It’s a small world: what leaders must do to achieve a healthy global economy

By Money Matters Editors

The previous global economic expansion was riddled with structural imbalances. Provided the balances are addressed, a global economic recovery will follow, but the task is huge.

Economists and policy makers are starting to call the previous economic expansion the ‘Bush era’ or the era of the pseudo-economic boom - a period when unsustainable borrowing by American citizens masked, for a short period, structural imbalances that almost guaranteed that the U.S. and global economies would fall into recessions.

Those imbalances were laid bare once the U.S. home-as-ATM era ended when the U.S. housing sector collapsed, and the correcting of those imbalances is one reason the recession has been long and deep. Investors should monitor the major economies’ progress at ending these imbalances. Here’s an update:

1) China’s over-saving and lack of consumption. Since its shift to a market-oriented economy, China’s savings rate has exceed 20 percent and its consumption rate as a percentage of GDP has lagged those of developed economies. Investment-based, export-oriented China’s philosophy was ‘make it cheaply, ship it to the west, and reap the rewards.’ The problems with that economic model are manifold, not the least of which is - when export demand disappears, so does the growth - and that’s why China’s GDP growth was cut in half during the global recession.

Since the slowdown’s start, China has done a decent job increasing domestic consumption and stimulating demand, but more must be done: tens of millions of Chinese citizens must become regular consumers, if the global economy hopes to have demand sufficient for adequate GDP growth. (Other emerging market nations, such as India, Brazil/Latin America, Russia/Eastern Europe and the Middle East, must also increase consumption to make-up for declines in U.S. consumption.)

2) U.S. over-consumption, under-savings. There’s been considerable progress in the land of the free: after a decade of unsustainable, home equity loan and refinancing-fueled over-consumption, Americas have cut back their spending. Some are calling the shift the ‘frugal consumer’ era, arguing that it will be a long-term trend. Similarly, after a decade of saving little, Americans are saving about 5 percent per year, and there is chatter that it may rise to 8 percent.

3) U.S. trade deficit and budget deficit. Further, the U.S. trade deficit is decreasing, due to fewer export purchases by those now frugal consumers, and the U.S. could begin to register a trade surplus as early Q4 2010. However, the U.S. budget deficit remains too high, at roughly $300-400 billion, excluding fiscal stimulus and bank bailout money. Health care reform will help cut entitlement spending (Medicare, Medicaid), but more spending cuts are needed, as is a tax increase on upper income Americans. For sustainable global growth to occur, the United States must be fiscally and economically sound, and that requires a balanced budget – fiscal discipline. By balancing its budget, the U.S. will show the world that it can live within its means, continue to serve as an attractive source for investment, and will not undertake policies that increase inflation, interest rates, or weaken the dollar.

4) Inordinate leverage and borrowing. In the wake of the September 11, 2001 terrorist attack, the U.S. Federal Reserve and other major central banks cut interest rates to limit the calamity’s impact on commerce. The monetary response was appropriate. The problem was, however, the ‘easy money period’ was too long, and it encouraged reckless mortgage lending, and high-risk business models. One classic example: American International Group (AIG), an insurance company that operated more like a hedge fund, as a result of its use of credit default swaps and excessive leverage. Some business models were intrinsically problematic, such as those banks that were leveraged at more than 40-to-1.

Since the onset of the financial crisis, the major economic powers have done an adequate job shoring-up systemically-critical banks and financial institutions. And leverage? The crisis has reduced leverage to the point where, now, the larger problem is a lack of lending and too-strict lending requirements, certainly with regard to commercial operations and home mortgages.

5) Too many export-dependent economies. In trade, the global economy faces, arguably, its toughest hurdle. Globalization – basically the establishment of free markets around the world and the transfer of production to lower-cost labor regions – increased trade tremendously during the 21st century’s first decade. The export-for-income-and-wealth-gains model became dominant. But as these new, national economies took the global stage, did anyone bother to think of who was going to continually buy the flood of new products and manufactured goods entering the global market? Or what would happen to these export-oriented economies if the trade gravy train suddenly stopped? Apparently, not enough did, and the result was, when the U.S. economy ceased to be consumer for the world, the current pronounced recession. Needless to add, this structural imbalance must be corrected for sustainable global GDP growth to occur.

In sum, the major economies have made progress regarding the most important structural imbalances, but much more work remains. The United States must eliminate its budget deficit and continue to save and invest more. And, equally critical, China and the rest of the developing world must consume more: in other words, the global economy must become an economy with multiple engines of growth, not just one. If that occurs, sustainable global GDP growth will ensue; but as of today, we’re still a long way from that goal.