Clearing up the mess in the global economy was never going to be simple. In the six months since the October meetings of the IMF and the World Bank there has been the sharpest and most widespread decline in activity since the 1930s. Last autumn, the IMF was expecting global growth of 3 percent this year; now it is predicting a contraction of 1.3 percent.
Japan’s projected growth of 0.5 percent has been turned into a 6.2 percent plunge in output; the modest 0.1 percent drop in Britain is now projected to be a 4.1 percent crash — worse than any year since 1945.
Yet chastened as they are, there is no real sense that policymakers have fully got to grips with the crisis. There is far too much focus on whether there are short-term signs of recovery rather than on whether the long-term causes of the downturn have been resolved.
Let’s just recap on how we arrived at this juncture. Globalization has led to the development of two groups of countries — those running big trade surpluses and those running big trade deficits. Germany and Japan provided the machines and high-grade capital goods that allowed China to become the source of low-cost manufactured goods. Countries where the industrial sectors had been hollowed out over the decades — such as the US and Britain — were ready buyers for cheap imports. Inflation fell, allowing interest rates to fall.
But manufacturing was not the only sector to be globalized. Banks became bigger and bigger, expanding their business across frontiers to the extent that national regulators found it harder to supervise them properly. With low inflation making traditionally safe investments less attractive, there was a global search for yield. As we now know, this led to speculative money flooding into places such as Iceland and into complex derivative products that nobody really understood. The banks became so big and had so many different functions that it was beyond the capacity of any chief executive — no matter how brilliant — to manage them properly.
It would be wrong to think that there were no warnings of trouble to come. Indeed, the IMF brought together the US, the EU, China and Japan in the hope that a system of multilateral surveillance would come up with a solution to the global imbalances. It didn’t. The debtor countries wanted the problem to be solved by the surplus countries expanding domestic demand. The surplus countries told the debtor countries to rein in their booming housing markets.
Paradoxically, the crisis is proving to be even tougher for the advanced surplus countries — Germany and Japan — than it is for spendthrift Britain and the US. Production was cranked up in expectation that the US would continue to be the global consumer of last resort, but the collapse in consumer and business demand has exposed the over-reliance of surplus countries on exports.
There is now a clear choice. Countries such as the US and Britain need to have a period in which the structure of their growth changes: they need to be less dependent on consumption and put a greater emphasis on investment and exports. But this will lead to the global economy running at a lower level of aggregate demand unless the surplus countries expand spending in their domestic markets.
So that’s one problem. The other is what to do about the financial sector, where far too many institutions fall into the category of “too big to fail.” Just over a year ago, there was a meeting of the G7 at which there was a discussion about how the leading Western nations would cope if a major US investment bank went belly up. After humming and hawing for a while, the gathering decided that it was too difficult a question to answer and went to have dinner instead. As things turned out, it was the most expensive sushi in history.