Look around the world and big risks abound. One or more countries may drop out of the eurozone. Violence may spread across the Middle East. The US Congress may yet drive the country off its fiscal cliff and into recession. An island dispute between China and its neighbours may flare up, provoking the US to intervene in the Pacific. But in my view, the single greatest risk is that one of these events or some other throws the world into another global financial crisis, a “GFC II”.
This is a possibility for three reasons. First, the world economy is still in fragile shape and only slowly recovering from the GFC of 2007-08. Households and governments are still struggling under heavy debt loads. Banks are still shrinking their balance sheets and uncertain over the evolving, but still vindictive, regulatory climate. Any new shock will add to their worries and cause further retrenchment.
Second, economic policy is maxed out. Both fiscal and monetary policy have hit their effective boundaries. The GFC created a balance sheet recession which means that Keynesian stimulus based on more government borrowing will be ineffective at best and counterproductive at worst. Central banks have held nominal interest rates near zero for an unprecedented length of time and pumped liquidity into their financial institutions through quantitative easing (QE). But the signs of a classic liquidity trap are everywhere. Banks find little demand for new loans and in any case the regulators tell them to build up their reserves. QE is helping to prop up the banks but it is not getting into the real economy, and the negative side effects for savers and pension funds are growing. If an external shock occurs, there is little that government policy can do to counteract it.
The third vulnerability is political weakness. Prolonged austerity is undermining political support for mainstream parties and encouraging the fringes, both left and right. The peripheral eurozone countries are at particular risk. A weak coalition in Italy after Spring elections or a separatist win in Catalonia could not only be the beginning of the end of the euro but the trigger for GFC II.
To mitigate this risk, international cooperation will be key. The objective should be economic surveillance to monitor crisis regions and, if necessary, economic containment. Contingency plans should be prepared to prevent the spread of financial crisis from one country to the rest of the global economy without retreating into protectionism. The G20 is the obvious place to coordinate this. Unfortunately it is Russia’s turn to lead the G20 next year. Yet another reason to worry.