Failure to Summit

Governments may not be able to address the deep-rooted problems in the current economic models. Government spending, if it can be financed, may not be able to adequately compensate for the contraction of consumption and lack of investment made worse by over capacity in many industries.

Government spending has little multiplier effect or velocity. The badly damaged financial system means that the circulation of money in the economy is at a standstill. While government spending may provide short-term demand boost and capital injections may partially rehabilitate banks, it is far from clear what will happen when all these measures are reversed.

Governments and central banks have limited available tools. Keynes famously described monetary policy as the equivalent of "pushing on a string." Given that interest rates are now at or approaching zero in many developed countries, there is no string at all.

Fiscal policy could be described as "pulling on the same string." The experience of Japan is salutary. Zero interest rates and repeated doses of fiscal medicine have not restored the health of the Japanese economy, which remains mired in a form of suspended animation. The rest of world’s current struggle is to avoid turning "Japanese."

Correcting global imbalances provides greater challenges. The world has relied heavily on debt-fueled American consumption to drive global growth. With 5% of the world’s population, the US is 25% of global GDP, 20% of global consumption and 50% of global current account deficit.

The US needs to decrease consumption, increase savings, reduce debt, export more and import less. The countries with large savings and trade surpluses need to do exactly the opposite: specifically, encourage domestic consumption. Currently both surplus and deficit countries are doing the opposite of what is required.

The challenge is evident in two telling statistics. Consumption is around 40% of the economy in China against over 70% in the US. Average earnings in China are only 10% of that in the US. The size of the adjustment is substantial.

David Rosenberg, an economist from Merrill Lynch, describes the process of adjustment: "This is an epic event; we’re talking about the end of a 20-year secular credit expansion that went absolutely parabolic from 2001-2007. Before the US economy can truly begin to expand again, the savings rate must rise to pre-bubble levels of 8%, the US housing stock must fall to below eight-months’ supply, and the household interest coverage ratio must fall from 14% to 10.5%. It’s important to note what sort of surgery that is going to require. We will probably have to eliminate $2 trillion of household debt to get there, this will happen either through debt being written off, as major financial institutions continue to do, or for consumers themselves to shrink their own balance sheets."