At the start of the year, I expressed concerns about the outlook for financial markets, owing to all the considerable uncertainties that I could identify, and to the many other potential risks that were not yet clear. This was after Russia had begun to mass troops on Ukraine's border, but before it had invaded. Now that Russia has launched its war of aggression, it has been almost totally removed from the international economy and markets, and energy and food prices have spiked.
At the same time, Western central banks have undertaken a major shift in their policy stances, having finally dropped the idea that today's inflation is a merely temporary phenomenon that would subside on its own. They are now deliberately tightening global financial conditions (by both unwinding their balance sheets and increasing interest rates), and this is adding to cyclical pressures on household incomes, and thus on the wider economy.
As if that weren't enough, China's economy – the world's second-largest and ten times bigger than Russia's – has been deliberately held back by the government's "zero-Covid" strategy. And this comes on top of existing efforts to dampen excessive housing prices, reduce credit growth, and rein in business sectors (starting with major tech conglomerates) that are seen to be interfering with the government's new "fairer growth" objective.
Given these developments, it looks as though a global recession could be upon us. If so, it will have been remarkably sudden, coming so soon after the lockdown-induced mini-recessions of 2020 and 2021. How bad will this downturn be, and are there policies that could avert it, or at least minimise its scale and severity?
In China, policymakers are worried that a more relaxed stance on Covid-19 could drive up infections and overwhelm the country's urban hospitals. Since we have already seen the same sequence play out elsewhere – particularly in the United Kingdom, which was forced to impose sudden, harsh lockdowns in 2020-21 – China can hardly be criticised for being generally cautious. But the evidence suggests that Omicron (the dominant global variant) is so transmissible that even lockdowns are unlikely to stop it completely. Moreover, it appears to be less virulent than previous variants, which makes a draconian response harder to justify.
China's blunt zero-Covid strategy comes on top of an already weak economy, so it has added to underlying cyclical weaknesses. The most recent trade data (for April) show that Chinese imports remain exceptionally low – just one of many signals pointing to a weak economy.
The problems facing China have implications extending beyond the economy and markets. China's single-party leadership has long legitimised its rule by delivering ever-rising living standards for the country's 1.4 billion people. But this implicit pact cannot easily be sustained under conditions of persistent economic weakness.
Having watched China for more than 30 years, I would say that one of its government's biggest strengths has been its exceptionally good risk management. In the past, it has dealt with major potential problems decisively and in a timely manner. Not so today. If it doesn't change course soon, there will be much more pain in store for its economy and for the rest of the world. On the other hand, if the government can abandon "zero-Covid" and some of its other more draconian economic crackdowns, growth could well rebound quickly.
As for the rest of the world, two major factors beyond China will determine how things play out: major central-bank policies and Vladimir Putin. The Russian president's intentions remain as difficult to predict today as they were three months ago when he launched his invasion. Finland and Sweden's sudden support for joining NATO shows that Putin has miscalculated abysmally. Though he might not end the war, his stupidity may well result in his removal from power (though many Kremlinologists consider this unlikely).
In any case, the blow to real incomes – and thus to consumer spending – from higher energy and food prices has been so large that central banks ought to think twice about their newfound hawkishness. After all, if the way to bring inflation under control is to weaken the economy, surging energy and food prices, together with tightening financial conditions, might have already done the central banks' job for them.
To be sure, if longer-term inflation expectations are rising and no longer anchored, that would change the calculation considerably. In the United States, where the Federal Reserve's policy changes have far-reaching global effects, the latest Consumer Price Index shows core inflation still above 6%, with service-sector price inflation accelerating. As such, the Fed might see little reason to abandon the tightening path that it has so loudly hinted at.
But the Fed would do well to consider the reduction in real (inflation-adjusted) disposable incomes in the US. Though the decline hasn't been as severe as in Europe, it has been significant, and the strong tightening of financial conditions may have already sown the seeds for an economic downturn soon.
So, are we heading into a global recession? Much will depend on the Fed, the Chinese leadership, and the erratic, isolated cipher in the Kremlin.
Jim O'Neill, a former chairman of Goldman Sachs Asset Management and a former UK treasury minister, is Chair of Chatham House.
Disclaimer: This article first appeared on Project Syndicate, and is published by special syndication arrangement