The Crisis Isnt Over Yet

By Erik Tollefson

Herb Stein, a former chairman of the Council of Economic Advisors, once famously quipped ``things that cannot go on forever don't (they stop).''

Although he wasn't explicitly referring to the onset of the current economic crisis, many may mistakenly believe that once the proper policy adjustments have been made and corporate malfeasants jailed that things will return to ``normal.''

While a reformed and simpler financial system, as well as better and more comprehensive government regulation, may help to correct past problems, current efforts will neither prevent another financial crisis from occurring nor the painful economic restructuring that needs to occur after the financial adjustment.

The latter problem, commonly referred to as ``global imbalances,'' was arguably one of the main causes of the financial crisis, and unlike more politically charged issues, has not been dealt with in a substantive manner.

``Global imbalances'' is a rather abstruse concept; put more simply, it refers to the existence of chronic surpluses and deficits posted by several key countries in the global economy.

For example, the United States has chronically run a current account deficit (peaking at roughly $790 billion in 2007) on the back of a trade deficit and low savings rate.

China, on the other hand, has posted trade surpluses since 2004; so did many countries in the Middle East due to high oil prices.

While the reasons for global imbalances are varied, including most importantly an increasingly interrelated global trading and financial system with new emerging players such as China and India, the important thing to remember is that in the end deficits and surpluses globally have to equal zero.

To put it another way: The excess reserves in China and other surplus countries has to go somewhere. While reserves could be used domestically, China chose to invest a large portion of its assets in U.S. treasury bonds to keep the yuan effectively pegged against the U.S. dollar, which led to a substantial flow of capital into the U.S.

Some of that money went into the U.S. housing sector, which coupled with low domestic interest rates, led to lower ending standards and an increase in subprime lending. Global imbalances also played a key role in keeping interest rates low globally and distorting incentives for investors to take risks they were not being adequately compensated for.

There has been some progress in dealing with this problem. Countries that previously posted chronic trade surpluses, such as China, Germany, and Japan, have experienced a steep reduction in exports. Japan recently reported a roughly 50 percent annual drop in exports in February alone.

This precipitous drop in exports is needed to correct previous imbalances as consumer demand in the U.S. and EU plummets; a reduction in exports, however a necessary but not sufficient response to solve the problem.

Indeed, a true correction in global imbalances can only happen if consumption increases in surplus countries and economic resources previously dedicated to the export sector are reallocated to other sectors focused more on domestic consumption tastes.

This change arguably isn't happening, in fact, there is ample evidence that some countries are doubling down to insure that exporters survive the downturn.

The Chinese government has recently announced numerous policies to protect failing exporter sectors such as textile, machinery, and shipbuilding to prevent a substantial increase in unemployment.

Finally, while leaders at the G20 partially addressed the issue through proposing reform at the International Monetary Fund (IMF), these are largely precursory in nature and fail to deal with the complex political economy issues underpinning the problem.

Overall, Asia is at the heart of the global imbalance debate and will be profoundly affected by how the problem is ultimately solved. Currently, most countries in Asia depend on exports for economic growth, some for a majority of their economic prosperity.

This economic structure will inevitably have to change over the long-term as U.S. consumers save more and Asian countries are forced to adopt policies to boost domestic demand.

As a result, firms in the export sector will face pressure to offshore jobs or substantially change their business model (or a combination of both) as wage levels naturally rise leading to increased displacement in the labor sector.

Countries with poor or substandard pension and social safety nets may witness a sizable increase in the working poor at the same time fewer younger workers face increasing tax burdens for retirees.

While new opportunities will undoubtedly emerge over the long-term, the societal symptoms one commonly associates with a crisis such as societal displacement, confusion, and a palpable economic and political shift will occur over the long-term.

While the high-level of market volatility over the past two years may not be repeated any time soon, one thing is for sure: As one of the main causes of the financial crisis remains undealt with, the crisis isn't over.

Erik Tollefson is an independent economic consultant based in Seoul. He can be reached at erik.m.tollefson@gmail.com.