Photo by Juliana Kozoski on Unsplash
Adding insult to injury, a sharp rise in geopolitical risk has come to compound already high macroeconomic uncertainty.
Macroeconomic uncertainty is our own fault. I have talked about this at length in previous blogs, but in a nutshell: in the last decade and a half we focussed obsessively on demand stimulus and distorted the economy with unsustainably loose monetary and fiscal policy, compounded by reckless shutdowns during the pandemic. Now we are striving to repair some of the damage: we struggle with stubborn inflation while keeping an anxious eye on how our economies and financial sectors adapt to an overdue rise in interest rates.
Macroeconomic fog
The set of economic uncertainties we face is daunting in itself:
Financial sectors re-learning how to price risk without a central bank safety net;
Labor markets finding a new equilibrium after the pandemic disruption, while digesting new flexible working arrangements and the impact of new technologies;
Central bankers weighing how quickly to bring inflation back under control and at what cost;
Governments trying to ignore that bloated public debt levels and overly loose fiscal policies will eventually have to be addressed.
When geopolitics slaps you in the face
These uncertainties would be hard enough to handle in a stable geopolitical context. But like the inflation spike, geopolitics has dealt us a harsh reality check. The horrific terrorist attacks against Israel have shown that progress towards stability in the Middle East was illusory — and have opened the door to a possible wider conflict in the region. The Russia-Ukraine war rages on. China has grown increasingly menacing towards Taiwan.
To be fair, in its approach to geopolitics the West had not been as egregiously complacent as in its economic management. Over the last several years we have acknowledged the backlash against globalization and witnessed the consequent rise in protectionism and nationalism. Dreams of a China-US honeymoon have been dispelled some time ago.
But we have failed to anticipate the broad, systematic and aggressive challenge to Western values and institutions. Countries like China, Russia, Iran and North Korea are experimenting with moveable alliances, united by their rejection of Western principles, to pursue greater strategic influence in Asia, the Middle East, Europe and Latin America. (Bizarrely, the Western media has instead decided to single out India for harsh criticism as a quasi-authoritarian state.)
The international institutions created to underpin the post-World War II order have lost legitimacy, credibility and effectiveness. To be blunt: they have become embarrassingly irrelevant. I am thinking of the International Monetary Fund, World Bank, World Trade Organization, World Health Organization, etc. And of course the United Nations.
Global disrupts local
The backlash against globalization had already had an important domestic impact through a surge in populism.
This latest wave of violence in the Middle East, however, has shown that global problems can trigger much more dangerous local disruptions within Western countries.
I noted with dismay in my previous blog that the Hamas terrorist attacks against Israel have been quickly followed by pro-Hamas demonstrations and a rise in antisemitic threats and incidents across Western countries. This appalling development does not signal a mere divergence of views on Middle East geopolitics: it shows that a significant number of people in Western countries sympathizes with views that are antithetical to the West’s own values and way of life. This is in part the result of failed immigration and integration policies; in part the reflection of extreme and poorly thought out political views — strident anti-Israel opinions have been voiced not just in student protests but by US members of Congress and the media.
Geopolitical disruptions now carry a much higher risk of spilling over into domestic terror attacks within Western countries — this has just led EU countries to suspend the Schengen Treaty on free movement of people and reintroduce some border controls. At a time when immigration is already one of the hottest political issues, the risk of increasingly fierce domestic political tensions gets even higher.
Seven major economic risks
This threatening layer of geopolitical uncertainty poses seven major economic risks:
Inflation. A wider Middle East conflict could send inflation spiking again, even if we have greater energy efficiency and more renewable power now than in the 1970s. In 1979, when the second oil shock hit, fossil fuels accounted for 91% of the world’s primary energy. Today they still account for 82% of a much greater global total, so the impact would still be very severe.
Supply chains and logistics. The risk of severe disruptions to crucial shipping routes is high — think not just of the Middle East, but of the simmering tensions in Asia. Companies have made some progress in shortening supply chains and reshoring, but only some. Global supply chains are still global, highly complex, and highly vulnerable to disruptions that could could cause shortages, price spikes and bottlenecks in production.
Communications. Cutting underwater internet cables can suddenly disrupt communications networks and digital infrastructure, as we have seen with a series of cable failures in Europe late last year.
Critical infrastructure. Digital-industrial innovation has made critical infrastructure more vulnerable to cyber attacks — energy, water, transportation, health care and more. We have already witnessed some attacks. So far we have avoided paralyzing widespread disruptions, but our luck might eventually change.
Digital technology. Taiwan produces about 90% of the world’s advanced semiconductors and about 60% of all semiconductors. Should China make a move on Taiwan the consequences for digital innovation would be colossal.
Innovation in energy and beyond. The green transition implies a very significant shift in the demand for raw materials towards copper, manganese, chromium, zync; broader technological innovation also implies increasing demand for rare earths and other raw materials which are in limited supply. More aggressive geo-strategic competition for these resources could affect the pace and distribution of technology advances.
Overall risk aversion. A surge of terrorist attacks within Western countries would trigger a spike in risk aversion, affecting both financial markets and corporate investment, as well as consumer behavior. It would also have a disruptive impact on local politics, igniting latent resentment towards immigration.
Unprepared
Governments have little scope left to mitigate the impact of any of these disruptions without sowing the seeds of even greater economic problems down the line. Deep interest rate cuts would wipe out the painful progress we’ve made towards monetary normalcy. A new round of higher government spending and burgeoning public debt would make fiscal outlooks increasingly unsustainable.
Even as geopolitical risks loom larger, the prevailing attitude seems to be to cross our fingers and hope for the best. Send the envoy, as Warren Zevon sang. Policymakers should instead prepare targeted and sustainable policy responses. Corporations and governments should bolster resilience. Investors should brace for a potential onslaught of known unknowns.