Peering into the economic crystal ball

Wednesday, 10 February 2010

Or can we get an inkling of the next financial turmoil?

During the recent World Economic Forum in Davos, Switzerland, the world economic luminaries attempted to peek into the future and predict what will cause the next economic crisis.

During the discussion module on “The Next Global Crisis” the participants voted for the most probable causes of future financial turmoil. With 50.7% the pole position was occupied by sovereign debt. In second place, with 37.3% the panellists rated protectionism. Finally, with 12% over-regulation came in third.

Government debt is the money the government borrows by selling bonds and other financial instruments. One must concur that the absolute value of government debt has been steadily rising in most developed countries during the last decade. This trend is indeed a reason for worries relating to the stability of the financial system. Put in relative terms, however, government debt is not increasing as much as we think. If we take the United States of America as an example, we can clearly observe that the government debt as a percent of the gross domestic product (GDP) does not take on historically high values (See Figure 1). This casts a shadow of doubt whether sovereign debt will indeed prove to be an insurmountable challenge for the future economy.

Source: Budget of the United States Government- Fiscal Year 2009 - (Note the data is projected into 2013)

In this economic discussion, protectionism means that countries begin to favour locally produced products by introducing barriers to trade such as subsidies, import tariffs, etc. for foreign products. Ruling elites often use anti-protectionist rhetoric to encourage free trade and what they see as greater economic well being. However, they fail to mention that the lack of protectionism creates complex interdependencies among countries. As a result, if one state experiences economic trouble, problems are likely to spread to its trade partners. Without a functioning global framework to address these risks, free trade can be just as dangerous as protectionism. This is why the protectionist argument can be considered rather weak.

Over-regulation is used in the discussion in the sense of having too many laws that choke economic incentives. The over-regulation standpoint has the same flaw as the protectionist argument, that is, the lack of regulation can be just as dangerous as its excessive use. For example, the relatively over-regulated European bank system proved much more resilient to the crisis compared to the American under-regulated one.

We can thus conclude that even though they constitute serious economic challenges, sovereign debt, protectionism, and over-regulation are not that likely to trigger major financial trouble. Judging on past experience, crises are caused by unforeseen economic factors that are identified as problems only post factum. This is why the most probable factors that will cause the next economic crisis are still unknown. We just have to wait for their identification and hope they can be addressed in time.