A Post-Crisis World of Risk

MILAN – The global economy’s most striking feature nowadays is the magnitude and interconnectedness of the macro risks that it faces. The post-crisis period has produced a multi-speed world, as the major advanced economies – with the notable exception of Germany – struggle with low growth and high unemployment, while the main emerging-market economies (Brazil, China, India, Indonesia, and Russia) have restored growth to pre-crisis levels.

This divergence is mirrored in public finances. Emerging economies’ debt-to-GDP ratios are trending down toward 40%, while those of advanced economies are trending up toward 100%, on average. Neither Europe nor the United States has put in place credible medium-term plans to stabilize their fiscal positions. The volatility of the euro-dollar exchange rate reflects the uncertainty about which side of the Atlantic faces higher risks.

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In Europe, this has led to several ratings downgrades of the sovereign debt of the most distressed countries, accompanied by bouts of contagion spilling over to the euro. More seem likely.

As for the US, Moody’s recently issued a warning on the country’s sovereign debt in the face of uncertainty about Congress’s willingness to raise the debt ceiling amid highly partisan debate about the deficit. Both issues – the debt ceiling and a credible deficit-reduction plan – remain unresolved.

Moreover, economic growth in the US is modest, and appears to come mainly from segments of the tradable sector that are exposed to and benefit from emerging-market demand. The non-tradable sector, which created virtually all of the new employment in the two decades prior to the crisis, is stagnating, owing to a shortfall in domestic demand and seriously constrained government budgets. The result is persistent unemployment.  Meanwhile, the tradable side is not large enough in competitive terms to take up the slack in growth and employment.

By contrast, emerging markets’ rapid growth and urbanization are delivering a global investment boom, documented in a recent McKinsey Global Institute study. A likely consequence is that the cost of capital will rise in the next few years, putting pressure on highly leveraged entities, including governments that have grown accustomed to a low interest-rate environment and may not see this shift coming.

Countries with persistent structural current-account deficits will incur additional external-financing costs, and eventually will reach the limits of leverage. At that point, the weak productivity and competitiveness of their tradable sectors will become clear.

Adjustments will need to be made. The options are higher investment levels financed by domestic savings, productivity growth, and increased competitiveness, or stagnant real incomes as rebalancing occurs through the exchange-rate mechanism (or a large dose of domestic deflation in the debt-distressed eurozone countries, since they do not control their own exchange rates).

Many of these structural problems were hidden from view before the crisis, thereby delaying both market and policy responses. In the US, excess domestic consumption, based on a debt-fueled asset bubble, helped to sustain employment and growth, though the current account held worrying signs. In several European countries, governments, aided by low interest rates, filled in the gap created by lagging productivity.

In all cases, assessments of fiscal balance were mistakenly predicated on the assumed stability and sustainability of the existing growth paths. The assumption that a benign growth and interest-rate environment was a permanent state of affairs led to a massive failure of fiscal counter-cyclicality in the advanced economies, as budget deficits became chronic, rather than a response to depressed domestic demand.

In emerging markets, China’s growth is crucial, owing to its size and importance as an export market for Brazil, India, South Korea, Japan, and even Germany. But inflation is a dual threat to China, jeopardizing both economic growth and internal cohesion. Housing has become unaffordable for many young people entering the work force. Reining in price and asset inflation without undermining growth will be a delicate balancing act.

Moreover, China shares with the US the challenge of limiting growth in income inequality. In both cases, the employment engines need to keep running or be restarted, in order to prevent political volatility and social unrest. Protectionism on a large scale is not a likely outcome – at least not yet – but that could change if employment and distributional issues are not handled well.

For Asia, which is relatively poor in resources compared to the Middle East, Latin America, and Africa, the rising cost of commodities, driven in part by emerging-market growth, is a cause for concern. Energy security is also a notable risk factor, especially given the uncertain outcomes of the popular uprisings in the Middle East.

Emerging-market growth is the world’s bright spot and looks to be sustainable even as the advanced countries experience an extended period of rebalancing and slow growth. But even there, risks lurk. A major downturn in Europe or America would have a significant negative impact on these economies, which can generate enough incremental demand to sustain their own growth, but not enough to make up for a large drop in advanced-country demand.

Markets may have factored in the combined effect of these macro risks, which nowadays are pervasive and correlated, but I doubt it. Nonetheless, all countries share a strong and immediate interest in reducing them. Let’s hope that an awareness of this will add a much-needed sense of urgency to national policy responses, as well as to efforts by the G-20 and other international bodies to improve international policy coordination.

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