A Rough Road Ahead for the Global Economy

2010 threatens to be another challenging year for the global economy. Not only will the major industrialized economies be entering 2010 with very fragile economic recoveries and still dysfunctional financial systems. Rather, one can readily identify all too many risks in all too many parts of the global economy that still threaten the world economic outlook.

In considering the various risks now confronting the global economy, it is well to recall how vulnerable the global financial system has become. In late 2007, a butterfly that flapped its wings in Iceland sent major ripples throughout the world's financial markets. Another that flapped its wings in Ireland had a major impact on the whole of the European banking system.

During 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 all contracted by close to 20 percent while their public deficits ballooned to palpably unsustainable levels. Attempting to correct these budget deficits within the straight-jacket of fixed currency arrangements is all but certain to deepen those countries' economic depressions and to fatally undermine the political support for their fixed exchange rate pegs. Any breaking of the Baltic country currency pegs would be particularly painful for a Swedish banking system that is over-exposed to this region.

A full-blown US dollar crisis runs the very real risk of roiling the US bond market in a manner that could snuff out any incipient US and global economic recovery.

An even greater European threat to the global economy could arise from the continuing bursting of the housing market bubbles in Spain and Ireland. The unwinding of these bubbles has already sunk these two economies into the deepest of recessions and wreaked havoc with these countries' public finances

2010 will be the year in which Spanish and Irish policymakers have the unenviable task of trying to restore fiscal policy sustainability in the midst of deep recessions. It would be highly surprising if Spain and Ireland made it through 2010 without political or financial crises as their recessions deepen and as their unemployment rates continue to rise to even more socially unacceptable levels. Any whiff of an economic or a financial crisis in Spain and Ireland would soon spread to the Euro-zone's other Mediterranean member countries, whose economies are also characterized by the weakest of economic fundamentals.

An even more threatening flashpoint to the global economic recovery is to be found on the other side of the Atlantic. During 2010, over US$500 billion in commercial market property market loans are due to mature in the United States at a time when the US commercial property market is already in freefall. In the event that US commercial property market prices were indeed to continue their freefall, it is all too likely that more than 1,000 US regional banks will fail in 2010. A US regional bank crisis would seem to be the last thing that the US economy needs at this delicate stage in its economic cycle. Unusually large gaps in the US labor market, as underlined by a double-digit unemployment rate, are already exerting substantial downward pressure on US wage and income growth that will constitute a major headwind for any meaningful US economic recovery.

Yet another economic flashpoint emanating from the United States could be a full-blown US dollar crisis. Particularly troubling in this context is the very poor present state of the US public finances at the very time that the United States is already the world's largest debtor nation. A full-blown US dollar crisis runs the very real risk of roiling the US bond market in a manner that could snuff out any incipient US and global economic recovery. It would also put paid to the hope that the world's major export-dependent economies, like Germany and Japan, could export their way out of their present economic difficulties.

Students of the Great Depression constantly remind us of the dangers to the world economy of a rise in protectionist pressures. Persistence of unusually high unemployment levels in Europe, Japan, and the United States in 2010 could create precisely those conditions that would be a fertile breeding ground for such protectionist pressures, especially against the Chinese economy. According to the World Bank, despite pious commitments at G-20 Summits, 17 of the 20 G-20 countries have already significantly intensified protectionist policies in 2009.

As if there were no shortage of purely economic flashpoints as we enter 2010, a number of geo-political risks that could disrupt the global economy now raise their heads. At a time when the US is still waging two major wars in the Middle East and when Iran is embarked on a nuclear enrichment program that could pose an existential threat to Israel, one can hardly exclude the possibility of a major oil supply disruption in the Middle East. Similarly, at a time when a reinvigorated Russia is flexing its muscles with a struggling Ukraine, one can hardly exclude the possibility of renewed major European gas supply disruptions.

With luck, many of the risks that now appear to be threatening the global economic recovery will not materialize in 2010. However, policymakers would be ill-advised to count on their luck to navigate the troubled global economic waters that lie ahead.

Desmond Lachman is a resident fellow at AEI.

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About the Author

 

Desmond
Lachman
  • Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund's (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.
  • Phone: 202-862-5844
    Email: dlachman@aei.org
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