In 2007-08, the global economy fell off a cliff. It is currently perched on a ledge partway down the precipice. Unfortunately, the ledge appears to be crumbling.
It is interesting to examine the various fault lines in the world economy and how they have arisen. It is also worth noting the possible implications for New Zealand.
The European Union is fraying at the edges. The structural flaw in the Euro common currency has been viciously exposed. Individual governments retain autonomy of taxation and public spending. This was fine during the good times when the world was awash with easy credit.
Now, profligate governments such as in Greece are being hammered by financial markets reluctant to provide them with additional credit.
Lenders of last resort such as the Germans or the IMF are fearful of creating a moral hazard. They are concerned that an easy bailout will only delay the inevitable.
Financial markets are betting that the errant governments of the European Union will lack the political resolve to fix their budget woes. They will cave in to public protests at the massive spending cuts required. A default on loan repayments by any of these governments would create a contagion effect as lenders rushed for the exit.
Meanwhile, the Chinese have their own problems. They have pegged their currency at a low rate against the United States dollar. This has given their exporters a huge competitive advantage.
The massive flow of funds into China as a result of this mercantilist approach to trade has created big asset bubbles in stocks and property in China.
The funds generated by the Chinese trade surplus have also been recycled in the form of loans and asset purchases to other countries. The recent bid for the Crafar farms in New Zealand is a small example of this process.
The pegging of the Chinese yuan at a low rate has also sucked demand out of the world economy. A significant revaluation of the yuan would provide Chinese consumers with a massive boost in spending power.
The unleashing of Chinese consumer demand for the products of other countries would be a key measure in rebalancing the global economy.
The US Government has been pushing for the Chinese to revalue their currency for this reason. However, the Chinese face a dilemma. A revaluation would slow their export-led growth. It could also burst the asset bubbles in shares and property.
A slowing Chinese economy would make it difficult to absorb the millions of peasants flocking to the cities for employment. A significant revaluation is necessary but is fraught with economic and political dangers for the Chinese Government.
The US economy appears to be something of a basket case at the moment. The government bailout and stimulus packages have led to a massive federal deficit. Ironically, a large segment of funding for this deficit has come from the Chinese buying US government bonds with their export earnings.
The Obama administration is also struggling with its financial reforms. Wall Street has mounted a very effective lobbying campaign to muzzle any proposed legislative changes to the financial sector. But these changes are necessary to prevent continued repeats of the 2007-08 experience.
It was the removal of the regulatory framework put in place following the Great Depression of the 1930s that contributed to the current mess. The length and severity of the 1930s depression led to widespread acceptance that unfettered financial markets are a major danger to economic stability.
It would be easy to write off the US as an economic powerhouse. But the entrepreneurial and innovative nature of American society and its economic and political freedoms suggest the US may have the greatest flexibility to cope with the creative destructions of modern capitalism.
Unfortunately, its economy is in the dog box at the moment and this removes a key pillar of stability in the world economy.
What does this mean for us? Europe and China appear the most likely sources of future instability. New Zealand's two main export markets are Australia and China. The Australian economy is heavily reliant on Chinese demand for its resources.
The Chinese conundrum of how to manage a revaluation of its currency is the key. If it is handled poorly, it could be disastrous for our exporters. If the Chinese do nothing, this maintains a roadblock to global recovery. It also continues to fuel the speculative frenzy in Chinese asset markets.
No-one can predict the future but it is possible to observe the pressures that could shape the future. It would appear that we are in for a long period of financial and economic volatility, particularly in the credit markets. Prudence suggests a move towards risk aversion.
The implications for New Zealanders should be to reduce debt as much as possible. Buy property for your own use or for rental yields rather than assumed capital gains. If investing in shares or bonds, it is wise to target infrastructure and utilities with good dividend yields and cash flows.
John Maynard Keynes summed it up best when he stated that much economic activity is driven by animal spirits rather than the cold rationality that some economists would have us believe.
• Peter Lyons teaches economics at St Peter's College in Epsom and has written several economic texts published in New Zealand and Australia.
