Worst-case scenarios for the world economy

Back in the 1950s, when Captain Ed Murphy of the US Air Force said, "If anything can go wrong, it will", he may have refered to the preparation of his plane before take off.

But since his warnings and predictions almost always came true, people started to use "Murphy's law" in a wider context. Facing last month's turmoil in the global financial market, a pessimistic economist like myself cannot help but think the same.

At the start of the global financial crisis back in 2008, as global investors and businesspeople hoped that the swift and coordinated intervention of the G-20 governments would quickly revive the wounded global economy, this pessimistic economist feared that such high expectations might not materialise due to three reasons.

The first reason is what John Maynard Keynes, father of Keynesian economics, called the "paradox of thrift". Feeling uncertain of what the future will bring, households and the private sector would likely consume and/or invest less to save more during recession. Although this seems to be beneficial to individuals, it might cause damage to the economy as a whole. This is because more thrift and less consumption and investment equals less employment and income, which in turn pushes the economy into deeper recession.

Arguably, this is the case with the US economy right now. Although US corporate profits as a share of nominal GDP (more than 12 per cent) are at their highest level in more than half a century, the unemployment rate is disturbingly high at more than 9 per cent. This means that US companies are hoarding cash rather than hiring, due to the low level of confidence.

The second reason for the pessimistic view is the fear that the US economy will fall into a "liquidity trap". This means that, although the central bank cuts its policy rate to zero and also injects excessive liquidity into the financial system in the name of "quantitative easing" (or QE), those walls of cash are still unable to revive the economy due to the commercial banks' inability, or rather unwillingness, to lend to the private sector.

In retrospect, this condition is also true in the case of the US economy right now. Despite all the easy-money policies and rounds of QE, the US commercial banks' lending contracted by 4 per cent compared to a year ago. This is because banks can borrow with negligible cost from the central bank and invest in safe assets like Treasury bonds. Hence, the policy is not only ineffective but it also gives the opposite consequence of what the policy is initially intended for.

The third reason for this scepticism is the political gridlock that should not have happened, but occurred nonetheless, to the US government. Admittedly, President Barack Obama came into power with a good majority and high expectations. The US$787 billion stimulus package that came with him also gave the power of hope like never before in recent history. He could have used his advantages as benefits to the economy, such as by pushing forward infrastructure plans or initiating workforce-training programmes to increase skills for the unemployed. Instead, his lack of political courage led the US government into political gridlock, evidenced by the drama associated with the last-minute debt ceiling deal. That event frightens investors as well as reinforces Standard & Poor's decision to downgrade the US credit rating, a perfect precondition for a second round of global crisis.

If these were three warnings that came true, what then could possibly go wrong from here? Looking forward, there are three nightmare scenarios that could happen.

The first is that the US economy might face a double-dip recession, which could range from a mild contraction to a harsh crisis. The trigger for this event could be anything, from a series of bad economic figures to the collapse of big conglomerates or a sovereign default. The possibility of this scenario is rising alarmingly; some research houses give it a high chance of 80 per cent.

The second scenario is a US lost decade, where the economy does not harshly contract but the growth rate is subdued for the next 5-10 years. Japan was the prime example of this scenario. Faced with a banking crisis back in the 90s, the Japanese government did not allow big and insolvent banks to collapse, but instead injected more money into them while cutting the interest rate to zero. The plan did not work, since the private sector did not want to borrow money, while the Japanese people preferred saving rather than spending. Japan subsequently faced deflation and the economy mildly contracted for more than a decade.

Arguably, the US is not Japan. Households prefer to spend rather than save. But this risk cannot be overlooked. Flooded with debt (more than 100 per cent of disposable income), US households' de-leveraging is still an ongoing process, while commercial bank lending to the private sector continues to contract. This implies that the US financial system is still not fully functioning and hence the risk of a lost decade is possible.

The third and final nightmare scenario is the most feared but least talked about: stagflation. This occurs when the economy faces a problem of inflation and deflation simultaneously, which can happen if the supply of goods is disrupted and the economy is flooded with liquidity. The last time this scenario occurred on a grand scale was during the second oil shock in the 1980s, when Opec cut production but the Western central banks increased monetary liquidity, which then led to high inflation along with economic contraction. Though possible, the full scale of this scenario is unlikely to occur in the near term considering the recent downward trend in oil prices.

In sum, the likeliest worst-case scenario is the combination of a double-dip recession and a lost decade, possibly induced by event-led shocks that feed through the financial market. Although it is hoped that central banks worldwide, especially the US Federal Reserve, are likely to come to the rescue in terms of liquidity injection, these nightmare scenarios certainly cannot be ignored.

Although hope and confidence are important for the world economy to move forward, business and policy decision-makers must prepare for the worst circumstance that could happen at any time. Risk mitigation as well as contingency procedures must be planned in advance in order to avoid disastrous consequences.

Piyasak Manason is vice-president of Kiatnakin Intelligence, Kiatnakin Bank.


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