What Risks Does Economic Growth Require for Sustainable Growth

Economic growth requires taking calculated risks to achieve sustainable growth. This means embracing uncertainty and volatility in the economy.

One key risk is the risk of inflation, which can erode the purchasing power of consumers and reduce the value of savings. Inflation can be caused by an increase in demand for goods and services, a decrease in supply, or an increase in the money supply.

Investing in new technologies and industries can also be a risk, but it can also lead to significant rewards. For example, investing in renewable energy can reduce our reliance on fossil fuels and create new job opportunities.

However, not all risks are created equal, and some can have more severe consequences than others. For instance, a global economic downturn can have far-reaching consequences, including widespread job losses and reduced economic output.

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Economic growth risks have been a major concern in recent years, and understanding the factors that contribute to these risks is crucial for making informed decisions.

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Financial conditions have been a significant driver of economic growth risks, with the Federal Reserve's monetary policy tightening cycle having a notable impact on the economy.

Since late 2021, financial conditions have swung from very accommodative levels to providing a significant drag on economic activity, with the Federal funds rate peaking in 2023.

The recent easing of financial conditions has led to a decrease in downside risks to employment growth, with the conditional distribution of employment growth now featuring less downside risk than at the end of 2023.

However, the conditional distribution of inflation has shifted uniformly to the left, with the modal forecast centered around 2 percent, indicating a lower risk of high inflation.

The analysis suggests that current financial conditions are near the top of the range of values that are compatible with the empirical distribution of GDP growth observed in the United States in periods of economic expansion.

This implies that the risk of recession is not as high as it was at the end of 2023, when financial conditions peaked.

However, the conditional distribution of one-year-ahead GDP growth implied by the August 2024 level of the FCI-G is skewed to the left of the non-recessionary benchmark distribution, with median growth 0.4 percentage points lower and downside risk to growth twice as large as under the non-recessionary distribution.

This suggests that while the risk of recession has decreased, there is still a significant risk of lower-than-expected economic growth.

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Financial Stability is a major concern when it comes to economic growth. The recent shift in the conditional distribution of GDP growth implies that downside risks to growth have decreased notably since late 2023.

The August 2024 conditional distribution of one-year-ahead GDP growth is skewed to the left of the non-recessionary benchmark distribution, with median growth 0.4 percentage points lower. This means that the economy is more vulnerable to negative growth.

The probability of negative average GDP growth over the next year, also known as downside risk, is approximately twice as large as under the non-recessionary distribution. This increased risk is a significant concern for financial stability.

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Financial stability is not just about avoiding crises, but also about maintaining a healthy financial system that supports economic growth.

The Bank of International Settlements (BIS) monitors financial stability through its Global Economy Meetings, which provide a platform for central banks and regulators to discuss and address potential risks.

The BIS uses various indicators to measure financial conditions, including the credit-to-GDP ratio, which shows that high levels of credit can lead to asset price bubbles.

A credit-to-GDP ratio of 100% or more is often considered a warning sign, as it indicates that credit growth is outpacing economic growth.

The BIS also tracks the debt-service-to-income ratio, which measures the proportion of income spent on debt repayment.

A high debt-service-to-income ratio can indicate that households are struggling to service their debt, which can lead to financial distress.

The US Federal Reserve uses a similar framework to monitor financial stability, which includes indicators such as the non-performing loans ratio and the credit spread.

These indicators help policymakers identify potential risks and take proactive measures to maintain financial stability.

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Financial conditions have swung significantly over the past two and a half years, moving from accommodative levels to providing a drag on economic activity.

Since early this year, financial conditions have eased moderately, with monetary policy communications signaling that the federal funds rate had likely reached its peak for this tightening cycle.

Financial conditions currently stand near the top of the range of values that are compatible with the empirical distribution of GDP growth observed in the United States in periods of economic expansion.

The predictive distribution of one-year-ahead GDP growth has shifted to the left and become skewed toward lower outcomes since late 2021.

However, since late 2023, downside risks to the growth outlook have decreased notably.

The conditional distribution of one-year-ahead GDP growth implied by the August 2024 level of the FCI-G is skewed to the left of the non-recessionary benchmark distribution, with median growth 0.4 percentage points lower and downside risk to growth approximately twice as large.

The probability of negative average GDP growth over the next year is roughly twice as large under the current financial conditions compared to the non-recessionary distribution.

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Economic growth is facing numerous challenges that can impact its trajectory. One significant challenge is the shift in GDP growth distributions, which has become skewed towards lower outcomes since late 2021, but has decreased notably since late 2023.

The conditional distribution of one-year-ahead GDP growth implied by the August 2024 level of the FCI-G is skewed to the left of the non-recessionary benchmark distribution, with median growth 0.4 percentage points lower and downside risk to growth approximately twice as large.

Technological changes are also bringing new challenges to economic growth. The rise of online shopping initially caused states to miss significant amounts of tax revenue, and states should remain vigilant for future technological innovations that could disrupt their fiscal outlook.

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Inflation and Employment Implications can have a significant impact on individuals and businesses alike. According to the article, moderate inflation of 2-3% can actually boost employment, but high inflation above 5% can lead to job losses.

The article notes that high inflation can erode consumer purchasing power, making it harder for businesses to sell their products, which can lead to layoffs. This can create a vicious cycle of unemployment and reduced economic growth.

In contrast, moderate inflation can stimulate economic growth by encouraging people to spend their money now rather than later, which can lead to increased demand and hiring. The article cites an example where a 2% inflation rate led to a 1% increase in employment.

However, if inflation gets too high, it can lead to higher interest rates, making borrowing more expensive for businesses and individuals, which can further exacerbate unemployment.

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Demographic changes threaten state budgets. States are facing significant demographic pressures in the coming decades, with Baby Boomers aging out of the workforce and a smaller workforce on the horizon.

Aging populations could lead to reduced state tax revenue, particularly from wage-based income taxes and sales taxes. Retirees tend to earn and spend less than full-time employees, and often receive favorable tax treatment on the income they do earn.

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A smaller workforce could also slow overall economic growth, as employers struggle to find workers with the right skills. In fact, a 2019 report from Montana's Legislative Fiscal Division noted that if employers are unable to fill entry-level positions, income tax collections would almost certainly decrease.

An older population could change the balance of spending demands on services, with more Medicaid enrollees and demand for expensive services like long-term care. This could put pressure on states to increase wages paid through Medicaid to recruit enough caretakers.

Some states are already taking steps to assess these risks, including Montana, which established a joint legislative committee to examine intergovernmental issues and prepare demographic projections. New Mexico's legislative finance committee has also produced a long-term budget analysis that projected significant structural budget deficits in future years.

Here are some examples of emerging state action to assess demographic risks:

These initial efforts can serve as a model for other states to identify and assess the challenges most likely to affect their fiscal futures.

Technological changes can bring new challenges to state budgets, disrupting existing revenue structures and creating demand for new state expenditures.

New technologies can cause rapid shifts in spending patterns, leading to revenue disruption. For example, the rise of online shopping initially caused states to miss significant amounts of tax revenue.

States need to think about alternative ways to fund roads, as more drivers shift to electric vehicles or high-mileage hybrids, weakening the connection between road use and fuel purchases.

Keeping up with technological progress can be expensive for state governments, with costs related to ransomware attacks exceeding $70 billion between 2018 and October 2022.

States may need to spend more to ensure they have sufficient cybersecurity, while also making contingency plans for responding to attacks.

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Highly peaceful countries maintain lower inflation volatility, which is a major plus for economic activity. This is because price instability can lead to contractionary monetary policies and make it difficult for businesses and consumers to borrow and invest.

Price volatility creates risks and reduces profitability, causing people to save their money in safer, but less-productive assets. In highly peaceful countries, the standard deviation of inflation is significantly lower, indicating less volatility.

Between 2000 and 2021, interest rates have decreased in very high peace countries, while in countries with lower peace levels, interest rates fluctuated significantly. This unpredictability arises from political uncertainties and higher inflation.

Highly peaceful countries are more attractive to international investors, who are drawn to their economic stability and security. In these countries, net FDI inflows as a percentage of GDP are significantly higher, often exceeding twice the proportions observed in less peaceful nations.

The correlation between peace and economic stability is clear: highly peaceful countries tend to have lower interest rates and more stable inflation. This makes them more appealing to investors and businesses, leading to stronger economic growth.

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Global events like wars and natural disasters can severely impact economic growth, as seen in the example of the 2020 COVID-19 pandemic, which led to a global recession.

A decline in global trade can also hinder economic growth, with a 20% decrease in international trade in 2020.

Fluctuations in global commodity prices can affect economic growth, particularly for countries heavily reliant on exports, such as oil-rich nations.

A decline in global trade can also lead to a decrease in foreign investment, making it harder for businesses to access the capital they need to grow.

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As we look at the global outlook, it's clear that external factors are having a significant impact on businesses worldwide.

The COVID-19 pandemic has led to a shift in consumer behavior, with many people turning to online shopping and digital services. This trend is expected to continue, with 75% of consumers preferring to shop online by 2025.

Global economic uncertainty is another major concern, with trade tensions and protectionist policies affecting international trade. The US-China trade war, for example, has resulted in tariffs being imposed on billions of dollars' worth of goods.

Climate change is also a pressing issue, with rising temperatures and extreme weather events affecting supply chains and business operations. In 2020, the world experienced 22 major climate-related disasters, causing over $100 billion in damages.

The impact of these external factors can be seen in the decline of certain industries, such as the travel industry, which saw a 70% decline in bookings during the pandemic.

Environmental disruptions will continue to emerge, bringing a wave of major disruptions in coming decades. This will have severe impacts on people and the environment, and affect state fiscal outlooks.

Acute natural disasters are already putting pressure on state budgets. The increasing frequency and severity of natural disasters is expected to continue, with growing pressure for more investments in pre-disaster mitigation and state support for response and recovery efforts.

States face an array of expenses related to natural disasters before, during, and after such incidents strike. Even with federal aid, states' disaster costs have been rising rapidly.

Chronic physical risks like sustained sea-level rise or extreme heat could carry significant fiscal risk. Coastal states may need to invest significant funds to help at-risk communities adapt to or retreat from rising water levels.

Sustained heat could also significantly affect outdoor industries such as agriculture, construction, and tourism. State economies, and therefore revenue, could suffer as a result.

Climate-driven economic transition could also bring fiscal disruptions. States that rely on oil and gas extraction taxes may see dropping revenue from these extractions, resulting in lower tax revenue.

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As states navigate demographic shifts, it's essential to assess and manage the associated risks to ensure sustainable economic growth. Bonaire's coral reefs have thrived despite climate challenges, but states face a different kind of challenge: a shrinking workforce due to aging Baby Boomers.

States with smaller workforces may struggle to collect tax revenue, particularly from wage-based income taxes and sales taxes. A 2019 report from Montana's Legislative Fiscal Division noted that unfilled entry-level positions could lead to decreased income tax collections.

Demographic shifts can also impact spending demands on services. With fewer school-aged children, education spending may decrease, but an older population could lead to increased Medicaid enrollees and demand for expensive long-term care services.