‘Dr. Doom’ Nouriel Roubini warns of painful stagflation caused by a new cold war with China and the ‘balkanization’ of the global economy

The highly respected economist, nicknamed Dr. Doom for predicting the last global financial crisis, said the two superpowers are in the process of extricating themselves from mutual interdependencies that are increasingly seen as security risks.

On one side, Washington aims to tear apart existing trade routes and build new ones with its closest allies, Roubini argued in an interview on Wednesday. Beijing, for its part, plans to insulate itself from potential Western economic sanctions by gradually decoupling from the U.S. dollar.

“We’ve gone from free trade to secure trade, from offshoring to friend-shoring, from just-in-time supply chains to just-in-case,” the NYU professor emeritus told Yahoo Finance Live. “These things are costly, they reduce global growth and increase cost of production.”

After the collapse of the West’s last systemic rival, the Soviet Union, the resulting Pax Americana ushered in an economic boom based on the primacy of free markets, liberal democracy, and the rule of law. Multinational corporations could arbitrage the best of a country’s competitive advantages, whether that be research and development or cheap and plentiful labor, driving down their manufacturing costs as part of the deflationary trend toward globalization.

In the process, however, these ensuing economic linkages created a web of interdependencies that now means China is the dominant supplier of critical resources like rare earth magnets, refined lithium, and monocrystalline silicon, which are needed for the green and digital transformation.

The West is also reliant on Taiwan as the sole supplier of its most advanced logic chips, forcing it to arm the small island nation to deter a possible invasion by its larger neighbor across the strait.

Commerce to suffer from unwinding efficient global supply chains

As a consequence, last week U.S. trade representative Catherine Tai said Washington sought closer economic ties with its allies to counter the rising threat posed by Beijing’s hegemonic ambitions.

Breaking the economic links with systemic rivals like China and Russia would lead to less efficient commerce through the “balkanization of global supply chain,” he argued.

Meanwhile China is negotiating with pariah state Russia to buy Moscow’s oil and gas without resorting to the dollar as a means of exchange—cutting the U.S. out of the equation in the process.

“Unfortunately, the cold war between the U.S. and China is getting colder by the day,” Roubini said.

Sensing the rising risk of war, Berkshire Hathaway CEO Warren Buffett already offloaded the bulk of his stake in Taiwan Semiconductor Manufacturing Company (TSMC), the largest chipmaker by volume and the only source of bleeding-edge silicon.

Losing reserve currency status exposes U.S. to its twin deficits

Establishing the yuan as the second global reserve currency would give China more protection against economic retaliation should it seek to expand through military means much as Moscow has.

“They’re worried that the kind of sanctions we imposed on Russia—if there was a conflict or escalation over, say, Taiwan—could be imposed on China, and China has over a trillion dollars of reserves that are in dollar,” the economist told Yahoo News. “So they need to have a unit of account, a means of payment, a store of value, that is an alternative to the U.S. dollar.”

The rise of the yuan would be bad news for Americans, who are only able to finance their consumption thanks to the willingness of other countries to constantly buy U.S.-dollar-denominated assets like Treasury bonds—which are effectively nothing more than government-backed IOUs—in return for their goods.

Should it no longer be the issuer of the world’s sole reserve currency, the U.S. would find itself competing with China as a haven for excess foreign capital. Borrowing costs would rise and Americans would no longer be able to enjoy the same lifestyle they do now.

“That means less financing of our own twin fiscal and current account deficits, when we still have very large stocks of private and public debt,” Roubini said. “That can push higher the cost of financing for the United States.”

Worst of the banking crisis still to come

Roubini echoed recent comments that the current crisis of confidence in the lending sector is not over, as too many banks suffered a trifecta: losses on their securities portfolio, a drop in the value of their loan book, and heavy exposure to the ailing commercial real estate market.

Many regional institutes in his view remain unable to offer their clients attractive enough interest rates to prevent a depositor flight to more profitable and ultra-safe money market funds.

“The worst in terms of severe banking stress is still ahead of us,” Roubini told Yahoo Finance.

The resulting credit crunch will tip the U.S. economy into a recession later this year, he predicted, as the Federal Reserve is ill-equipped, in his opinion, to deliver on its dual mandate of low inflation and maximum employment while rescuing banks.

Roubini voiced his concern that with core consumer prices continuing to tick higher, rising one-tenth of one percent to hit an annual rate of 5.6% in March, the U.S. could see the worst of the 1970s in terms of inflation and the worst in terms of insolvency following the 2008 collapse of Lehman Brothers.

“You have only one policy instrument, in this case the fed funds rate, to hit three targets—price stability, growth and financial stability,” he said. “To me that looks like mission impossible.”