Stephen King: Like Dr Pangloss, the West's investors may be in for some unpleasant surprises

For anyone thinking about the economic outlook in 2007, there's an obvious puzzle. Financial investors seem to think we live in the best of all possible worlds. Yet policymakers seem to be increasingly uncertain about the economic outlook.

Equity markets soared through 2006 and, after an initial sell-off, bond markets recovered their poise. The inflationary fears that dominated the early months of 2006 are now fading fast, and most investors expect the Federal Reserve to lower interest rates one or two notches in the coming year.

Consensus forecasts point to a slight moderation in global growth in 2007: just enough to squeeze any residual inflationary pressures out of the system, but not enough to threaten any kind of unpleasant increase in unemployment or decline in company profitability.

Policymakers' growing anxieties reflect two underlying concerns. First, investors may be simply mis-pricing risk, forgetting about the potential pitfalls that can undermine the returns of even the cleverest financial alchemist. Second, globalisation is changing tried-and-tested economic relationships so rapidly that policymakers themselves are unable to keep track with what is really happening in the global economy. As a result, their own propensity to make mistakes has risen to uncomfortable levels.

Policymakers looking at the behaviour of financial investors might be reminded of the teachings of Dr Pangloss, the mentor to Candide in Voltaire's eponymous satire. Dr Pangloss took the view that if God made the world and God is perfect, we must live in the best of all possible worlds. Dr Pangloss's arguments slowly unravel as the imperfections of the world we live in are revealed. When the old woman tells of the occasion when her buttock was sliced off to feed the starving guards in Azoff, you know that Dr Pangloss is on slippery ground.

In fairness, economic progress in 2006 was very good. Although the housing market crumbled, the rest of the US economy held up rather well. Growth in both the eurozone and the UK came in much higher than expected. Meanwhile, it now looks as though China's economy expanded at a 10.6 per cent clip in 2006 (at the beginning of the year, consensus forecasts suggested only an 8.7 per cent rate of expansion). India was also immensely strong, with output up an impressive 9.1 per cent.

Policymakers, though, aren't confident that this good news will be sustained: they are, if you like, on the lookout for the occasional buttock-slicing event. In the US, the weakness of the housing market still presents a threat to other sources of economic growth. Consumer spending remains strong at the moment but companies are becoming a bit more cautious: business surveys have shown waning confidence, and capital goods orders have wilted in recent months. If the labour market is hit by this new corporate constraint, it may be too much to expect consumers to keep the US economy afloat in 2007.

The Bank of Japan seems confident that Japan's economy will carry on expanding, but assumes that the US economy will slow only modestly in 2007. A more sustained US slowdown would create problems for Japan, for the simple reason that Japan's growth remains export and investment-led. Despite rising incomes and an improving labour market, the Japanese consumer remains reluctant to spend, leaving Japan in a position of high dependency on events elsewhere in the world.

Germany, like Japan, has seen growth driven by exports and investment. Germany's gains partly reflect the strength of activity elsewhere in the world, but also are a sign of improved competitiveness as German companies have successfully driven down domestic labour costs. For the eurozone as a whole, however, this creates a bit of a problem. Arguably, Germany's export gains are France's and Italy's export losses. Add to this a persistent tightening of monetary policy from the European Central Bank and a slowly rising euro, and you have the recipe for a sustained slowdown in eurozone growth through 2007.

As for the UK, the central issue in the early months of the year will be whether the members of the Bank of England's Monetary Policy Committee decide to raise interest rates further. The housing market is strong and capital spending has rebounded - two factors favouring a bit more monetary stringency - but, at the same time, the absence of any significant wage pressures points to ongoing price stability.

On this debate, I come down on the side of those who'd rather leave interest rates unchanged, largely because of the extraordinary increase, though immigration and the return of the over-55s, in labour supply. I suspect we'll see only moderate wage increases in the coming pay round. This, though, is one of those areas of uncertainty that leave central bankers' opinions split down the middle.

Most of the good economic news in 2007 will come from emerging markets. In my view, they're engaged in a secular process of economic catch-up. The problems that used to plague these economies have partly faded. In particular, most of them now have large current account surpluses and, therefore, are no longer dependent on the hot money inflows which all too often reversed during the 1990s.

There are one or two exceptions to this general rule - India and Turkey, with their growing current account deficits, spring to mind - but the general picture is one of financial security. Global growth may remain relatively robust in 2007, but only because of the emerging markets. Put another way, the fate of the G7 nations no longer determines the fate of the global economy.

Politically, this is a big conclusion. The political map of the world is being redrawn to reflect the growing economic influence of these emerging giants. China plays a bigger role in Africa. Russia plays a bigger role in European energy supplies. Iran's influence in the Middle East is on the increase as the chaos of Iraq erodes American authority in the region. And, increasingly, emerging markets trade with each other. No longer is the world defined by the G7 with "the rest" playing only a supporting role.

How will we in the West react to this changing world? For central banks, the difficulty increasingly lies in defining where the boundaries for monetary policy should be set. In the old days, excess demand led to higher inflation because labour supply was mostly determined by national boundaries. Today, national boundaries are increasingly porous. The old concepts of "output gaps", "spare capacity" and "natural rates of unemployment" no longer seem quite so relevant. As for politicians, their concerns will be increasingly focused on income inequality or, put another way, the winners and losers from globalisation.

This, I suspect, means that the debate will shift from economic efficiency and the maximisation of output towards the fairness with which that output is distributed. It's for this reason that we're seeing a rise in protectionist rhetoric from many Western politicians. They're only too aware that many voters see themselves as globalisation's losers.

For the most part, financial markets like unfettered capitalism. If, though, we're moving slowly away from this free market model, financial investors might find themselves in for a bit of a rude shock. Sliced buttock, anyone?

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com