Structural Change Watchlist

Through the Looking Glass

Airplane in hangar
Diane Swonk

Diane Swonk

Chief Economist, KPMG US

+1 312-665-1000


Lewis Carroll’s Through the Looking Glass and What Alice Found There was the first and only book that my father ever gave me. It was not long after I was diagnosed with dyslexia, a reading disability that afflicted him as well.

The symbolism of a young girl attempting to navigate an alternative universe that was a mirror reflection of the one in which she lived was not lost on me. One of the first things she discovered was a book of poems written back-to-forward; the only way to read it was to hold it up to a mirror.

Even the timing and staging of the novel is the mirror image of its prequel, Alice’s Adventures in Wonderland, which starts outside on a spring day instead of inside on a snowy winter day.

Later, the book provided a useful metaphor for the reverse world we entered after Russia invaded Ukraine. Inflation accelerated, even as growth cooled and the risk of a global recession intensified. The term stagflation was resurrected from the rubble of the 1970s.

Now, the symbolism within the book seems even more poignant. A major theme of the book is time itself. Alice had to run to stay in place and walk away from something to get closer to it. We can’t go back in time, but we can move forward and learn from past mistakes. The key is to identify where we are, what is going well and what isn’t.

Economists observe two forms of change:

  1. Cyclical shifts, such as the collapse in economic activity in response to initial lockdowns that are over in months or quarters. That recession was deep but short-lived, only two months in duration.
  2. Structural changes are slower moving and take years to play out. They include things like the chronic staffing shortages associated with changing demographics, immigration flows and the legacy effects of COVID due to high infection rates, the blow to educational attainment and the debilitating effects of long COVID.

Structural shifts are more profound than cyclical shifts, as they upend existing business models; they are the reason that no two business cycles are the same. The subprime crisis and the deep recession it triggered are examples. It was much worse and harder to recover from that previous recession because of the massive overhang of underwater debt we were carrying in our homes.

This inaugural edition of our new publication focuses on the structural changes we are seeing and how they are likely to play out. Everything from the pandemic to the war in Ukraine and climate change are reshaping the economic landscape. Our challenge is to minimize the scars that those blows leave on our economic complexion. They are the main reasons that no two business cycles are alike.

A Top Ten List

The following list is far from complete but underscores the challenges we face and the opportunities they provide. Evolution is a way to adapt to change and survive. Knowing the trends already underway is a powerful tool when hedging economic risk.

#1. Haunted by past bouts of inflation. There is not a major central bank I can think of, including the Federal Reserve, which wasn’t permanently scarred by the unmooring of inflation expectations and resulting stagflation of the 1970s.

The term was first used in reference to the vicious cycle of escalating inflation, eroding living standards and persistently weak growth in the U.K. in the 1960s. Later, it was used to describe the U.S. after OPEC moved to embargo oil in 1973. The surge in oil prices triggered a synchronous rise in inflation and unemployment. Inflation and elevated levels of unemployment persisted, even after the recession ended in 1975.

The Fed is good at learning from past mistakes. Fed Chairman Jay Powell and his colleagues have underscored the point by arguing that unemployment is “unsustainably” low. They are willing to accept a recession today to derail a more persistent and corrosive bout of inflation going forward. (Those shifts in policy open the door to the Fed making a new set of mistakes.)

Central banks can’t calibrate recessions. The impact rate hikes have on the economy is nonlinear. No one, including researchers at the Fed, knows how reductions in the balance sheet will amplify short-term rate hikes. That means that the Fed can’t calibrate the magnitude of credit market tightening or the depth of the recession it might trigger. Financial markets are more integrated than in the early 1980s, the last time the Fed derailed inflation.

#2. Sovereign debt burdens are mounting. Developed as well as developing economies took on massive levels of debt to counter the effects of the pandemic. That added to the debt accumulated in the wake of the global financial crisis in the 2010s.

Aggressive interventions by the International Monetary Fund (IMF) and ultra-low rates made those debts sustainable for a time. The surge in inflation and rate hikes following Russia’s invasion of Ukraine could be the straws that break the camel’s back.

Developing economies are more at risk of default than developed economies. They are struggling to subsidize the costs of food and energy, which are rising even faster for them than elsewhere as the currencies that they use to buy those necessities are depreciating. That is creating a vicious cycle of rate hikes to defend weakened currencies, which is further raising the cost of debt.

Sri Lanka’s default represents an extreme but cautionary tale. Years of corruption and economic mismanagement made it vulnerable to default. Large infrastructure loans from China exacerbated the pain. Pakistan could be next. It came close to missing a debt payment in April. It has turned to China and the IMF for help but remains on shaky ground.

Developed economies are not immune. The recent surge in bond yield spreads between Italy and its neighbors in the Eurozone highlights the risks. The European Central Bank (ECB) vowed to leverage its existing tools and launched a new facility to keep rates of individual countries from spiking.

Much of the sovereign debt outstanding is held by banks in the very countries that are issuing it. Any default would not only cut off that country from international financial markets, it could trigger what is known as a “doom loop” of losses in its financial system.

Banks with large holdings of a country’s worthless debt could become insolvent. That would trigger bank runs and a financial crisis as access to credit disappeared.

Why do we care? Because there is no Las Vegas in the global economy; what happens abroad does not stay abroad. A financial crisis elsewhere could not only roil our financial markets but compound the pain we endure.

#3. China becomes a drag instead of an engine of global growth. The pandemic exacerbated but did not create the problems that China now faces. China adopted a growth model that combined forced savings, market liberalization and very high, government-directed investment to correct decades of economic mismanagement.

The problem is that it maintained that model for more than a decade after it was useful, investing in nonproductive investments that fueled an unsustainable accumulation of debt. The overhang in the country’s real estate market, which accounts for about a quarter of GDP, is just one example.

That debt overhang and the country’s zero COVID policy mean it cannot stimulate as it once did. Those waiting for China’s consumer to snap back and carry the global economy will be disappointed.

The situation is so unusual that China’s leadership recently abandoned its growth target. It opted instead to “strive to achieve the best possible results.” 

There is concern that slowing growth will spur China’s desire to counter U.S. hegemony. The rapid escalation and showdown in the Taiwan Strait, which further disrupted global supply chains, illustrates that fear.

#4. Defense spending is poised to accelerate. Russia’s invasion of Ukraine succeeded where the pandemic failed; it unified much of the world against a common foe: Vladimir Putin. NATO has expanded instead of contracting in the wake of the crisis, with Finland and Sweden joining its ranks.

With those shifts has come a new commitment to defense spending. Even Germany has upped its commitment, while Democrats and Republicans appear to be in a rare bidding war over who can spend more on defense.

This will add to existing debt and could stoke more inflation down the road. Defense spending is designed to fund weapons that destroy infrastructure, while defense contracts have been among the most riddled with cost overruns in the past.  

#5. Rule of law and respect for human rights rise in importance. Environment, Social and Governance (ESG) targets have come to include everything from respect for the rule of law to human rights. We saw that happen in real time as firms chose or were forced to opt out of doing business in Russia within weeks of its invasion of Ukraine.

Shareholders, investors, the general public and prospective employees all want to be associated with firms that not only say but do the “right” things. KPMG’s recent American worker pulse survey showed that 72% of workers believe it is important for their organization to respond to ESG issues; only 58% believe their companies are delivering on that promise. 

That opens a window of opportunity for firms that rank those issues high on their list of objectives. It also underscores the need for more specific ESG targets that can be measured and verified. The era when firms and governments could pay lip service to their goals alone has ended. Financial markets and regulators have already begun to punish those that do not follow through on what they say they are doing.

#6. The global economy is becoming more fragmented. The pandemic, the war in Ukraine and a surge in extreme weather events revealed the fragility of global supply chains and intensified the desire for countries to turn inward. The goal is to become more self-reliant.

What we are seeing is more regionalizing of supply chains than onshoring. The goal is to shorten travel times for key components, not just offshore to the cheapest producer.

Russia’s actions have underscored the need to assess geopolitical as well as economic costs. That has led to what is known as “friend-shoring,” or locating to countries with friendlier relations with the U.S.

Mexico will likely be the largest winner of such shifts. It is more costly but safer to produce there than in other developing countries. The USMCA trade pact, which was negotiated by the last administration, ensures that.

#7. A pivot from just-in-time to just-in-case inventory systems could seed more boom-bust cycles. Just-in-time inventory systems were developed and perfected in Toyota’s manufacturing plants in the 1970s. The goal was to cut costs, improve quality and eliminate the need to store inventories in a country where space is limited.

The vehicle industry was the first to advance the concept. Much of the early effort in the U.S. focused more on shifting the costs of carrying inventories from the largest producers to suppliers. Consolidation among suppliers and a shift to outsource entire systems instead of just parts leveled the playing field and enabled suppliers to carry fewer inventories as well.

The vulnerabilities those shifts introduced into the system proved to be problematic. In the late 1990s, the UAW figured out the pressure point of one of the country’s largest vehicle producers, went on strike and shut down much of the company within hours. Striking workers lost their pay, while the union was able to retain the pay of furloughed workers, which compounded the opportunity costs triggered by shuttered plants.

More recently, we have seen large retailers, known for their inventory management, hit with an unwanted surge in inventories. Some have resorted to discounting. Few (if any) are scrambling to build warehouses and store inventories. Rather, they are asking their suppliers to take on more of the costs of transporting and storing inventories for them. The result will leave the economy more susceptible to inventory cycles, but not as prone to booms and busts as we saw before the adoption of just-in-time systems.

#8. Labor market shortages will not easily abate. The aging of the baby boom into retirement, the pandemic and a sharp drop in immigration all contributed to the shortages of labor that we experienced as the demand for workers skyrocketed when the economy reopened.

The problem is that many of those supply-side challenges are not likely to disappear. The baby boom generation isn’t getting any younger, while generation Z (those who are 25 and under) is a much smaller cohort.

The pandemic disrupted educational attainment, stoked physical and mental health crises and left millions struggling with long COVID. A recent Household Pulse survey suggests that about one in seven workers has experienced long COVID. That further constrained the supply of workers, especially in frontline jobs where initial infections hit workers the hardest.

Add the surge in the number of workers out sick due to ongoing infections (those ranks were more than 60% above the monthly levels prior to the pandemic in July alone); it is little surprise that staffing shortages are likely to persist

Bottlenecks in the immigration process will likely unwind but, barring immigration reform, are not likely to reverse the drop in immigration. A loss in foreign students seeking education in the U.S. will add to the shortfall in workers.

#9. Disruptions due to extreme climate events will accelerate. We are living with the consequences of climate change in real time. Temperatures the world over are hitting record highs. Those shifts have ignited fires, exacerbated droughts and floods, increased fatalities due to heat exhaustion and stressed energy grids. 

The war in Ukraine and the disruption to Russian oil and natural gas it triggered have intensified the push to adopt more renewable energies, notably in Europe. Getting from here to there is not easy. In the interim, the war has increased the use of coal plants and is adding to carbon emissions.

Those shifts are further disrupting supply chains; it is hard to work, let alone produce amidst rolling blackouts.

Insurers have been ahead of the curve in reacting to the surge in extreme weather events, raising costs and pulling out of markets most at risk of damage including flood plains and coastal areas, where water damages are surging. They have pulled out or raised the costs of insurance for large carbon producers and emitters as well.

The Federal Reserve is not stress testing for climate change. That hasn’t stopped large banks from assessing their credit exposure to the damages caused by extreme climate events, which is boosting the borrowing costs for carbon producers and major emitters and will eventually raise borrowing costs for developers.

The European Central Bank (ECB) does stress test Eurozone banks for climate change, which is increasing borrowing costs abroad. This is in addition to increased regulation and efforts by governments to accelerate the transition to renewables.

Carbon capture needs to be in the mix as we can’t simply flip a switch and transition to renewables without triggering massive economic losses and hardship. Developing economies, where we have exported our carbon emissions via offshoring, need aid to reduce their carbon footprints and stem deforestation. Many of those same countries are suffering the worst consequences of extreme weather events.

Those shifts are all in addition to the $130 trillion in private sector funds that are committed to accelerating the transition to renewables and reversing the devastating effects of climate change.

#10. Inequality both within and across country borders is intensifying. The pandemic initially hit low-income families, who were more dependent on in-person jobs, harder than those who could work from home. They suffered more COVID cases and more fatalities than the overall population.

Low-income students had a harder time staying online and in college during the pandemic, while women with young children were knocked off their career trajectories as they bore more of the responsibility for childcare.

Physical and mental health suffered. Those without the resources to deal with those challenges face higher hurdles to work and be productive.

The surge in inflation and rents once rent moratoriums were lifted increased the ranks of the working homeless. The incidence of hunger, especially among children, has risen with the cost of food.

Developed economies weathered the pandemic better than developing economies. Access to vaccines was greater along with the quality of health care. Children weathered the shift to online schooling better; a whole generation of children could be left behind in what were some of the most promising developing economies prior to the pandemic.

Wealthier countries and families have more resources to deal with the consequences of extreme weather events. This is compounding the greater threat to health they are facing due to higher exposure to floods, fires and famine. 

Bottom Line

At the end of Carroll’s iconic novel, Alice awakens as if from a dream, back in a chair with her cats nestled in her lap. She returns to the world as if she had never left it. We don’t have that luxury. Many of the trends we are enduring weren’t started by the pandemic but were accelerated by it. Nearly all the shifts we are seeing will add to inflation if left unchecked.

The silver lining is that in every challenge there is a solution. That is another gift my father gave me with that book. Dyslexics are used to stumbling, finding their way around and over the obstacles of everyday life. I can’t remember a time that I knew which way to turn when exiting an elevator. When I ask for directions, my colleagues know to tell me to turn my other right when I have turned left.

That is another useful metaphor, as the problems we face require unity. It is not impossible. We did it emerging from World War II and proved we could do it again after Russia invaded Ukraine. In those actions, there is hope. To borrow another cliché; we get by with a little help from our friends. We can’t get enough of them now.