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The year 2010 threatens to be challenging for the global economy. Not only are leading industrialised economies entering it with very fragile recoveries, extraordinarily high unemployment rates and still-dysfunctional financial systems, but there remain too many risks in much of the global economy. Should any of these risks materialise, they could derail the incipient global recovery and set back the slow healing of the financial system.

In considering the various risks, it is well to recall the poor state in which the global economy still finds itself. It is also well to remember how vulnerable and inter-connected the global financial system has become. In late-2007, a butterfly that flapped its wings in an economy as small as Iceland’s sent ripples throughout the world’s financial markets. Another that flapped its wings in Ireland had a big impact on the whole of the European banking system.

In 2010, it is all but certain that butterflies will be vigorously flapping their wings in the hapless Baltic economies. Already during 2009, as their outsized property and credit market bubbles started to burst, the Estonian, Lithuanian and Latvian economies contracted by nearly 20 per cent. At the same time, the public deficits of these countries ballooned to unsustainable levels as their tax collections collapsed along with their economies. Attempting to correct these budget deficits within the straitjacket of fixed currency arrangements, especially at a time of housing market busts, is all but certain to deepen those countries’ economic depressions and to heighten their social tensions. It is also all but certain to undermine fatally the political support for maintaining their fixed exchange rate pegs.

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Desmond Lachman is a resident fellow at AEI.