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A Weakening World Economy Faces a Host of Challenges
: : By Douglas O. Walker

Dr. Douglas Walker is a Professor of Economics in the Robertson School of Government at Regent University. Previously, Dr. Walker served as a senior economist with the United Nations Department of Economic and Social Affairs monitoring and forecasting current developments in the world economy. He has also served as a consultant to governments in the design, development and implementation of information systems and econometric models for forecasting and macroeconomic management. In this capacity, he undertook many missions to countries in Asia, Africa and Latin America as an advisor to governments. He may be reached for comment at dougwal@regent.edu

The year 2008 has been one of financial turmoil and economic slowdown, not only in the United States, but across the globe. The deterioration in performance at home is now being matched by that abroad, and this deterioration is expected to continue and could be severe and long-lasting.

The End of the World Upturn
The global boom preceding the downturn of 2008 was mild by historical standards, but it was widely shared and, until recently, appeared to set the stage for an ongoing and long-lasting expansion of the world economy. For more than half a decade, economic activity had increased at average rates well above five percent annually in the developing countries of Africa, Latin America and the Caribbean, Western Asia, and South and East Asia. Spurred by high prices for commodities such as oil, gas, metals and cotton, growth was even higher in the transition countries of Russia, the Ukraine, and other countries of the Commonwealth of Independent States. Although slower, the pace of growth in the more economically advanced areas of Europe, North America, Japan and Australia/New Zealand had, nonetheless, picked up markedly after the world downturn of 2001 and 2002. The widespread upswing since 2003, was bolstered by a very rapid expansion in the volume of world trade, which increased at rates exceeding 10 percent from 2003 into 2007.

The boom of recent years was brought to an end by accumulating and unsustainable financial imbalances in the United States. A spreading falloff in world growth began in the fourth quarter of 2007, when the U.S. economy weakened markedly due to sub-prime mortgage woes, which greatly damaged its financial sector, and a surge in oil and other commodity prices, which aggravated its already outsized external deficit and lifted inflationary pressures.  As credit criteria became tighter and mortgage rates rose, the U.S. housing sector went into a deep decline, and housing inventories rose substantially while housing prices fell significantly.  High and rising oil prices sapped consumer purchasing power and started an economy-wide adjustment process that negatively affected the auto industry and other energy-dependent sectors of the economy. 

Early in 2008, recession fears and concerns about rising default risks spread to the U.S. corporate bond market, and questions were raised about the financial viability of the banking system and the government-sponsored agencies Fannie Mae and Freddie Mac. Confidence in U.S. financial markets fell, the dollar slumped and foreign buyers of U.S. Treasuries and corporate bonds began to sell their holdings as the Federal Reserve eased U.S. monetary policy.  As the financial tumult worsened, American banks and financial service firms began to recognize the losses and write-down the value of their securities, leading to the effective bankruptcy of a number of large financial institutions such as Bear Stearns, Lehman Brothers, Merrill Lynch, and the insurance giant AIG. The turmoil continues today.

Spreading Difficulties Across the World
It is important to note that the difficulties before the U.S. are shared by other countries.  Domestic demand in all the more economically developed areas of the world has slowed sharply this year as financial disturbances restrain investment and rising prices weigh on consumption.  GDP in the Euro area, for example, fell in the second quarter, and the European Commission has just marked down its estimates for growth for all of 2008 in Europe as a whole, with recessions forecasted for Germany and Spain next year on the basis of a host of downbeat indicators, including orders, retail sales, export prospects and inflationary pressures. Reports from Japan’s Cabinet Office indicate that its economy may be deteriorating. The potential for turmoil is building in these countries.

Growth in many developing countries remains robust to date, but that may be changing.  Capital flows to emerging markets dropped sharply in recent months, and equity markets in Russia, China and elsewhere have fallen by more than a quarter since the first of the year. In the deteriorating environment for world trade, export growth has eased in China and the momentum of exports from Latin America, especially Mexico, has slowed markedly. Oil demand by the more economically advanced countries measured in volume terms has been broadly declining for three years, and the pace of the decline picked up in 2008. With the recent plunge in crude oil prices, revenues into the oil producing countries are sharply off and  will dampen their economic activity and import demand.  Finally, industrial production in many developing countries is slowing, and there are scattered reports of slower GDP growth in this large region with more than 80 percent of the world’s population. The transmission of turmoil to these countries is quite possible.

The Coming Worldwide Downturn
The world economy now stands on the brink of a potentially deep recession. Financial markets in the major developed market economies and many developing countries are in a state of disarray, and the disarray is spreading. The pace of economic activity is slowing in many countries and the strong impetus international trade gave to world production is rapidly waning.  The large global imbalances that describe the external accounts of the United States and other countries persist and, at the same time, prices for primary commodities remain high and hold the potential to aggravate existing inflationary pressures. Risks to the current world economic situation, already difficult and worsening, must be considered high.

The key to overcoming the challenges now before the world economy is to understand that the standard tools of policy intervention, incremental fiscal and monetary policy measures introduced step-by-step, are not sufficient to re-establish the foundations for rapid and balanced world growth in an age of rapid technological advancement and fundamental demographic change.  Immediate efforts to stabilize the present situation and reform the financial sector here and abroad, are, of course, essential to both domestic recovery and the restoration of the channels of international trade and finance on which the prosperity of all countries depends. But, they will not be enough. Looking to the longer-term, overcoming the persistent and ongoing fiscal and trade deficits of the United States must be seen as a top priority.

The domestic economic profile and the international transactions of many countries, not only the United States, are described by huge deficits in their government budget, household, and external trade accounts that go back many years. The world enjoyed an extended period of economic expansion, low inflation, low interest rates and overall macroeconomic stability, dating back to the 1980s. But it was, nonetheless, accompanied by accumulating internal and external imbalances which raised indebtedness to the point of insolvency. In the case of the U.S., imbalances in its fiscal and trade accounts reached five to six percent of its GDP in recent years.  Similar imbalances can be seen in other countries.

Restoring the Foundations for World Growth
Restoring financial stability and economic growth to the world economy will mean eliminating these imbalances at a time when aging populations and rapidly changing patterns of international trade are already reshaping the world economic landscape. This will require a significant adjustment of patterns of production and a substantial restructuring of Wall Street and other financial markets.  Failure to do so will threaten the entire world economy in the months and years ahead. The most important contribution the United States can make is to strengthen its financial position by eliminating its outsized budget and trade deficits and supporting similar adjustments by other countries. 

Restoring the foundations for growth in the world economy is a challenge that will take many years and involve much sacrifice. If this challenge is not met, the unprecedented expansion in production and trade the world has enjoyed since the end of the Second World War may well come to an end.