The Burning Platform

IMAGINE SOMEONE HAD TOLD YOU in early 2008 that the U.S. stood on the verge of a financial market meltdown of    historic proportion and the longest and deepest recession since the 1930s. Would you have believed it? What if you were told that the euro zone’s very survival would soon become a subject of front-page debate? Or that a wave of unrest would soon sweep the Middle East, toppling autocrats across the region, forcing Egyptian president Hosni Mubarak into prison and plunging Syria into civil war?

Would you have believed that all of those things would happen within five years?

Recent news appears more encouraging. The U.S. economy looks to be slowly regaining its footing, and equity markets have climbed to new heights. Europe, despite continued queasiness, appears headed toward calmer waters. The upheaval in the Arab world has so far generated limited global market impact. Yet the convulsions of the past five years arose from structural faults — financial, economic and political — that have not been fully resolved. And there are new worries. Economic growth among leading emerging markets has slowed considerably as much-needed reforms have been postponed. In particular, China — on track to become the world’s largest economy while still a poor country — has lately behaved in erratic ways on the international stage. Talk of a “peaceful rise” rings increasingly hollow for many of China’s neighbors as its military picks fights with Japan in the East China Sea; with Vietnam, the Philippines and others in the South China Sea; and with India along the Line of Actual Control that has divided the two states since 1962. A wave of cyberattacks on U.S. companies and government agencies traced to the Chinese military creates more friction. But the biggest longer-term worry is that China’s new leadership faces the most ambitious economic reform process in history as its unstable, unbalanced and ultimately unsustainable development model must be rebuilt to shift wealth from politically connected elites and state-run companies toward an increasingly plugged-in and demanding middle class.

Adding to the volatility, we’re living in a G-Zero world, in which no single power or working alliance of powers has both the muscle and the appetite to provide global leadership. That’s important, because the world needs leaders that are willing and able to accept the costs and risks of establishing and maintaining a coherent global order — putting out fires, writing the checks others can’t afford and imposing compromise to prevent conflict.

In a G-Zero world it takes a crisis to force cooperation among, and sometimes within, governments. In the U.S. only an obvious emergency could have persuaded so many lawmakers of    both parties to support big-ticket bailouts and massive stimulus spending in 2008–’09. Only a potentially catastrophic market meltdown could have induced China and other emerging-markets heavyweights, Europe and the U.S. to agree on concrete actions to help pull financial markets back from the brink. It took the threat of systemic calamity to European banks — and fears for the future of the broader European project — to create public support for the sharp spending cuts that have inflicted pain across entire societies and elite support for a redesign of the euro zone. Only revolution could have toppled seemingly well-entrenched autocracies and brought the beginnings of long-overdue political change to the Middle East.

Unfortunately, the sense of crisis has lifted on all these fronts, encouraging some to see in the changed landscape a sustainable “new normal,” a period of painfully slow but predictable economic progress, as forecast by Pacific Investment Management Co. CEO and co-CIO Mohamed El-Erian, or the more sanguine view of many investors willing to bet that a surge in liquidity in the U.S., Europe and Japan makes for a more robust way forward for all these countries — and for everyone else. Some believe U.S. lawmakers can now afford to postpone tough choices, the Europeans will muddle through, China can smoothly rebalance its economy, and fires in the Middle East can be left to simply burn themselves out.

These are dangerous illusions. The deeper questions that created the recent convulsions have not been answered, and the easing of so much useful fear will make them much more difficult to address. That’s why the uncertainty and volatility of the past half decade is far from finished — and is almost sure to trigger new crises. Be sure your seat belt is securely fastened, because nothing has really come to rest. We have entered the New Abnormal, a period in which every market assumption must be questioned and the wise investor is prepared to be surprised.

BEYOND THE G-ZERO PROBLEM, there are two more reasons political and market turbulence has plenty of room to run. First, complacency enables short-term thinking and political and policy gridlock that will play out in different places in different ways. In the U.S. lawmakers stepped back from the fiscal cliff, and warnings that sharp spending cuts triggered by the so-called sequester will have dire consequences remain abstract for most voters, even if those cuts are already denting growth. Volatility elsewhere in the world reminds investors that America and its dollar remain, at least for the moment, the safest port in any storm, and pressure for a plan to finally address U.S. long-term fiscal imbalances has eased. The underlying question has not been resolved, however, and the failure of negotiations between Democrats and Republicans to produce a grand bargain on long-term spending, entitlements and taxes continues.

The European Central Bank has so far convinced jittery investors that it will do whatever it takes to buttress the single currency and the governments that depend on it, and as market pressures subside there is less urgency for Spain, Portugal and Italy to accept the austerity measures that Germany insists are the price for their rescue. This worry is beginning to play out most ominously in Italy, where an election in February produced another round of political confusion and voters validated a populist protest candidate and the euro-rejectionism he represents. New elections, which are unlikely to yield a credible solution to Italy’s troubles, cannot be ruled out in the months to come. And with German voters casting ballots in September, austerity fatigue in the periphery is colliding with bailout fatigue in the core.

The much-hyped BRICS — Brazil, Russia, India, China and South Africa — are losing steam as well. China’s leaders, who publicly pride themselves on their strategic long-term vision, have allowed the internal influences of economic stakeholders to slow progress on the crucial reforms needed to ease China’s dependence on exports and investment for growth and to empower the Chinese people to save less and consume more of the country’s output. In India a sharp economic slowdown over the past two years has not forced the tough political choices and substantive reforms that enabled a historic liberalization in the early 1990s. Instead, with national elections next year, the opposition Bharatiya Janata Party and heads of smaller parties across India have put enormous pressure on the ruling Congress Party–led United Progressive Alliance to avoid most of the crucial reforms that impose near-term pain, bringing policymaking in New Delhi almost to a standstill.

Brazil’s central government has a freer hand than India’s, and its policymaking is much more efficient, but here too political complacency often begets the kind of short-term political calculation that allows solvable problems to grow. There are 24 parties represented in Brazil’s lower house of Parliament, and President Dilma Rousseff’s coalition includes ten of them. Coalition-building in Brazil is often ad hoc and varies from one issue to the next. A combination of easy monetary policy that has triggered higher inflation, looser fiscal policies that have increased debt and delays in the structural reforms needed to boost potential growth have yielded mediocre growth.

In resource-rich Russia, even with oil prices hovering at or above $100 per barrel, potential growth is barely 3.5 percent and actual growth is no better: Corruption; ham-fisted authoritarian politics; rising state control of the economy; unfriendly policies toward domestic and foreign private investors; and lousy demographics are sapping confidence and strength. The newest member of the BRICS, South Africa, suffers from serious social cleavages, poor policymaking, sluggish growth and low levels of physical, infrastructural and human capital.

The other big factor feeding the New Abnormal is strong public demand within all these countries for a political focus on domestic challenges, allowing transnational problems like collective security, climate change and the security of food and water to slide toward the bottom of the agenda. Officials in the U.S., Europe and Japan, as well as those in China, India and other emerging economies, face far too many complex and dangerous tests at home these days to venture abroad in search of new ones.

Washington has helped backstop the euro zone almost entirely through its influence within the International Monetary Fund, and technological progress in energy production is now encouraging policymakers to avoid deeper engagement in the explosive Middle East. The development of new energy reserves at home has already reduced U.S. dependence on OPEC oil by 20 percent in just the past three years. In fact, the International Energy Agency has forecast that the U.S. could become the world’s largest oil producer by 2020 and energy self-sufficient by 2035 as more-efficient automobile engines and a surge in the production of renewables ease total energy demand. Even in Asia, increasingly the focal point of   U.S. foreign policy, Washington spends much more time managing potential emergencies than working to shape outcomes.

For their part, European officials are far too busy saving the single currency to take on more foreign policy heavy lifting. The French and British rid Libya of Muammar Qaddafi in 2011, then pulled back, and France has already begun to withdraw the 4,000 troops it sent to Mali late last year to combat an Islamist military advance there. European officials have no more appetite than do Americans for taking a direct role in Syria’s civil war or providing direct financial help for a still-struggling Egypt.

For evidence that China’s foreign policy is designed almost entirely with domestic economic goals in mind, read the CVs of the 25 members of its Politburo. Virtually none of these officials — the core of China’s leadership — has substantive foreign policy experience. China’s interests beyond its borders lie mainly in securing the technology, commodities and return on investment needed to generate the growth that creates the jobs that reinforce that country’s baseline social stability and the ruling party’s hold on political power.

Don’t look for collective action to fill the vacuum and end the New Abnormal. Following the onset of the financial crisis, the Group of 20 held consequential summit meetings in November 2008 in Washington and in April 2009 in London. Concrete steps were taken to coordinate monetary and fiscal policy to limit the risk of a collapse of global financial markets. Without a credible threat of collective catastrophe, the G-20 is mainly a talk shop — one that includes too many negotiators with too diverse a set of political and economic interests to offer leadership on complex questions. Only when each member feels threatened by the same problem at the same moment and to more or less the same degree, as in the depths of the recent crisis, are substantive compromise and coordinated action possible. This is also why talks have yielded little progress on global trade, climate change, cybersecurity, energy and food security, coordination of monetary and fiscal policy, currency regimes and global current-account imbalances, a new regime of financial supervision and regulation, and reform of the international monetary system and the role of the U.S. dollar as a major reserve currency.

What does all this mean for market-moving policy choices? Advanced economies continue to face complicated challenges, but the policy responses that political officials have used so far — monetary and quantitative easing and fiscal stimulus that is now constrained by high debt levels — are Band-Aids applied to avert a near-term slide back into recession rather than a genuine effort to resolve long-term structural questions.

How can governments deleverage from high private and public debts without driving their economies back into the ditch? How can they minimize the drag on growth and fiscal accounts imposed by aging populations? How can they implement structural reforms to increase growth; streamline bloated welfare states; enable technological change that is capital-intensive, labor-saving and skills-based; and reduce income inequality that can stoke social and political instability? No serious attempt is being made to answer these questions.

In fact, fiscal policies in developed countries are now moving in exactly the wrong direction. U.S. policymakers should commit to longer-term fiscal consolidation that reduces the liabilities of official debt and unfunded commitments to Social Security and health care. And to revive growth in the near term, fiscal austerity should be postponed or back-loaded rather than front-loaded. Instead, credible plans for consolidation are being put off because of gridlock (the U.S.) or austerity fatigue (the euro zone), and officials are leading with austerity in both the core and periphery of the euro zone, Britain and now the U.S.

In addition, the risk of currency wars may be overrated, but central bank strategies are designed to answer national, not international, questions, and the likelihood of free riding and beggar-thy-neighbor currency policies remains high. In a world in which painful private and public deleveraging ensures that domestic demand remains weak, the only way for advanced economies to achieve growth closer to potential is to increase net exports via currency depreciation triggered by competitive quantitative easing. In other words, there is still a zero-sum game in currencies and trade balances that extends the New Abnormal into financial markets.

If governments are to coordinate on efforts to reduce global current-account imbalances, those with sizable surpluses — China and Germany, for example — will have to save less, spend more and allow their currencies to appreciate. Deficit countries will need to save more, spend less and let their currencies weaken. In this G-Zero world, surplus countries like Germany can try to force those like Spain that overspent and undersaved to spend less and save more, yet the Germans remain unwilling or unable to perform their half of the rebalancing act by restructuring their growth model to stoke domestic demand.

Adding to the problem, advanced economies are now running out of policy bullets. If and when a new crisis erupts, they will not have the tools they need for an effective response. Monetary and quantitative easing is becoming increasingly ineffective at jump-starting growth. Instead, it is creating froth and asset inflation in financial markets. With large and growing public debts, options for more fiscal stimulus are limited. Sovereign risk is becoming a systemic risk of its own.

THE NEW ABNORMAL HAS IMPORTANT implications for economic growth, employment, inflation and interest rates in advanced economies and is nearly certain to intensify before it recedes. As the deleveraging is ongoing and structural reforms needed to boost competitiveness are delayed, economic growth will remain anemic for many more years to come, and unemployment rates will stay high. Given the slack in goods and labor markets, inflation will remain subdued for a long time. Very aggressive monetary policy — quantitative easing, credit easing, zero policy rates and bold forward guidance — will thus continue for a little while longer, as it is the only game in town given the constraints on fiscal policy. But with falling velocity, anemic credit growth and weak growth, such monetary easing will not cause goods inflation, though it may lead to asset inflation in credit and equity markets. And with low policy rates for a longer time and more easing, long-term interest rates in advanced economies that can monetize their debts will remain low and rise only slowly. In countries without monetary autonomy and sovereign risk, like the euro zone periphery, long rates will depend on fiscal adjustment, options for growth recovery and continued ECB willingness to backstop the distressed nations and their banks.

Maybe the most dangerous source of continued volatility, and a primary reason the New Abnormal will continue in coming years, is the global economy’s steadily increasing reliance for growth on unpredictable emerging-markets countries. According to the IMF, developing economies have accounted for three quarters of global growth over the past half decade and are expected to expand two to three times faster in coming years than their rich-world counterparts. That should worry us because while some of these economies will continue to grow, others may be in for an especially rough ride. That is important to remember despite the world’s focus on turmoil in the U.S. and Europe since 2008.

In short, some emerging economies will fail to fully emerge, particularly given the relative immaturity of political and financial institutions in some of them and the fact that many of their governments have used recent successes as an excuse to postpone the reforms needed to lift them to the next stage of development. The risks that individual emerging markets may pose are compounded because they increasingly depend on commercial relations with one another. Trade among the BRICS has grown by more than 1,000 percent over the past ten years, and all five member nations are now grappling with economic slowdowns.

In addition, when China’s GDP surpasses the U.S.’s in coming years, it will mark the first time in modern history that the world’s largest economy remains a developing country. The Communist Party has designed an ambitious reform plan intended to help China build a dynamic, digital-age economy, yet some within the governing elite, particularly those who profit from the successes of state-run companies and an economy built on exports, have both a vested interest in obstructing change and ample opportunity to do it. China’s leaders face plenty of other enormously complicated challenges, like managing the risks created by a shrinking labor force, the increasingly free flow of information within the country’s borders, the degradation of its air and water, and the costs and complexities of providing for a rapidly aging population. And given China’s outsize importance among emerging states — its economy is larger than those of the other four BRICS combined — its successes and failures will be felt globally.

The New Abnormal will produce winners as well as losers because some markets are simply more resilient and adaptable — better able to absorb shocks — than others. There are two crucial attributes that a country needs to outperform in a volatile environment: a government with the political capital necessary to make unpopular policy decisions and an economy buoyed by a broadly diversified set of trade and investment partners.

Slowing growth in many emerging markets and the rise of middle classes with the capacity to pressure policymakers for better and more accountable governance ensure that substantive political and economic reform is critical for sustainable long-term performance. Globalization has provided the thrust that lifted these markets off the launchpad, but the next, delicate stages of their ascent require the ability to adapt to a new, more challenging and more fragmented global environment. To pull this off, leaders must have the power to bring about changes that are as politically risky as they are economically necessary.

Of course, different developing states have different kinds of leadership structures, and investors must identify where decision-making power really lies. In an individual autocrat? An elected multiparty Parliament? A commercial elite? Or is power shared among national, regional and local officials? In India, for example, the popularity of a particular prime minister and his or her finance team matters less than in a more centralized state because the success or failure of individual reforms there remains largely in the hands of state-level and local officials. In Russia the preferences of parliamentarians or regional governors are all but irrelevant. Authority rests almost entirely inside the Kremlin.

Next, investors should develop a sophisticated understanding of how political capital should be measured from one market to the next. The popularity of individual leaders and the power of the opposition to resist change are the key variables. If the country in question holds meaningful elections, how far off are they? In an authoritarian state, is a particular regime at the beginning or nearing the end of its life span? Generational change is coming sooner rather than later in Saudi Arabia and Cuba. China’s new leaders are only now settling into their seats.

In democracies presidents and prime ministers usually enjoy maximum political capital during the honeymoon period right after elections. Without a galvanizing crisis or other dramatic event that sharply changes the status quo, capital then tends to erode over time, finally transforming a leader into a lame duck. In authoritarian states the opposite is true. Autocrats need time to entrench their supporters in strategic positions, establish new patterns of patronage and adapt the existing political system to suit their needs.

The more political capital a country’s decision makers hold, the greater the likelihood that they can bring about the political and economic changes necessary to solve the structural problems that a developing nation will face — and the less likely that officials will succumb to the temptation to blow up their budgets for short-term political gain or to secure their hold on power. For investors this is a leading indicator of medium-term success.

This is why the best medium-term emerging-­markets bets remain countries like Brazil (despite the current slowdown), Chile, Colombia, Malaysia, Mexico, the Philippines and Turkey. All these states have broadly popular elected leaders with a demonstrated commitment to investor-friendly changes. India, Peru, South Africa and Thailand, on the other hand, will probably underperform in an environment in which shocks remain likely, because those who make policy in these countries are on unsure political footing and reacting to events rather than opting for the tough choices needed to shape that policy.

Between these two broad categories lie Russia and China. In Russia, President  Vladimir Putin’s popularity remains strong outside the largest cities, but a lack of new ideas is eroding public patience with his administration, and Russia’s poorly diversified economy is still deeply dependent on energy exports at a time when technological changes in U.S. energy production are sharply increasing supply beyond Russia’s borders. In China a capable party elite faces not only an enormously complex reform agenda requiring a radical structural rebalancing of the economy, but also reform-­resistant interest groups within the government and a country undergoing increasingly rapid social change.

There is also the question of commercial diversification. Investors in a country’s stability are concerned, and rightfully so, with the diversity of the goods and services it produces. Yet those most likely to weather this crisis-prone global order also benefit from a diverse set of trade and investment partners. The New Abnormal would not exist were there not so many connections among governments and markets. During the Cold  War, economic developments behind the Iron Curtain mattered relatively little for day-to-day trade and investment flows in the West and the performance of U.S. and Western European markets. In that sense, the Berlin Wall was a buffer as well as a barrier to escape. In today’s intimately interconnected global economy, on the other hand, a bad day on Wall Street is probably bad news for Shanghai — and vice versa — and diversification of risk has never been more important.

Here again, Brazil, with its still relatively popular president, remains a good bet. It helps that Brazil lives in one of the world’s safest neighborhoods. Corruption and organized crime are chronic problems, yet the likelihood of traditional military conflict in South America is lower than in any other part of the emerging-markets world. Terrorism and militancy are limited to local challenges in a few states. As a result, Brazil’s government need not spend significant financial and political capital to defend its borders or combat terrorism as BRICS partners China, India and Russia do. More to the point, Brazil is still open to foreign investment in most sectors and enjoys a broadly diversified array of trade and investment relationships. It continues to maintain strong political and commercial ties with the U.S., China (now its largest trade partner) and a growing number of other emerging markets, particularly in Africa. Still, the recent slowdown of Brazil is not just cyclical. It is also in part the result of the rise of elements of state capitalism in this otherwise market-oriented economy: delays in structural reforms, the role of state-owned enterprises and state-run banks in the economy, resource nationalism, import substitution, industrialization and protectionism. Brazil needs to move away from state capitalism to grow faster.

Turkey, with per capita income nearly double that of China and four times that of India, has built a similar position. The Justice and Development Party government remains broadly popular after more than a decade in power and holds nearly 60 percent of the seats in Turkey’s Parliament. But the diversity of the country’s international relationships is another important source of ballast for its economy. NATO membership gives Turkey influence in Europe and the U.S. Many in the Arab world look to Turkey as a dynamic, modern Muslim state, and it still enjoys more-profitable trade relations with Israel than does any other Muslim government. Its position at the crossroads of Europe, Asia, the Middle East and the former Soviet Union provides another crucial commercial advantage.

Though the New Abnormal has created headwinds for African economies, a result of both the turmoil facing the continent’s European trade partners and the upheaval across the Arab world, many African emerging and frontier markets have developed a resilience created by unprecedented commercial competition for access to their resources and, crucially, to their consumer markets. In 2000 total foreign direct investment in Africa totaled just $9.4 billion. According to a report published in March by the United Nations Conference on Trade and Development, France alone had about $58 billion of cumulative FDI stock in Africa at the end of 2011. The U.S. finished a close second with some $57 billion, and the U.K. followed in third place with about $48 billion. The report found that China was responsible for just $16 billion, though that number is significantly understated, a result of quirks in China-related investment statistics. Malaysia and India contributed $19 billion and $14 billion, respectively. In Africa as elsewhere, diversification enhances the ability to absorb shocks, a critical attribute in an unpredictable world. The better growth stories on the continent are Angola, Botswana and Mozambique in Southern Africa; Gabon, Ghana and Nigeria in  West Africa; Kenya, Rwanda, Tanzania and Uganda in East Africa.

Emerging markets are not the only ones profiting from this trend. Canada remains vulnerable to a slowdown in the U.S. but is not as vulnerable as it used to be thanks to a deliberate long-term effort to forge new trade and investment partnerships. The country was working to build commercial ties with Asia for years before recession took hold in the U.S. and is now well on its way to finishing a free-trade agreement with the European Union. As a result, Canada draws about 40 percent of its imports from countries other than the U.S., and a cargo vessel loaded with Canadian exports leaving port in British Columbia is more likely headed to Asia than to America.

What challenges does the New Abnormal pose for individual companies? The most important comes from the tendency of increasingly risk-averse governments to intervene in their domestic economies, including in areas that were once relatively free of direct state involvement. As a result, investors and corporate decision makers must recognize the ways in which geopolitical uncertainty pushes governments to redefine their interests and make new rules to advance them — even in sectors like finance, telecommunications, pharmaceuticals, and retail and consumer, which have traditionally drawn less state intervention than arms, high technology and energy and other commodities.

The New Abnormal creates big risks for banks and other financial institutions. The days of high returns on capital based on excess leverage and slim liquidity buffers are gone as the screws of tighter regulation and supervision start to tighten. Banks and investment banks will need to reinvent their business models, and that will not be easy. Higher capital and liquidity ratios will reduce returns but will also slow credit creation and hamper growth. In the euro zone the death spiral linking banking and sovereign risk has not been stopped or broken, only delayed with the ECB’s outright monetary transactions program. The rise of large financial institutions in growing emerging-­markets economies will challenge established dominant players in advanced economies. And if the tail risks that may lead to another global economic and financial crisis were to materialize, the political capital to bail out banks again will not be there. Nor will there be fiscal resources to backstop the financial system.

Further, on a planet where 560 million Chinese are online, more than 700 million Africans have phones in their pockets and Arabic-language satellite television networks compete for viewers across the Muslim world, we cannot be surprised that communications technology has the attention of security-minded governments. Over the next decade a growing number of companies in every new area of media and communications will be pressured to provide access to information that governments deem relevant for national security as the price of market access.

Health care companies are also at risk. Central to the task of establishing long-term stability in China is the creation of a strong social safety net for an aging population. In the health care and pharmaceuticals sectors, China’s government now faces the unprecedented challenge of providing health and drug coverage for 1.3 billion people. Reform of drug pricing is a core component of this task. In 2009, Beijing published an “essential drugs list” that set price ceilings for listed drugs. Particularly in a poor country, lower prices can undermine quality control for manufacturers struggling to contain costs, leaving foreign pharmaceuticals companies in jeopardy when damage is done and local regulators need a scapegoat.

Even in the retail and consumer sector, the New Abnormal will create headaches for companies and investors, especially when food and water are involved. In 2012 the United Arab Emirates’ Economy Ministry introduced an electronic system for goods monitoring to track the prices of meats, cereals, dairy, oils, sugar and nearly 200 other basic food commodities to ensure that retailers abide by government-set price ceilings. Several foreign consumer goods companies have since reported that some manufacturers have stopped supplying and selling in the UAE because it is no longer profitable. In this case a government trying to avoid shocks may well be helping to create them instead.

WILL THE NEW ABNORMAL END with a bang — an economic, financial or security meltdown that makes 2008 look mild? An unstable environment can’t last forever, but just as it took the financial crisis for U.S. lawmakers to authorize massive bailouts and the euro zone meltdown for Europe’s core and peripheral governments to agree on real reform, it will probably take some form of emergency to set the foundation for a sustainable new global order. Leaders of the established powers will act to protect their security, wealth and privileges. Policymakers in emerging states will take action to ensure that crises don’t prevent their countries from emerging. Governments won’t act until they believe they have to — and until they are confident that other governments won’t do it for them. They will work together or act separately, strengthen existing international institutions or build new ones. Either way, the G-Zero is not a new world order, and the New Abnormal will prove a temporary period of turbulent transition.

Where might the next big emergency arise? Say a new meltdown in European financial markets sparks a banking crisis much larger than the 2008 version, and we discover that the ECB and the untested bailout mechanisms since put in place can’t stand the stress. Or China’s economy slows sharply into a hard landing, millions are put out of work, the leadership loses control of information flows within the country, and unrest takes on a violent life of its own. Or Syria’s civil war spills into Iraq and Lebanon, drawing Hamas, Hezbollah, Iran, Israel, Turkey and the U.S. into direct conflict.

Or a sudden implosion in North Korea generates confusion and panic. Sick and starving refugees flow across borders; hostile neighbors go on high alert as U.S. and Chinese troops race to secure the country’s nuclear material. Or a spectacular terrorist attack on an Indian city triggers a war with nuclear-armed Pakistan. Or the inability of governments to agree on a plan to slow the progress of climate change severely disrupts weather patterns, leading to more-frequent extreme weather events, creating droughts in some places and floods in others that trigger a food price shock that makes the 2010 spike in grain prices look like a tremor.

There is another big tail risk. The Fed’s (and other central banks’) liquidity injections are not creating credit for the real economy but rather boosting leverage and risk-taking in financial markets. It may be too soon to say that many risky assets have reached bubble levels and that leverage and risk-taking in financial markets is becoming excessive, but the reality is that credit and equity bubbles are likely to form in the next two years owing to ongoing loose U.S. monetary policy.

Even when the Fed starts to raise interest rates, it will proceed slowly. In the previous tightening cycle, which began in 2004, it took the Fed two years to normalize the policy rate. This time the unemployment rate and household and government debt are much higher. But if financial markets are already frothy, consider how frothy they will be when the Fed starts tightening — and then when the Fed finishes tightening. From 2001 to 2004 interest rates were too low for too long, and the subsequent rate normalization was too slow, inflating huge bubbles in credit, housing and equity markets.

We know how that movie ended, and we may be poised for a sequel. The weak real economy and job market, together with high debt ratios, suggest the need to exit monetary stimulus slowly. But a slow exit risks creating a credit and asset bubble as large as the previous one, if not larger. Pursuing real economic stability, it seems, may lead again to financial instability. Thus the exit from the Fed’s QE and zero-interest-rate policies will be treacherous: Exiting too fast will crash the real economy, while exiting too slowly will first create a huge bubble and then crash the financial system.

None of these emergencies is likely, but all are entirely plausible. Any one of them would have global impact and force a coordinated response to limit the resulting fallout.

One thing is certain: Political decision makers can be relied on to act in their countries’ own interests rather than make the world a better place. That hasn’t changed. If some common threat persuades U.S., European, Chinese and other officials to see tighter international policy coordination as a cost-effective means of enhancing their own security and prosperity, they may become more willing to invest in multinational agreements that require them to abide by mutually agreed-upon rules. This doesn’t necessitate global cooperation. Regional trade deals like the Trans-Pacific Partnership, China’s agreement with the Association of Southeast Asian Nations or a proposed U.S.-EU agreement may well succeed where global trade talks have failed, by creating increasingly complex commercial webs that provide incentives for rules-based trade on a grand scale.

The most important variable to watch is the state of U.S.-Chinese relations. The U.S. remains the world’s leading established power and China its most important emerging state. The two have the largest economies. The U.S. is the biggest borrower, China its leading lender. They are the largest trading nations, the biggest polluters and probably the two heaviest investors in both offensive and defensive cybercapabilities. To rebalance the global economy; reverse the worst effects of climate change; manage the conflicts surrounding wild cards like North Korea, Iran and Pakistan; and ensure stability and the free flow of Asian commerce, Washington and Beijing must work together wherever and whenever possible. Much will depend on how secure Chinese leaders feel about their longtime hold on power at home and the durability of their belief that a peaceful world and a stable global economy will strengthen it.

Unfortunately, Washington and Beijing often appear on a path toward conflict, one more likely to be fought in cyberspace or in financial markets than on familiar battlegrounds. It is a confrontation made more dangerous by the two countries’ deep economic interdependence. A pragmatic, mutually profitable geopolitical partnership forged by the U.S. and China is our best hope if the New Abnormal is to end with a smooth landing. • •

Ian Bremmer is the president of political risk research and consulting firm Eurasia Group and the author of   Every Nation for Itself:  Winners and Losers in a G-Zero  World. Nouriel Roubini is a professor of economics at New York University’s Leonard N. Stern School of Business, chairman of Roubini Global Economics and co-author of Crisis Economics: A Crash Course in the Future of Finance.