di Martin Wolf

It is nearly three years since the world became aware of the coming financial tremors. Since then we have experienced a financial sector earthquake, a collapse in economic activity and an unprecedented monetary and fiscal response. The world economy has now recovered. But this crisis is far from over.

As Raghuram Rajan of the University of Chicago Booth School of Business and former chief economist of the International Monetary Fund notes in a thought-provoking new book, the underlying “fault lines” are still with us.* More trouble may lie ahead. His voice is worth listening to: in 2005, he presented a controversial, yet now acclaimed, paper at the annual Jackson Hole monetary conference entitled “Has Financial Development Made the World Riskier?” His answer? Yes.

We already know that the earthquake of the past few years has damaged western economies, while leaving those of emerging countries, particularly Asia, standing. It has also destroyed western prestige. The west has dominated the world economically and intellectually for at least two centuries. That epoch is over (see charts). Hitherto, the rulers of emerging countries disliked the west’s pretensions, but respected its competence. This is true no longer. Never again will the west have the sole word. The rise of the Group of 20 leading economies reflects new realities of power and authority.

Yet this is far from the only change in the global landscape. The crisis has revealed deep faults within western economies and the global economy as a whole. We may be unable to avoid further earthquakes.

In his book, Prof Rajan points to domestic political stresses within the US. Related stresses are emerging in western Europe. I think of it as the end of “the deal”. What was that deal? It was the post-second-world-war settlement: in the US, the deal centred on full employment and high individual consumption. In Europe, it centred on state-provided welfare.

In the US, soaring inequality and stagnant real incomes have long threatened this deal. Thus, Prof Rajan notes that “of every dollar of real income growth that was generated between 1976 and 2007, 58 cents went to the top 1 per cent of households”. This is surely stunning.

“The political response to rising inequality … was to expand lending to households, especially low-income ones.” This led to the financial breakdown. As Prof Rajan notes: “[the financial sector’s] failings in the recent crisis include distorted incentives, hubris, envy, misplaced faith and herd behaviour. But the government helped make those risks look more attractive than they should have been and kept the market from exercising discipline.”

The era of easy credit, much of it backed by housing, is now over (see chart). Meanwhile, in all western countries, the state supports the welfare of the individual. But the fiscal consequences of this crisis – a huge rise in deficits – will interact with pressures from ageing, to make fiscal stringency the theme of policy for decades. The long bear market in shares and prospects for a “jobless recovery” add further to these woes.

It is little wonder then that the politics of western countries and, above all, of the US have become discordant. President Barack Obama – a pragmatic centrist – is vilified. On the right, the call is to overthrow the modern government in an effort to return to the 18th century. This, then, is a crisis of government itself.

Exacerbating these internal fault lines within western economies are those in the world economy. Here Prof Rajan notes two risks: first, the structural export-dependency of a number of economies, particularly Japan, Germany and now China; and, second, the unresolved clash of financial systems. The interaction between global fault lines and those inside the domestic economies of western countries, particularly the US, helped trigger the crisis and now make it hard to rebuild after it.

As Prof Rajan notes, a number of significant countries have built their economies around exports. The resultant dependence on foreign demand means the credit-dependence they proudly avoid at home emerges abroad. The constraint upon them is what Prof Rajan describes as a “politically strong, but very inefficient domestic-oriented sector”. The problem is that the countries that used to provide the demand – the US, at world level, or Spain, in the eurozone – have over-indebted private sectors. So we see a zero-sum battle over shares of structurally deficient global demand. This is a threat to survival of the eurozone and even the open world economy.

Similarly, it has proved extremely hard to manage the integration of market-based financial systems with ones based on personal and even political relationships. Episodes of large-scale capital inflows from the former to the latter ended up in crises. This then led to the huge accumulations of foreign currency reserves that helped to drive the current crisis. Today, the risks of large-scale capital flows across frontiers are all too disturbingly evident. It may even be hard to sustain financial integration.

The crisis, then, can be seen as the product of fault lines inside advanced western economies – above all, the US – and in the relationships between advanced countries and the rest of the world. The challenge of returning to some form of reasonable stability, while maintaining an open global economy, is enormous. Anybody who thinks that the present fragile recovery represents success with these tasks is myopic, at best.

We can see two huge threats in front of us. The first is the failure to recognise the strength of the deflationary pressures (see chart). The danger that premature fiscal and monetary tightening will end up tipping the world economy back into recession is not small, even if the largest emerging countries should be well able to protect themselves. The second threat is failure to secure the medium-term structural shifts in fiscal positions, in management of the financial sector and in export-dependency that are needed if a sustained and healthy global recovery is to occur.

The west is not the power it was; its debt-fuelled consumers are not the source of demand they were; the west’s financial system is not the source of credit it was; and the integration of economies is not the driving force it proved to be over the past three decades. Leaders of the world’s principal economies – both advanced and emerging – will need to reform co-operatively and deeply if the world economy is not to suffer further earthquakes in years ahead.

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