Will a global recession accelerate geopolitical fragmentation?

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Dimitri Zabelin, Associate, LSE IDEAS

• Key economic indicators in the US point to the possibility of a global recession.
• Populist and nationalist movements tend to thrive amid economic difficulties, increasing geopolitical fragmentation.
• Setting the narrative is crucial to avoid the rise of extremist viewpoints.

Inflation continues to be the headline risk for investors and policy-makers. Countries are wrestling with shocks from the war in Ukraine, and the residual effects of domestic fiscal/monetary stimulus packages during the pandemic. As a result, the ripple effects in the economic, social and political domains could accelerate geopolitical fragmentation.

The war in eastern Europe is indirectly reshuffling the political economy of Asia, as Russia and key oil producers in the Middle East form new alliances. Supply chains for key commodities are being re-oriented, trade in strategic technologies is being closely scrutinized, and increased unilateralism especially has undermined the international, rules-based system.

While these problems are global in scope, due to the US’s centrality in the world’s financial system, we will initially focus here. The Federal Reserve has hiked interest rates from near zero during the pandemic to a 4.50-4.75% band in less than three years in order to help curb inflation, and notably reduced its $9 trillion balance sheet.

To better contextualize the urgency: in 2022, the Federal Reserve raised interest rates by 0.75% in one day for the first time since 1994 – and then did so three more times in the same year. The US has been used to an ultra-accommodative interest-rate policy for well over a decade, and the rapid changes are exposing frailties in the system.

The volatility in the banking sector and largest cryptocurrency bear market in history demonstrate weaknesses that were previously masked by a low interest rate environment. Housing – as a key measure for upward mobility – is less affordable now than it was in 2008, right before the mortgage market collapsed and a recession ensued.

US inflation for January rose 0.5% on a monthly basis and registered an annual reading of 6.4%, far above the Federal Reserve’s 2% inflation target. Shortly after, Chairman Jerome Powell said in a press conference: “The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.”

The combination of raising interest rates and balance sheet reduction has not only tightened credit conditions domestically, but also rippled out to the broader financial system and raised the cost of borrowing the US dollar. Emerging market economies with USD-denominated sovereign debt are particularly vulnerable to increased funding costs and weaker growth globally.

Naturally, financial markets wilted at the prospect of tighter credit conditions, weaker growth and a lower threshold for risk appetite. Furthermore, domestic labour conditions continue to remain tight, leaving room for potentially more interest rate hikes. Policy-makers, CEOs and former central bankers are all warning of recession in 2023.

Exploiting anger

So what does this mean for political stability? Astudy cited by The Economist found that European political dynamics – though this almost certainly has global applications – are strongly influenced by oscillations in macroeconomic conditions. One paper found that “a one percentage point increase in the unemployment rate was associated with a 2-3 percentage point rise in the share of votes captured by fringe parties”.

Another study by Hans Peter Grüner and Markus Brückner concluded that: “While estimates vary between specifications, we find that roughly a one percentage point decline in growth translates into a one percentage point higher vote share of right-wing or nationalist parties.”

When macroeconomic conditions deteriorate enough to irritate underlying socio-economic problems – such as hyper-inequality – democratic institutions are threatened. Opportunistic authoritarians frequently tap into the vein of resentment and redirect the flow of the population’s anger to an agenda that suits his or her political aspirations to unchecked power.

Right-wing, populist, nationalist parties appear to have a tendency to outperform their communist counterparts in times of economic crisis. One possible explanation is that these kinds of political movements/groups emphasize order, structure and the prioritization of their nationals (or a specific ethnic group) during a time of social dissolution and economic uncertainty.

One example is the collapse of a mortgage credit boom in Hungary that subsequently led to the rise of a far-right party. A study by the London School of Economics & Political Science shows how “the post-2008 fragility is correlated with the geographic variation in the rise of the right-wing Jobbik party”.

The battle for narrative

During times of economic uncertainty and rotting social cohesion, institutional support for freedom of speech and open debate are crucial for publicly challenging extremist views and defeating false narratives.

A UN report found that between 2015 and 2020, the number of far-right attacks tripled globally, with the pandemic playing a key role. However, no coin is without two sides. The rise of the extreme right is also the fault of moderate centrists for failing to state a case for liberally rooted values and concerns of a disillusioned fringe, whether it be on the right or left.

Francis Fukuyama remarked that extremism on both sides of the political aisle often attributes power to a small but influential cabal of people who are secretly pulling the strings of global affairs. Clearly, introspection and nuance are not fortes among the world’s far-right and far-left extremists; it is in fact antithetical to the very basis of their own ideological legitimacy.

In the US – but increasingly globally – politics is devolving into a caricatured dichotomy of rootless globalists vs blood and soil nationalists. As a result, there is little room for moderately minded centrists who believe both in national sovereignty and global cooperation on issues no leader or nation alone can tackle.

With the advent of deglobalization, trends of geopolitical fragmentation have accelerated at a commensurate rate, with the pandemic amplifying this trajectory. After enduring the slings and arrows of a virus-induced recession, another economic contraction could have significant implications for global geopolitics.