Look around the world and there are big risks almost everywhere. Countries may drop out of the eurozone. Violence may spread across the Middle East. The US Congress may yet drive the country off its fiscal cliff and into recession. An island dispute between China and its neighbours may flare up, provoking the US to intervene in the Pacific. But in my view, the single greatest risk is that one of these events or some other throws the world into another global financial crisis, a “GFC II”.
This is a possibility for three reasons. First, the world economy is still fragile and slowly recovering from the GFC of 2007-08. Households and governments are still struggling under heavy debt loads. Banks are still shrinking their balance sheets and uncertain over the evolving, but still vindictive, regulatory climate. Any new shock will add cause for further retrenchment.
Second, economic policy is maxed out. Both fiscal and monetary policy have hit their effective boundaries. Signs of a classic liquidity trap are everywhere. Banks find little demand for new loans and in any case the regulators tell them to build up their reserves. Quantitative easing is helping to prop up the banks but is not getting into the economy, and the negative side effects for savers and pension funds are growing. If an external shock occurs, there is little government can do to counteract it.