Donald Trump has warned that the US economy is heading towards a "massive" recession. Some analysts and blog writers have also warned that we may be heading to another and possibly worse financial crash than what occurred in 2008.
According to several economic indicators, the downturn in the global economy started at the end of last year. At a glance it seems like a normal downturn in a matured business cycle, but several risks are shadowing the world economy, which have the potential to transform the downturn to a renewed and potentially more damaging financial crash than the Great Recession. Below I list five of the biggest risks as reported in our latest business cycle forecast.
The five major sources of global economic uncertainty
Probably the biggest worry to the global economy comes from the balance sheets of central banks. All the major central banks have exhausted their publicly approved monetary policy tools and they have only three extreme options left for stimulating the economy. First, central banks can begin the so-called helicopter drops of money, where liquidity, from newly created money by the central banks, is added to the deposit accounts of consumers. Secondly, they can start to monetize the debt of sovereign states, which would create means for increasing the public expenditures (this is also sometimes referred as "helicopter money" although it is not what the term originally meant). The most radical option would be to introduce large-scale negative interest rates to banks by charging interest on their deposits in the central bank. This might be followed by restrictions on cash withdrawals, because some consider them crucial for the negative interest rate plan to work. If deposits can be transferred to physical cash, negative interest rates have the tendency to lead to bank runs and to capital outflows to countries with positive rates, and not to increased demand. Other, more subtle ways of introducing negative interest rates have been proposed (see, for example, the proposition by R. Agarwal and M. Kimball), but at least for now the use of negative rates has been limited. "Helicopter money" is not without problems either. It may be hard to implement and if the money could not be sent directly to consumers' bank accounts it would be just deficit financing of the government that would easily break the independence of the central bank.
The second major risk for the global economy is the high level of private and public sector debt in major economies. This seriously limits the ability of governments to provide fiscal stimulus if needed and it raises the likelihood of private and public sector defaults.
Third source of risk are the black swans that may, once again, lurk in the financial sector. In the US, the failure of Lehman Brothers may have limited the risk appetite of financial institutions, but in Europe and especially in China there have been no such events limiting the moral hazard problem (moral hazard refers to a situation, where someone else than the risk taker bears majority of the risks of his/her actions) in the financial sector. Quite the opposite actually. While several hundred financial institutions were let to fail in the US during and after the Great Recession, basically all the troubled banks were saved in Europe and in China.
Fourth source of risk is the political instability. Europe is facing an extraordinary number of overlapping crises. The migration crisis is testing the uniformity of the European project and risk of another full-blown crisis in the Eurozone is building up. Although several institutions have been put into place after the financial crash of 2007-2008 and the European debt crisis that followed, their effectiveness during an acute and major crisis is untested. European banking sector is very vulnerable with a high portion of non-performing loans threating its stability. In Great Britain, support for Brexit, or the exit of Britain from the EU, remains high as does the likelihood of Grexit or the exit of Greece from the Eurozone. The terrorist attacks in Europe and geopolitical ambitions in Europe and in the Middle-East can lead to unpredictable political and military developments that can have long-term effects on global markets.
Fifth source of uncertainty is the matured commodity super-cycle, which has pushed down the prices of several commodities, like iron, copper and oil. If the cycle turns upwards and the prices of these commodities start to increase, central banks would be forced to raise the interest rates, which could push the world economy into a deflationary recession.
Anticipation of crises and the socialization of risk Not many people know, but the crash of 2007-2008 was anticipated by many recession prediction models, because there were signs in the financial markets that something troubling was going on. The biggest problem in the current situation is that central banks have hidden several market signals with unconventional monetary policies. QE's of world major central banks have pushed the risks of several asset classes to far ends of the probability distributions. What this means is that if the actual price of an asset does not meet its market-based value, the true level of risk is not properly priced in. Socialization of risks of private entities with monetary or fiscal measures hides the risks behind politically motivated decision. This is probably the biggest risk threating the world economy, that is, the mispricing of risk by unknown magnitude.
So, where are we heading? Unfortunately, all we know with a fair certainty is that we are facing some form of a downturn. It may be a mild one, but if any of the above listed risks would to materialize, the downturn would have the potential to turn into a systemic crash under current conditions. What this means is that we currently face a highly uncertain future with fairly decent growth prospects and that we can do very little to diminish the uncertainty, but to hope for the best.