The biggest downside risks to a global economy

Occasionally, over the last several years, I've posted a list of downside risks to economic growth — and here is another one. Currently my forecast is still for sluggish and choppy growth, but I think there are reasons to expect US economic growth to pickup in the next year or two, perhaps to trend growth. As I noted last month in "Two Reasons to expect Economic Growth to Increase," residential investment is now a tailwind for the economy, and the drag from state and local government cutbacks is mostly behind us.

There are always many downside risks (meteor strikes, major terrorist attack, war somewhere — possibly with Iran), but I think these are the most probable downside risks:

The European financial crisis: The European crisis has been threatening to spill over into the US for several years. Looking back, I was writing about Greece, Ireland and Spain sovereign debt issues in 2009. This year the recession in Europe is hitting US exports, but so far there is little financial contagion.

The European situation could spin out of control at any time. Currently the unemployment rate is 25.1 percent in both Spain and Greece, and that is politically unsustainable. There are decisions to made soon regarding Greece (another round of financial help) and Spain (when will they ask for a bailout?) — and also about fiscal union and easing back on austerity.

The economic slowdown in China: The recession in Europe has spilled over into China, and has led to fears of a sharp slowdown.

Growth in China's gross domestic product fell to 7.4 percent in the third quarter compared with a year earlier, China's National Bureau of Statistics said Thursday, down from 7.6 percent in the second quarter and the weakest since the beginning of 2009. The seventh consecutive deceleration reflected a combination of weak demand from abroad, flagging investment at home, and insufficient spending by China's households to pick up the slack.

Data for September showed some signs of stabilization. Industrial output growth rose to 9.2 percent year-over-year, from 8.9 percent in August. Exports also bounced back, up 9.9 percent year-over-year in September, after 2.7 percent in the previous month. And Chinese refineries processed a record high amount of crude oil, 7 percent more than a year earlier.

China reports GDP on a year-over-year basis (the US reports an annualized rate quarterly). A sharp slowdown in China might lead to a higher trade deficit with the US — and also might reveal some financial issues in China. As Warren Buffett said "It's only when the tide goes out that you learn who's been swimming naked."

Of course a slowdown in China might lead to lower commodity prices, and that would help many sectors in the US.

The Fiscal Slope: This is commonly called the "fiscal cliff," but it is more of a slope. This refers to several federal tax increases and spending cuts that are scheduled to happen at the beginning of 2013. This includes ending the Bush-era tax cuts, ending the temporary payroll tax reduction, ending extended unemployment benefits, and some large budget cuts mostly for defense spending. No one expect this to be resolved before the election, but after the election this could become a significant issue. This doesn't have to be resolved immediately — policymakers could wait a few months — but this probably has to be resolved fairly early next year.

My assumption is that some sort of reasonable agreement will be reached and the fiscal slope will only have a minor impact on economic growth in 2012. My guess could be wrong, and policymakers might not be able to reach a deal.

Note: There is also the possibility of stronger than expected growth next year. This could lead to the Federal Reserve slowing or even stopping QE3 — but I think that would be considered a strong positive. Right now, sluggish growth with some pickup in 2013, seems most likely.

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