Five things that could derail the global economy

By Lucy Dean

September 22 2017
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The global economy is in better shape than it was a year ago and the pick-up is no “flash in the pan”, but that doesn’t mean it’s risk-free.

That’s the opinion of the assistant economic governor of the Reserve Bank of Australia, Luci Ellis. Speaking earlier this week, Ms Ellis said there’s a “reasonable prospect that – as long as nothing really bad happens – this global expansion could continue for a while”.

She said that the global economy last year saw a turnaround in both sentiment and rhetoric as well as growth in global merchandise exports, increasing growth in industrial production and a recovery in investment.

However, “of course” there are conditions and situations that “have the potential” to upset the current global economic momentum.

According to Ms Ellis, there are five main factors:

Geopolitical risks in Europe

“I think it is fair to say that geopolitical risks in Europe and specifically the euro area have receded,” Ms Ellis began, noting that while it “remains to be seen” how Brexit will affect the global economy, an “existential crisis” within the EU “no longer seems so close”.

Ms Ellis added that geopolitical risks are “particularly difficult risks” to incorporate into macroeconomic analysis. She explained: “We aren't political analysts. And I question whether anyone can truly know what the odds of certain events occurring might be.

“But we can at least think about what those risks might be and whether they might be increasing or receding.”

And geopolitical risks in Asia

While the geopolitical risks in Europe have receded somewhat, those in Asia have increased. According to Ms Ellis, these risks are “low probability, high-impact events that can only ever be a risk to one’s forecasts”.

She added that until an event occurs, these risks “do not and should not affect the central scenario”. Further, even if the event had been noticed and identified, the economic ramifications of its occurrence could still be “difficult to predict”.

Ongoing low interest rates

Ms Ellis called financial risks “ever-present” issues for macroeconomic outlooks while also being “almost as hard” as geopolitical risks to quantify.

She added that the ongoing low interest rates and investors resulting search for yield is one risk that “seems to be becoming less pertinent”.

“Now that policy interest rates globally are starting to rise, if only slowly, the urgency of the search for yield surely becomes less pressing.”

Household sector balance sheets

Closer to home, Ms Ellis said Australia’s household sector balance sheets should be considered a “potential exacerbating factor”. By that, she explained, any shock that hit Australia would be made worse by the high levels of household debt.

“Of itself, the level of indebtedness is unlikely to be a triggering factor that sparks a negative outcome. But it is an important consideration in the context of other triggers.”

Regulatory moves to improve the risk profile of newer lending and debt have been effective as lenders shift to keep in line.

“The level of debt owed matters most when the borrower is facing a large negative shock. Strong lending standards mitigate the effects of moderate shocks, and can help prevent a shock turning into a default event.

“But in the face of a large, economy-wide shock, even the best lending standards might not be enough to protect borrowers and lenders. At that point, the absolute amount of debt owed becomes the binding consideration,” she warned.

The global monetary policy environment

Economic recoveries have been bolstered by expansionary monetary policy as well as less contractionary fiscal policy, but the economic and market reactions to the global monetary policy environment still pose a risk, Ms Ellis said.

She noted that growth in prices and wages has “remained quite low”, despite some economies experiencing close-to-full employment and productive capacities.

Ms Ellis called for policy that remains “appropriately expansionary” and also avoids “further build-up” of debt and financial risks.

"To sum up, the global economy is looking better than it did a year ago. The turning point was around the end of last year. While it doesn't seem to have picked up further recently, neither is this expansion a flash in the pan. That is positive news for the Australian economy, too," Ms Ellis said.

"Noticing that change in momentum required economic forecasters to be alert to the right indicators, and have the right framework for thinking about the signals these indicators send... There are times when you have to be willing to make a call, because waiting until you are 100 per cent sure things have changed means waiting too long. And that means taking a view and being willing to evolve that view as new data come in," she concluded.

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