How the rest of the world could put the U.S. at risk in 2013

December 28, 2012

This is the third of three posts looking at how the U.S. economy will perform in 2013. Wednesday's installment examined the solid fundamentals that should drive a U.S. recovery. Thursday we looked at risks to that outlook created by policymakers in Washington. Today's installment looks at risks to the U.S. economy from abroad.

In forecasting 2013, it is easy to look at the risks staring us in the face. Yet again and again in recent years, international surprises that have had an outsized impact on the U.S. economy--the Eurozone crisis, for example, and this year's slowdown in Chinese growth. Beyond America’s borders, there remains peril in all directions—though of a variety that is hard to measure and predict. Here are some of the spots that could undermine the nation’s solid growth prospects. Back in 2008, the U.S. financial crisis sparked a global recession; we need to be on watch for another country doing the same to us.

Europe is the economy that is forgotten, but not gone. Financial markets have been surprisingly bullish on the Eurozone since late summer, when the European Central Bank announced a potentially bottomless backstop to prevent the dissolution of the 17-nation euro currency area.

There are a whole world of economic and geopolitical risks out there. (Russian Earth Observation centre)

That has led to a surprising sense of calm on global markets. Even when there are political or economic tremors—such as new worries over Catalan separatism in Spain in October or the return to the political scene of bombastic former Italian prime minister Silvio Berlusconi earlier this month, it no longer results in huge sell-offs of the Spanish and Italian bonds and global stock markets. Even Greek bonds are on a bit of a bull run in the last few months, as investors start to think that nation has seen the worst of it and will stay in the Eurozone and eventually claw its way out from the economic abyss.

The question for the U.S. economy is whether the Pax Europa can hold. Will the ECB’s firewall and the European governments’ commitment to collectively backstop each others’ banks and government treasuries be enough even in the face of what is already a recession in much of the continent (and quite a severe one in Greece, Spain, and Portugal). Germany holds elections in the fall; might there be a populist outcry to the perception that Chancellor Angela Merkel and her government are bailing out a bunch of profligate Greeks and Spaniards? 

Markets are increasingly betting that the Eurozone crisis is solved. For the sake of the United States, we had best hope they are right.

Europe isn’t the only trouble spot on the world map. Egypt is in turmoil, Syria is in flames and the Middle East a seemingly perpetual tinderbox. If the unrest were to spread to some of the major oil producing nations on the Arabian peninsula, or armed conflict to break out between Iran and Israel, it would almost surely drive the price of oil way up. Geopolitical turmoil and higher gasoline prices are the last thing that an economy trying to pull out of its rut needs.

Then there is China. The world’s growth juggernaut decelerated this year, with growth in 2012 somewhere in the ballpark of 6 percent as opposed to the 10 to 12 percent that had become the new normal.

While for almost any other nation on earth that would be a gangbuster growth
rate, the slowdown sparked worries among the pundit class that even a modest slowdown would expose structural weaknesses in the Chinese economy: The years of high investment and relatively low consumer spending, the political favoritism driving those investment projects, the discontent bubbling beneath the surface of an emerging middle class that lacks democratic means to vent those frustrations.

The good news is that none of that has brought China to the brink of crisis. Rather, it seems to be experiencing a routine economic slump without anything worse bubbling to the surface. That is good news. As a new government takes office and finds its footing, the best hope is that China can continue working through its longer-term problems with only a modest hit to short-term growth.

The same could be said of other major emerging markets, like Brazil, India, and Indonesia. Each saw a slowdown in the second half of the year, sparked in no small part by weakness in their export market of Europe. As long as those nations can maintain their steady progress without any big hiccups, they will be supportive of
growth.

Finally, it is worth mentioning a nation that has suddenly become an interesting spot on the global economic tableau. Japan, the world’s third-largest economy, elected a new government last week that is pledging to undertake an aggressive Keynesian prescription for the nation’s longstanding economic ills, including new spending and pressure on the central bank to push more money into the economy and try to provoke more inflation. It will be a great test of the policy prescriptions offered by many on the left for the Western world.

If it works, Japan will finally reverse two decades of economic stagnation and low-level deflation and perhaps eventually even become a growth juggernaut, making up economic ground lost over the course of the last generation. If it fails, then Japan’s largest-in-the-world debt relative to GDP will come crashing down in a scary variety of crisis. At Japan's level of public debt, even a very slight rise in interest rates could leave its finances in precarious shape.

The first outcome would be generally good for the United States (though bad for American exporters that compete with Japanese companies). The second could be a catastrophe.

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