Resilience Is Not Forever

Imagine it's the early fall of 2000, and you're asked to play futurologist and determine how the world economy will look in four years' time. To make your task easier a soothsayer whispers that the long expansion of the 1990s is about to end in a resounding bust of the dot-com bubble; all the major world economies for the first time in many years will soon be in recession simultaneously; the world will be shocked politically and economically by horrendous terrorist attacks on U.S. territory; financial markets will be further challenged by both the biggest sovereign debt default and the largest private-sector bankruptcies in history, not to mention nasty corporate scandals; the U.S. will fight not one but two regional wars with significant geopolitical consequences; and in four years the price of oil will be 50% higher.

Had you believed your soothsayer's dire pronouncements, your predictions for 2004 would probably have been terribly gloomy, to say the least. Well, as we all know, those disasters did occur, but a shattered global economy in 2004 did not result. That's not to say that the road from the end of the dot-com euphoria has been painless. However, global growth in 2004 will be the highest it's been in nearly 30 years, and inflation--despite the recent explosion in commodity prices--remains at historically low levels.

Causes of Resilience

By any measure, the international economy since 2000 has exhibited unprecedented resistance to some ugly shocks. Exploring the reasons for this is not an idle exercise, as we can gain valuable insights for the future. I submit that the world economy has been able to weather these storms because important reserves for maneuvering had previously been built into the system. Take the U.S. economy, the chief global locomotive. Its recession in 2001 was one of the shortest in history, and not too long afterward the U.S. was able to lead the global recovery. Ample fiscal stimulus--through sizable tax cuts and increased government expenditures--coupled with expeditious monetary accommodation were absolutely crucial to shortening the valley of the business cycle and avoiding a much bigger economic disruption. Fiscal laxity was possible and effective, however, because the slowdown and subsequent unsavory surprises found the American economy in a position of great fiscal strength, with a sizable fiscal surplus and a declining public debt. This, along with the enormous reserve of credibility that U.S. monetary authorities had built over many years through their firm stand against inflation, was also the reason monetary expansion could proceed aggressively without fueling inflationary expectations.

The increasingly successful globalization of newly emerging economic powers created other reserves of resilience, most notably China. Depending on the method of measurement, this country's growth alone is responsible for up to a third of the total increase in global output since 2001. To no minor extent, China's dynamism compensated for the sluggishness registered in other parts of the world.

Having endured the storm pretty well, will the world economy be able to sustain the recovery and avoid a major derailment if confronted with another major shock? Risks on the downside abound. Much higher oil prices, episodes of violent conflict that have significant geopolitical consequences, the fragility of Europe's and Japan's recoveries and doubts about China's landing (will it be hard or soft?) from its present investment boom are some of the elements in the risk agenda for the near future.

Unsustainable Borrowing Binge

Yet, for good reason, the biggest concern stems from the global imbalance: a huge current account deficit in the world's biggest economy, the U.S., coupled with sizable surpluses in practically all the other major economies, developed or emerging. Since the current account deficit reflects the excess of expenditure over income, it only comes with increasing U.S. indebtedness, which, logically, cannot continue forever. Part of this imbalance is a reflection of the fact that the U.S. economy, because of its sustained growth in productivity and other structural strengths, is considered to be a more attractive place to invest than anywhere else. But there is more to it; for too long the U.S. has had a declining savings rate, a trend that recently has been accentuated sharply by a mushrooming fiscal deficit.

Inevitably that trend will be corrected. The choice is not between adjusting or not adjusting, it's between orderly or chaotic adjustment. At the end of the day, the latter is much more painful than the former. Orderly adjustment is not, of course, a piece of cake. It requires recognizing that sooner rather than later fiscal deficits do matter, that an expansive monetary policy can become a curse rather than a cure and that no currency has the eternal confidence of investors divinely bestowed upon it. Harsh decisions must be made to confront these mulish certitudes. Macroeconomic coordination with the relevant countries would go a long way toward easing the pain of adjustment. Admittedly, in the short term even orderly adjustment would be accompanied by slower economic growth. But if you dislike this scenario, consider the alternative:a messy combination of much higher interest rates, high inflation, financial panic, rampant protectionism, a long recession and eventually, in order to fix the mess, a much tighter belt. Better to admit now that resilience does not last forever, and act accordingly.