How are geopolitical risks affecting the world economy?

Geopolitical risks posed by elections, polarisation and conflicts within and between states have inevitable knock-on effects on the economy, both globally and for individual countries. This year more than ever, managing these risks and shoring up institutions that promote stability are essential.

The war in Ukraine and the conflict between Israel and Hamas in the Middle East – further complicated by Houthi missile attacks on ships in the Red Sea – highlight the extent to which geopolitical developments are a key determinant of global economic performance in 2024.

Elections around the world are also likely to have a significant impact on the direction of the global economy. With at least 64 countries going to the polls, this effect will be seen not only through potential changes in trade and investment policies but also by increased uncertainty and political polarisation.

How does geopolitics affect economic performance?

The term geopolitics denotes a broad analytical framework in international relations, encompassing different phenomena such as political instability, tensions and military conflicts between countries, terrorist threats or geographical events that can have regional or global impacts.

The global economy can be affected by geopolitical events both directly and indirectly through financial, trade and commodity price channels.

In terms of financial markets, this happens both through direct capital controls or financial sanctions, and indirectly through increased uncertainty, higher risk premia or asset price surges (Catalán et al, 2023).

On the trade side, increased restrictions due to tensions between countries can disrupt trade flows and cause supply chain problems even in third-party countries. Restrictions can also affect commodity prices and lead to shortages of key resources such as oil and gas, affecting industrial production worldwide.

Taken together and mutually reinforcing each other, the global economy can experience higher inflation, lower growth and significant welfare losses in times of geopolitical tension (Góes and Bekkers, 2022).

The term geopolitics is also used in the context of internal political affairs, which can influence domestic and global financial markets. In this sense, governments can influence economic activity through various fiscal policies (taxes and spending), and economic and strategic decisions based on different priorities, depending on their political orientation.

Further, rising populism poses significant threats to long-term stability and economic performance. Populist governments often implement policies that can bring short-term benefits at the expense of long-term sustainability. Such policies include trade protectionism or increased government spending (fiscal expansion), which can disrupt global trade flows, increase market volatility and hinder long-term growth.

Indeed, a recent study covering a sample of 60 countries between 1990 and 2020 shows that countries experience significantly lower output and real GDP per capita growth in the medium and long term under populist governments (Funke et al, 2023).

In turn, economic policies and outcomes have a profound impact on politics – shaping public opinion and voter behaviour, and affecting the balance of power.

Typically, good economic performance – such as strong economic growth, low unemployment and stable inflation – tend to favour incumbent leaders and political parties. Conversely, research shows that bad economic outcomes, including high unemployment and high inflation, can lead to popular discontent and increase the voter turnout at election time (Burden and Wichowsky, 2014; Marx et al, 2022; Frank and Martínez, 2023).

In addition, some studies show that economic recessions cause political landscapes to reshuffle (Giuliani and Massari, 2019). They can also pave the way for populist and non-mainstream political parties (Hernández and Kriesi, 2016).

How can we measure geopolitical risks and what does this tell us?

Measuring geopolitical risks is an important but arduous task. One method is the geopolitical risk index (GPR), which is constructed using the frequency of articles in leading newspapers that discuss adverse geopolitical events such as wars, terrorism and tensions among political organisations (Caldara and Iacoviello, 2022).

As a continuous measure of risk, higher GPR values indicate higher intensity of adverse events, increased probability of negative events in the future, and greater expected intensity of future negative events.

Related empirical studies show that higher GPR values are associated with higher oil prices (Mignon and Saadaoui, 2024), lower firm- and country-level investment (Wang et al, 2023), higher inflation, lower economic activity and lower trade (Caldara et al, 2022), more volatile capital flows (Kaya and Erden, 2023) and lower levels of private sector credit in emerging markets (Lu et al, 2020).

Figure 1 shows the evolution of the GPR and the specific index for the UK since 1985. Three observations stand out:

First, the global and UK-specific indices are highly correlated.
Second, the index captures well-known historical events associated with wars, terrorism and other international conflicts such as the First Gulf War, the 11 September 2001 attacks on the United States, and Russia’s invasion of Ukraine.
Third, the index has recently spiked with the renewed conflict between Israel and Hamas from October 2023. Although the index has eased slightly in the following months, it remains in the top 5% of the historical series.

Figure 1: Geopolitical risk index

Source: Caldara and Iacoviello, 2022

Note: Data downloaded from here on 15 January 2024.

While the GPR is useful for tracking how geopolitical risks develop over time and for empirical research, it has certain limitations as a risk measure:

First, the index is not forward-looking and has limited predictive power for the potential evolution of risks.
Second, being an aggregate measure of geopolitical risks, the index fails to distinguish between the different risks, each with distinct probabilities of occurrence and impacts.
Third, the index is unable to capture the complexity, sources and persistence of risks. As a result, risk analysts typically complement GPR indices with qualitative analysis, expert consultation, probability-based assessments and scenario analysis to provide more dynamic and tailored risk assessments.

What are the major risks facing the global economy today?

Many of the significant geopolitical risks that the world faces in 2024 come from existing conflicts and tensions.

Experts have identified the elections in the United States (amid increasing polarisation and declining trust in the country’s political system); a possible escalation of the Israel-Hamas conflict into a wider conflagration in the Middle East; and a further deepening of the Russia-Ukraine war as top of the list (Bremmer and Kupchan, 2024).

In relation to the crisis in the Middle East, a central-case scenario of a limited military conflict has been suggested (Bremmer and Kupchan, 2024).

But the likelihood of a larger regional war has increased due to the Houthi attacks on ships in the Red Sea. In addition, although less likely, there is a risk that the regional war could result in actions against or by Iran that could significantly disrupt Iranian and global oil supplies.

Further, the crisis in the Middle East could have a significant impact on global markets, even without disrupting oil supplies. Given that approximately 12% of global maritime trade passes through the Red Sea, the Houthi attacks are likely to keep freight insurance rates elevated, cause longer trade journeys, disrupt supply chains and increase inflationary pressures.

At the same time, the situation in Ukraine is becoming increasingly challenging as the likelihood of a de facto partitioning of the country has increased (Bremmer and Kupchan, 2024).

Russia holds material advantage and its economic and military capabilities have strengthened. Ukraine, on the other hand, grapples with manpower shortages and needs to enhance defence production.

What’s more, political and economic support from the United States is weakening, while the European Union (EU) is affected by fiscal limitations and a lack of political consensus. Political implications – such as damage to the credibility of NATO and the United States – aside, a partitioned Ukraine would continue to pose challenges to the global economy, particularly through further disruptions to oil and food markets.

Outside these major risks posed by conflicts, the world is facing others posed by unregulated and more powerful artificial intelligence (AI) tools, increased protectionism, which disrupts the trade of critical minerals, and the failure to address macroeconomic and financial market vulnerabilities.

Increased cooperation among rogue states – such as Iran, North Korea and Russia – and the setbacks to the Chinese growth model also bring international risks (Bremmer and Kupchan, 2024).

Lastly, researchers’ assessment of global risks indicates a high probability of sub-par global GDP growth due to tighter monetary policies (Bremmer and Kupchan, 2024). More generally, the probability of a deeper economic contraction, resulting from monetary overtightening, financial shocks and higher energy prices due to heightened geopolitical risks has slightly increased with the escalation of conflicts in the last quarter of 2023.

How might elections and political risks affect the economy?

Over half of the world’s population will vote in general or local elections worldwide this year. Unsurprisingly, therefore, elections will be a key political theme in 2024.

Some elections, such as those in Indonesia, Mexico and Türkiye, may have limited local or regional effects. Others, such as those in India and Russia, will not produce surprising outcomes.

Others still could have significant foreign policy implications. For example, the result of the recent elections in Taiwan could affect relations between China and the United States, while those in Iran could affect the trajectory of the Israel-Hamas conflict and lead to commodity price spillovers.

The upcoming European elections are also crucial as they will determine the composition of the EU parliament at a time when far right parties are on the rise and the bloc is becoming increasingly polarised.

The US elections are likely to have the greatest impact on the world’s political and economic outlook. The return of former president Donald Trump could affect the global economy in three main ways.

The first is through increased pressure on the Federal Reserve – the US central bank – and unconventional fiscal policies (tax and public spending). Although Trump pushing for interest rate cuts could harm the disinflationary process, his unconventional tax cuts could put even more pressure on fiscal balances through higher deficits.

In addition, his proposed policy of imposing 10% tariffs on all imported goods could further disrupt supply chains and have a significant impact on US GDP and household wellbeing, particularly if trade partners retaliate (Lee, 2023).

Finally, Trump’s position on foreign policy and security issues, particularly regarding NATO, could alter global power dynamics. And regardless of the election outcome, the US political system is becoming increasingly dysfunctional, and citizens’ trust in political and social institutions has reached historically low levels.

Do we need a new macroeconomic framework?

Although the threats posed by geopolitical events are very real, there are also some positive outcomes to consider:

First, major economies have shown resilience despite experiencing one of the most aggressive monetary policy tightening episodes in decades.
Second, the Chinese economy may recover more quickly than previously anticipated.
Third, despite the risks posed by belated government regulation, developments in AI have the potential to unlock new innovations and bring significant productivity gains.
Fourth, developments in the Middle East have not yet led to a surge in oil prices.

All in all, the impact of geopolitical risks may not be as severe as anticipated.

Nevertheless, given the potential risks, is there a need for reform of the established macroeconomic framework to address global challenges more effectively?

The existing consensus on the macroeconomic framework includes free movement of goods and capital, rule-based fiscal policies, independent central banks with a focus on inflation targeting, public institutions that prioritise maintaining financial stability, and international institutions for financial supervision and increased cooperation between countries.

Abandoning this framework may not be desirable, as the global economy has greatly benefited from a private sector-based model, and the evolution of these institutions is based on internationally agreed laws and agreements.

But incremental reforms that could strengthen the international consensus are necessary due to the increased likelihood of geopolitical risks, the fragmentation of global markets and the climate-related risks that the global economy faces. These include designing central bank mandates and fiscal rules to respond to shocks more flexibly, revamping international institutions such as the World Trade Organization’s dispute settlement mechanism, and improving the process of consensus-building.