There is little to suggest that the US federal budget deficit will narrow to a sufficient extent. That is worrying, especially given that the country in the long term will see sharply increasing costs for medical care, health care and pensions. As a result there is a clear risk of rising market rates in the US that could trigger a fall in house prices, which in turn could dampen private consumption. A reduction in public expenditures would also have a tightening effect but in the long term would lead to a more balanced development and thereby prevent an overly quick rise in rates. Another risk factor is the oil price. As the US is more oil-dependent than the euro area countries, its economy is more sensitive to changes in oil prices. Should the oil price remain at a high, fluctuating level it may curtail growth in the US. All in all, this picture of large global imbalances implies a clear risk that growth will be more subdued over the coming two-year period. The question is how fast this slowdown may come about. If controlled, the moderation would be softer, while rapid changes could entail a considerable weakening of the world economy and thereby also check Sweden’s economic performance in the period ahead. In addition to the competition problems that an ever stronger euro means for Europe there is the issue of how we are to meet the competition from low-wage countries, both the new member states of the EU and the emerging economies in Asia.
The system switches to a low-liquidity equilibrium. These liquidity droughts were perhaps the defining feature of the financial crisis during 2007 and 2008. In the model, the likelihood of such systemic liquidity crises depends critically on two key structural characteristics of the financial system – the two c’s: concentration and complexity. The greater the concentration within the financial system, the greater the potential for systemic collapse as larger banks spread a disproportionate amount of financial pain around a densely networked financial system. A greater degree of system complexity has a similar effect, creating more channels for contagion and heightening banks’ incentives to hoard liquidity when the weather worsens. The two c’s are very much features of today’s financial system. On the face of it, that bodes ill for future systemic crises. So what role might policy play in avoiding those crises? The model provides a test-bed to consider a range of policy options, including for haircuts policy. An illustrative policy experiment, based on a simulation of the model in which haircuts spike sharply, is shown in Chart 1. Up the vertical axis is a measure of the probability of a systemic liquidity crisis. Along the horizontal axis is the initial size of the haircut on secured financing transactions. The three lines trace three policy options. Consider first the “baseline” path without policy intervention. Provided haircuts remain high come rain or shine – in the example, above around 20% – the probability of a liquidity crisis remains very low.