Economic Revival Requires a Broad Spread of Demand

We are talking about the end of the economic crisis while it deepens. Economic projections have had to be continuously revised downward. Yet a relatively quick economic recovery is possible, provided four things happen.

First, public authorities must restructure and rewrite balance sheets in the financial sector, when necessary by taking over banks, instead of waiting any longer. Second, public expenditure must replace faltering private demand to reverse the downward spiral before it becomes a rout. Third, this must be done with international co-operation so that the global current account imbalances that contributed to the crisis will diminish rather than increase. Fourth, there must be aid to the most vulnerable so that they will not be pushed into destructive despair.

Will politics allow all this to be accomplished in time to avoid a catastrophe? If so, growth may resume some time in 2010. Even under this optimistic scenario, however, the world will have changed irreversibly.

By force of events, the role and reach of government will have increased. The assets taken over and the programmes put in place will have to be managed, at least for a while. Moreover, the idea that markets can regulate themselves without the “visible” hand of public policy has been thoroughly discredited. This means that societies throughout the world will be looking for better ways to combine government action with private markets.

An extreme form of market fundamentalist ideology had been influential since the early 1980s, reaching unprecedented “exuberance” at the turn of the century – acclaimed analysts were predicting that the Dow Jones industrial average would more than triple, reaching 36,000 in a decade. This ideology has collapsed; the Dow stands at barely 20 per cent of that level.

A central problem in many markets has been short-termism and herd behaviour. There were quite a few in the financial sector who sensed that the house of cards might be about to fall but competition meant that a manager accepting a 4 per cent return when everyone else was showing 8 or 10 per cent would lose his or her job. Part of the fundamental rebalancing will have to involve a regulatory framework and corporate governance that tie rewards to longer-term performance.

Will the global economy again be able to deliver the results we came to expect? Can long-term growth reach the 3 to 4 per cent range that seemed possible before the crisis? A look at the supply side suggests the answer is yes. Relying on its own high savings rate, Asia is investing about 40 per cent of its gross domestic product (compared with a worldwide average of about 22 per cent) and so will account for an increasing share of the world economy, pulling the potential investment rate upwards. The information revolution facilitates rapid diffusion of technology and know-how, allowing solid productivity increases to accompany high investment rates in emerging markets. The technological frontier is advancing, which should allow respectable growth in advanced economies. Close to 2 per cent long-term growth in aggregate potential output in the US, Europe and Japan, 6-7 per cent in Asia and 4-5 per cent in other parts of the world appears feasible as far as the supply side is concerned. This could result in the long-term growth of the world economy rising from 3 per cent to 3.5 per cent as the weight of Asia continues to increase over the next decade.

The realisation of this growth potential will depend, however, on how aggregate demand is managed. The crisis has shown that potential supply does not automatically translate into effective demand. Two things need to happen for demand expansion – driven in the past by asset bubbles and US consumers – to resume, but in a more sustainable fashion. In the immediate future, current account surplus countries, including Germany and Japan but led by China, must play a greater role in the expansion of demand. In the longer term, the distribution of income inside countries and worldwide must shift towards less concentration at the top, supporting a broad-based expansion in consumer demand.

There are huge unmet needs, even in advanced economies. A move towards a less unequal income distribution would allow spending by lower income groups. President Barack Obama, as seen in his budget proposals, aims for a more balanced income distribution through tax, healthcare and education reforms, which should help the US and the world move in this direction provided it is accompanied by appropriate macroeconomic policies in surplus countries. Otherwise the need for demand growth could collide with an ever increasing US current account deficit and unmanageable global imbalances.

The crisis should teach us to manage risk on a global basis and not to underestimate the potential damage from events deemed unlikely or hard to predict. The costs of the financial crisis may pale in comparison to some of the long-term risks attached to irreversible global climate change, pandemic diseases or nuclear weapons proliferation. A crisis can also be an opportunity for fundamental improvement. If this one teaches us that robustness is as important as efficiency in human affairs, it will have been such an opportunity.