The real potential trouble lies in the Middle East and China. The possibility of the Gaza conflict escalating into a broader war involving Israel and Iran has not received enough attention.
In the 1930s, the French government built what it believed was an impenetrable defense system to avoid another German invasion like the one at the start of World War I. The Maginot Line, though seemingly formidable, turned out to be ineffective when the German attack in 1940 came from a different direction.
Recently, financial markets have shown a similar mindset to the Maginot Line mentality. They are right to sense potential threats but are mistakenly focusing on the possibility of a U.S. recession as the main danger. The real risks are elsewhere–China and Middle East.
While the U.S. economy is indeed slowing, it’s not on the brink of recession. Unemployment is rising but remains historically low. The Federal Reserve may have been slow to cut interest rates, but it can still address this issue in the coming months. The U.S. economy has demonstrated resilience in the past and is expected to continue doing so. By the end of last week, Wall Street seemed to accept that the U.S. is likely headed for a soft landing, which seems to be the most plausible scenario.
Historically, such tensions would lead to a sharp rise in oil prices, but this has not happened yet.
One reason for this lack of reflection in commodity markets is China and Middle East’s deteriorating growth prospects. Financial markets assume that Beijing will act to stimulate the economy and that the slowdown will be short-lived. This assumption is questionable.
China’s economic issues are structural and have significant global implications. For years, China relied on a growth model centered on massive state investments and cheap credit for industrial expansion. This approach resulted in weak consumer spending and a deflating property bubble.
A shift in this model towards greater consumer spending is overdue. However, China’s social safety nets are less robust than those in the West, and the domestic economy struggles to absorb all the goods produced. Excess capacity has been exported, leading to significant trade surpluses in Middle East.
Although China’s leaders occasionally consider changing their strategy, they remain committed to the model that has made China the world’s second-largest economy. This export-driven growth has also affected inflation in the West, as evidenced by the UK’s lower goods prices.
According to Zongyuan Zoe Liu of the Council on Foreign Relations, China is producing more solar panels than the global market can use and a significant portion of car manufacturers are unprofitable. She warns that China’s overproduction could lead to a cycle of falling prices, insolvency, factory closures, and job losses.
Signs of stress are evident, with growth expected to fall short of this year’s 5% target and export figures missing market expectations. A leading indicator of future growth, the money supply measure, is also signaling trouble.
There are key differences between Middle East and China now and in the 1990s. The issues of overcapacity and overproduction are more severe, and Western governments are no longer passive. They have imposed tariffs on Chinese goods and, in the U.S., provided subsidies to domestic producers.
China might respond to Western pressure by limiting exports and altering its economic model, but this seems unlikely. More probable is an increase in tensions between China and the West. China is trying to reroute exports through third countries to avoid tariffs but has yet to impose retaliatory measures.
In the short term, Western protectionism could lead to higher prices, inflation, and interest rates. In the long term, if Western countries ramp up production, it could exacerbate the global surplus of goods, leading to a crisis in global capitalism, as predicted by Karl Marx.
