There is anxiety in the global financial system as the international community of political, economic and business leaders gather in Davos. It’s only anxiety, however, not an acute sense of slowdown in growth or a sharp contraction of asset prices.
The world economy is gradually and slowly moving away from the Great Recession and the crises in Europe. The United States is taking the lead. The labour market has improved. The job engine is working again and employment numbers are slowly moving upwards. Household debt has been reduced and the balance sheets are gradually improving.
Having spoken to a large number of people in the financial sector as a part of outreach activity in the run-up to Davos, my sense is that there is confidence in US growth. But it’s also clear that few people expect a normal recovery: productivity and investments have been slower than usual.
Europe is also in better shape. The fiscal deficit of the eurozone is likely to land below 3% for 2015. Some of the countries in crisis, particularly Spain, Ireland and Latvia, have made substantial progress, both in terms of structural reforms, restoring public finances and cleaning up the banking system.
Even after the World Bank reduced its global growth forecast for 2015, it still expects slightly below 3.5%, which means that in 20 years global GDP could almost double. Many Asian and African countries will grow at 7% or more per year, and high-growth countries will quadruple their GDP over the next two decades. Growth is cutting back poverty and the emerging-market middle class is growing into a consumer force to be reckoned with.
Why the anxiety?
With oil prices falling and central banks keeping interest rates low (and even doing further quantitative easing), there is certainly potential for global growth. So, why the anxiety? I think there are a couple of reasons. Firstly, global monetary policy is not in sync, and that can create a lot of turmoil in currency markets, and more vulnerable emerging-market economies in particular.
Secondly, the US is gathering pace. Sooner or later the Federal Reserve will start unwinding some of the unconventional measures taken during the Great Recession. At the same time, growth is weak in Europe; the European Central Bank is discussing if, how and when its balance sheet should be expanded. I think both the Fed and ECB are moving in the right direction.
Some of us remember, however, that policy shifts and policies that are not in sync can cause turmoil. Back in 1994, when the Fed started to tighten, that was expected. But it didn’t prevent large portfolio flows from disrupting markets. Given that we have been seeing unprecedented monetary-policy action for a long time, it is impossible to foretell how the market will react if the ECB heads in a more expansionary direction and the Fed cuts its quantitative-easing measures.
An uncertain future
This is a challenging environment for emerging markets. Flows in capital accounts are difficult to manage under normal circumstances; and the unintended side effects of new Fed and ECB policies will only add more uncertainty. If there are domestic political problems (particularly in countries with exposure to oil prices) the temperature will nudge even further upwards.
If the global economic order is to be legitimate, it’s vital that everybody feel they count and their interests are part of the policy equation. The Forum’s Annual Meeting in Davos comes at a crucial moment, when interaction between all stakeholders is especially important.
Another reason for anxiety is geopolitics. In the decades after the Cold War, geopolitics was not high on the economic agenda. The conflict in Ukraine changed that. Even if there have been few illusions about President Vladimir Putin’s leadership, the general perception is that he has tried to modernize Russia. Few leaders who have transformed countries – Otto von Bismarck, Deng Xiaoping, Olusegun Obasanjo – have done it for purely benevolent reasons, or with the patience of Nelson Mandela. To strengthen a country and make it more united, economic growth is absolutely necessary; therefore trade and markets have been opened for all but liberal reasons.
The problem is that nationalistic populism has features similar to inflation: there is a risk of a self-enforcing negative spiral. So, if escalating conflict causes an economic contraction and undermines Putin’s popularity, what will be the answer? Further escalation?
Clearly, geopolitical risk is high on the world agenda. The conflict in Syria and Iraq has wrought tremendous human suffering and unleashed unprecedented refugee flows. It also increases the general sense of growing troubles. The Ebola epidemic, for instance, is still not under control. The global community has not been able to muster the resources to avoid a pandemic, and it’s not difficult to predict scenarios that are extremely disruptive.
The threat of deflation
Next to geopolitical risk, the ghost of deflation is also hovering. The sharp reduction of oil prices is definitely good for growth, but it adds to the short-term downwards pressure on inflation expectations. Even if metals, food and other commodities haven’t moved with the same speed as oil prices, the direction has been clear. Particularly in the eurozone, the risk of deflation is significant. Growth is likely to be anaemic (1-1.5%) and wage increases low. The price pressure from demand and unit labour costs will also be low. At the same time, the credit channel is still in bad shape in parts of Europe. There are clear deflationary risks that central bankers have to take seriously.
To me, it’s quite logical that the global financial system is feeling anxious ahead of Davos. The financial sector is also going through a difficult transition. The new regulatory environment has brought higher capital requirements and tougher supervision, and the demands of risk-averse counterparties are changing the banking sector. In the long run, this means a more resilient banking system, but the transition stage is fraught with operational uncertainty. In a few years the new structure will be in place and we will have a clearer understanding of the unintended side effects and whether regulatory arbitrage has to be dealt with, but we are not there yet.
Another reason the business environment is changing is the combination of a growing mobile-banking sector, spearheaded by m-pesa in Kenya and other emerging markets, and new innovations in transaction, lending and other consumer services that will increase pressure on traditional banks. Bitcoins and other electronic currencies have been slow to catch on, but that might be changing.
It is genuinely difficult for businesses to navigate a global environment in which there is slow recovery and clear geopolitical and economic risks. And given that banking is also going through an enormous regulatory overhaul, it’s no wonder there is anxiety. But let’s be clear: it’s an improvement on the crisis-related depression we have seen in Davos over the past few years.
Author: Anders Borg is a Swedish economist and politician who served as Minister for Finance in the Swedish Government. He is the Chair of the World Economic Forum’s Global Financial System Initiative.
Image: People walk past clocks at Reuters Plaza in London. REUTERS/Jon Jones.