On a Knife’s Edge

The year 2012 is Europe’s moment of truth. If their dithering continues, European politicians will soon lose control of the continent’s economic and financial future. After all the excitement of 2011, it is also a make-or-break year for some Middle Eastern countries in the midst of tricky political transitions. Even the United States is being shaken out of its social slumber as concerns mount about income inequality and, more generally, the fairness of the "system."

All this speaks to an increasingly bimodal outlook for the world economy in the years ahead. At one end, timely and proactive policy measures can help with the healing and put the globe back on the path toward higher growth, job creation, and better social justice. At the other, political dysfunction and financial deleveraging could lead to economic fragmentation, higher unemployment, trade wars, and social unrest.

In an attempt to shed light on the key issues in play, what follows is an attempt to identify four factors that could wreck the global economy in the next few years, and four factors that could propel it to greater stability and prosperity. Let’s hope our leaders choose wisely.

THE WORST CASE

European economic and financial fragmentation: As of today, the biggest risk for the global economy this year is the disorderly collapse of the eurozone. It would bring economic and financial activity to a standstill across the continent, cause widespread corporate bankruptcies and bank runs, and destroy millions of jobs. Other countries, be they advanced or emerging, would be contaminated by the collapse in global trade, the curtailment of credit, and the spike risk aversion that would lead investors to rush into cash. A complete eurozone collapse would be both chaotic and an unmitigated disaster.

Disruptions in the Middle East: As the New York Times’ Thomas Friedman brilliantly pointed out in a recent column, there are two types of destabilized countries: those that implode when highly stressed, and those that explode, affecting entire regions. Iran and Syria are of the latter type, and both are near boiling point due to internal and external developments. The greater the instability in these two countries, the higher the risk of regional contamination and, accordingly, worrisome global repercussions. This could include surging oil prices, leading to an ugly global stagflation.

Central bank exhaustion: Unconventional measures by central banks have, up to now, played a critical role in avoiding debt deflation and economic recessions in advanced economies. In the process, the banks have ballooned their balance sheets to previously unthinkable levels (from 20 percent of GDP for Britain and the United States to 30 percent for the European Central Bank). No one knows with any degree of confidence how far these balance sheets can expand safely, nor is there sufficient clarity on the collateral damage and unintended consequences. What is clear is that we are in unchartered waters and, given that they are the only agencies that have stepped up to the policy plate, the world can ill afford a loss of central bank credibility and effectiveness.

Social unrest: Enabled by social media technologies that facilitate broad-based coordination, the world has witnessed an astonishing outburst of grassroots social movements that are pressing for greater social justice — from the Arab Spring to the Indignados in Spain, the Occupy movements in the United States, Israel’s protesters, and anti-austerity riots in Greece and Italy. Having come together on the basis of legitimate grievances, these movements now face the challenge of pivoting from complaints about the past to helping to build a better future. The longer it takes the pivot, the higher the probability of frustration and of the protests turning violent — and governments reacting inappropriately.

THE BEST CASE

"Refounding" Europe: France and Germany have embarked on an effort to strengthen the underpinnings of a restructured and reformed eurozone — what French President Nicolas Sarkozy has labeled a "refounding." So far, this effort has been half-hearted, trying to meet too many objectives with too few instruments. Both Europe and the world would benefit from a more focused effort to enhance the core of Europe through greater fiscal and political integration and countering the fragility of banks. The likely outcome — namely, a smaller but more robust eurozone focused more on the Germanys and Netherlands of the region as opposed to a Greece or Portugal — would remove a major uncertainty that holds back investments and job creation.

America’s Sputnik moment: The United States remains the global economy’s best locomotive for growth. But its vibrancy is threatened by unprecedented political squabbling that undermines any attempt to lift the impediments to growth. What America needs is reminiscent of what followed the Soviet Union’s successful launch of Sputnik in 1957 — the convergence of American society around a common vision and purpose. A 2012 economic Sputnik moment would lift structural obstacles to growth (including in housing, public finance, and credit), unleash the considerable dry financial powder currently on the sideline, and empower the entrepreneurship that is unquestionably in place; and the post-Sputnik efforts would revolve around improving education, infrastructure, innovation, and other enablers of long-term growth.

Political healing and leadership: It is not due to complicated technical difficulties that many of the world’s economic problems persist and deepen. In most cases, today’s malaise is a reflection of political dysfunction and ineffective leadership, both of which pre-empt any meaningful effort to take the difficult yet necessary decisions. Witness how the U.S. Congress has torpedoed President Barack Obama’s job initiative. As a result, the credibility of the system itself suffers. Fortunately, several key countries, including the United States, are holding elections this year, giving citizens an opportunity to send a message to their elected representatives. The greater the clarity and urgency of that message, the higher the probability that bickering politicians can overcome real and perceived legacies to unite in doing the right thing for current and future generations of citizens.

Unleashing the emerging consumer: Emerging economies, China in particular, are in a very different place today than Europe and the United States. With a savings rate that has consistently been among the highest in the world, their consumers have the wallet but not the will to spend. Their behavior is a complex reflection both of self-insurance against the uncertain public provision of social services and of government policies that favor production at the cost of consumption. By moving on the latter, for instance accelerating the liberalization of the exchange rate system and tweaking the balance of taxes and subsidies, emerging economies can have a material impact on global growth and trade.

The world economy faces an unsettling outlook for the next few years. It can either break out of its current malaise and deliver economic prosperity, jobs, and greater social fairness; or, instead, it can slip deeper into unemployment, inequality, financial instability, and trade wars. Neither is preordained at this stage as leaders still have an important ability to influence outcomes to the better. But, as Europe demonstrates, the longer they dither and bicker, the higher the risk that policies will lose both effectiveness and credibility.