Global economy has not yet left long shadow of financial crisis
Caution reigns supreme in the post-lehman era. Scarred by the excesses of the last decade, our economic inhibitions are higher than before. The mere threat that something could go wrong has the propensity to weigh heavily on economic activity. This year compared to 2017 is a case in point.
In one respect, 2018 remains similar to 2017. Economic fundamentals are much the same. Global demand growth is still in the “goldilocks zone”: consumption growth is not so slow that the upswing feels sluggish and central banks need to worry about deflation, as in 2011-15; yet nor is it so fast that inflation is rising rapidly as production struggles to keep up with demand.
In another respect, 2018 differs from 2017. Last year, political waters became calmer as the year progressed. Markets were riding high. After the Macron win in France’s May elections, there were no major votes to worry about in Europe. Upon taking office, US president Donald Trump did not follow up on the trade war threats he had campaigned on in 2016 – the erstwhile relief in markets now seems naively premature.
This year the tide of risk has turned. Trump’s decision to withdraw the US from the Iran nuclear agreement has added upward pressure to the already rising oil price coming from strong global demand and an effective effort by Opec to constrain its own production.
With luck, the rise in the oil price from $50 to $75 per barrel of Brent crude will not slow global consumption growth much. However, a sudden rise in the oil price to, say, $100 per barrel would matter. This seems unlikely as long as tensions between Saudi Arabia and Iran do not escalate far beyond the current proxy wars in Yemen and parts of Syria, and the Strait of Hormuz remains open. Still, it is a risk worth watching.
Italy – the third largest economy in the eurozone – has elected a radical government whose policy promises of reform reversal and deficit spending put it on a potential collision course with bond markets.
With the European Stability Mechanism, outright monetary transactions, and quantitative easing the eurozone now has more powerful weapons to contain contagion risks than it did during the euro crisis. But misguided economic policies in one country of Europe can potentially cause problems for its neighbours. The recent rises in bond yields in peripheral Europe amid the breakout of Italian risks were a faint echo of the euro crisis trends of 2011-12.
The threat from trade wars tops the list of risks in 2018. Mr Trump seems ready to upset the global order, taking aim at China and the EU due to his misguided concerns about bilateral trade imbalances, but not sparing the US’S neighbours, north and south, either. After Trump imposed US tariffs on steel and aluminium, the EU, Canada and Mexico have all promised a measured retaliation.
How much damage could full-blown trade wars do? Nobody knows for sure. Historical examples ranging from the catastrophic collapse of global trade after the 1930 US Smoot-hawley tariffs
‘By threatening trade wars, Trump seems to be hoping for major concessions from the US’S trading partners’
to the mild restrictions imposed by Ronald Reagan in the Eighties can offer only limited guidance for the issues we are facing in the age of instant information and globalised supply chains.
By threatening trade wars, Trump seems to be hoping for major concessions from the US’S trading partners. Looking at the initial reactions of the EU, China, Mexico and even Canada this outcome seems unlikely. There is a real chance that the threat of a trade war could persist for the foreseeable future.
Risks are a part of life. The advanced world is in better shape now than it was before the 2008/09 financial crisis. However, together these threats, as well as others, such as the risk posed to emerging markets from the rising dollar as investors seek safety in uncertain times, could spark just enough caution to take the shine off the global upswing.
In Europe – where growth has softened since the start of the year – there is evidence of this happening already. In the US, the fiscal stimulus provides an offset against the hit to demand that would normally come from the build-up of such risks.
Chances are that these risks will either pass or we may simply learn to live with them. But what if things do not improve? What if the global upswing starts to soften dramatically?
So far during the post-lehman upswing central banks have played a crucial role. They have stepped in with a helping hand any time demand or confidence seemed to be slipping. The question is, after eight years of economic growth, is this global central bank “put” still available? For now, yes.
The Bank of England, by delaying the rate hike that it had previously signalled would come in May, has already acted as the buffer in the UK. In the eurozone, modest wage growth and inflation give the European Central Bank the headroom to lengthen its bond purchases policy beyond the expected end in December 2018 if the eurozone recovery started to lose a lot of momentum.
For the US Federal Reserve the risks would be more significant. The ongoing fiscal stimulus could help to raise US inflation persistently over and above the 2pc rate the Fed sees as tolerable.
Still, if the US economy started to wobble badly, the Fed could justify stepping in on the basis that the weaker demand would dampen inflationary pressures anyway.
Such a response by central banks would probably be enough to lean against any softness coming from these risks. Still, the mere fact that potential risks are starting to weigh on economic activity shows that the global economy has not yet fully escaped the long shadow of the financial crisis.
Bad memories take time to fade. The age of caution will probably last for much longer than it will take for the wounds of the financial crisis to heal.
Kallum Pickering is the senior economist at Berenberg