Let me start by saying that I have no idea what the worst-case scenario looks like, as indeed no one does. Because of unexpected events — black swans, unknown unknowns, or, to use the term of the moment, Knightian uncertainty — it’s impossible to know just how bad things could get in the global economy. But a few dominoes could fall that might make things very uncomfortable in the markets, and it’s worth considering what the world would look like then.
The most obvious risks are in the eurozone and China. If Greece defaults and eventually has to abandon the euro, the currency’s sheen of invulnerability will disappear. The impossible will have become possible, and investors will be forced to consider the fact that other countries — Portugal may be next in line — might someday exit the eurozone as well.
Uncertainty about the underlying value of the euro will increase dramatically. There will be no way to know what the euro or euro-denominated securities ought to be worth if the makeup of the eurozone itself is unpredictable. Central banks built up euros as a counterweight to dollars in their reserves for years; that trend, already in reverse, could turn into a swan dive. Onetime hopes of making the euro the primary currency for financing global trade have already evaporated, as the renminbi moved into second place behind the dollar two years ago.
All other things equal, though, Greece’s exit will make the euro more valuable. Countries with weaker fiscal positions and demand for securities only serve to dilute the strength of Germany, France, and the other euro stalwarts. But the appreciation of the euro could hurt exports from those same countries, eroding the scant economic growth they’ve been able to achieve — and they’re much more important to the global economy than Greece.
Now throw in the bursting stock-market bubble in China. Companies there have used high stock prices to pay off debt through new public offerings. But investors have borrowed hundreds of billions to finance their portfolios, pushing prices still higher. If the markets crash — and even a loosening of rules on margin trading hasn’t been able to stop their recent slide — free-spending companies will have garnered an undeserved measure of solidity at the expense of millions of Chinese households. Billions in private saving will have financed a raft of pointless projects, destroying wealth and distorting incentives at the same time.
The global implications will be equally bad. Many financial institutions have undoubtedly bet against the Chinese markets, but those that held onto Chinese securities will be forced to pull back the riskier assets in their portfolios. Any contagion of Greece’s problems in other less-creditworthy countries will be magnified. Meanwhile, Chinese investors will have to sell their holdings abroad to cover their margins and losses at home. Major markets will drop, except for the beneficiaries of the usual flight to safety.
Perhaps more importantly, Chinese demand for imports will also decline — not just because of the disappearance of wealth, but also because the dip in the markets will depress the value of the renminbi. Along with Australia, Hong Kong, and Mongolia, a dozen countries in sub-Saharan Africa send at least a quarter of their exports to China. So do Chile, both Koreas, Oman, and Turkmenistan.
For quite a few of these countries, a drop in exports will pose a difficult challenge. Some, like Gambia and Mauritania, have incurred heavy public debts that require tax revenue for interest payments. Others, like Burkina Faso and Sudan, need inflows of hard currency to build up their reserves and cover their inflated money supplies, as indicated by the most recent figures from the World Bank. Fiscal and/or currency crises in these countries could further destabilize regions already struggling with cross-border conflicts and the threat of extremist groups.
And speaking of cross-border conflicts and extremist groups, the potential for violence in the Middle East and North Africa has continued to grow. When these regions flare up, the price of oil tends to climb — and so can security and insurance costs for global commerce. As a result, the global economy may experience an additional drag just as its financial markets are reeling.
If growth in the United States begins to falter at the same time — and historical data suggest that it might — the worldwide rout will be complete. The American, European, and Chinese economies will be in retreat, toppling many smaller ones along the way. The United States and China would likely rebound within a couple of years, but the damage to livelihoods and lives will already have been done. There wouldn’t be the same kinds of dislocations in the financial markets as last time, since institutions’ balance sheets are somewhat stronger now. But in the United States alone, a couple of years in recession could preempt the creation of several million new jobs.
So how likely is this scenario? This week, analysts gave Greece up to a 50 percent chance of leaving the eurozone. The Shanghai Composite has already plunged by 20 percent since June 12. Academic and government economists see little chance of an American recession now or in 2016, but the probability is still higher than it has been in the past couple of years.
These events are not independent; each one makes the other more likely. Still, the overall chance of this not-quite-the-worst-case scenario happening soon may be fairly small. But the scenario is so bad that it’s a risk worth taking seriously.
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