest rates. Rates would have to rise to four or five or six percent.

The enormous debt levels in the economy would then become highly problematic. Some corporations would fail if they had to start servicing their debt at 6% instead of 3%. Some governments with unfunded liabilities would go bankrupt.

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The scenario is not all so likely. The central banks will try to finesse the balance of stimulus and counter-inflationary policies. They’ve succeeded in that respect for decades. But the situation could get to a point where they lose control because the levels of debt in the system are so high.

Watch where bond yields go over the next three or five or ten years. Higher rates could induce a bond market collapse which could lead to a “death spiral” where one debtor after another defaults. The underlying insolvency of it all would then become exposed.