The world's leading economic forecasters have been marking down their growth estimates for 2012 due to the ongoing euro crisis and the prospects of a recession in euro-land this year. Business, government and citizens are thus preparing for tougher times in the immediate period ahead.

But the world economy will face a long haul on the road to recovery in the coming years.  It will also be important to prepare for the inevitably new and different realities after the resolution of the crisis.  The light at the end of the tunnel could shine on a fundamentally different economic landscape.Recent ups and downs in the world economy

When the Lehman shock struck in September 2009, the global community through the G20 and other processes responded very decisively with economic stimulus.  The global economy bounced back quickly.  The US economy returned to growth of 3% in 2010, and emerging Asia also roared back with 9 1/2% growth, and became a locomotive for the global economy.  Australia did much better than other developed OECD countries, sailing through hardly missing a heart beat.  Many imagined that it was just a matter of toughing it out before we would see a return of the good times.

Then the euro zone descended into turmoil.  At first, the case of Greece seemed trivial -- it is after all a tiny economy.  But euro governments bumbled in their response, and markets progressively focussed on unsustainable finances in a number of other euro economies.

Euro governments have spent a year or more trying to play catch-up.  As they persist in negotiating among themselves, they are in fact trying to negotiate with reality, an impossible proposition -- like the cancer patient who begs his doctor to allow him a few cigarettes.

This mess is now dragging us all down.  The IMF, World Bank and others have recently published new forecasts for this year and next. According to the IMF, the global recovery is threatened by intensifying strains in the euro area and fragilities elsewhere.  The IMF has just slashed 3/4 of a percentage point off world economic growth for this year and next relative to its previous forecasts released last September.

World output might now grow by 3 1/4% in 2012 and 3 3/4% in 2013, a big drop from 2010's growth of 5 1/4%.  Growth in emerging Asia has also been cut by 3/4 of a percentage point to around 7 1/2% for both 2012 and 2013.

But according to the IMF, downside risks have risen sharply.  In other words, world output growth is likely to be even lower for several reasons. Adverse feedback loops between sovereign and bank funding pressures in euro-land could put downward pressure on credit and output.  In the US and Japan, there are no serious plans for fiscal consolidation.  A hard landing of some key emerging economies can't be ruled out. And world oil markets are exposed to supply risks due to growing geopolitical tensions in the Middle East and North Africa.

These and other downside risks will cast a heavy pall over the world economy for many years to come.  There will be much damage to the world economy in terms of foregone GDP growth, missed investment opportunities and loss of skills by the long-term unemployed.  Business, government, and citizens will have to prepare for dealing with these realities. The remainder of this note will discuss some of the main factors that will shape this economic landscape.

Debt and deleveraging

The long boom in the world economy leading to the global financial crisis was substantially financed by a global credit bubble and buildup in debt. Thus many of these world's leading economies now have excessive levels of private and government debt which must be worked off ("deleveraging").  As the recent McKinsey Global Institute reminds us, the deleveraging process which began in 2008 is proving to be long and painful.

The deleveraging process is still in its early stages in most economies.  In the US, households have made much progress in reducing their debt relative to disposable income.  Their debt could reach sustainable levels in the next two years or so.  Progressively, consumers are now spending again, helping the economy move to a solid growth path.  But there is still no serious plan for tackling the exploding government debt.

In Europe, deleveraging is proceeding much more slowly.  In the UK and Spain, it could take a decade to reduce private sector debt to sustainable levels.  The effect of fiscal austerity on economic growth is also undermining the capacity of European economies to reduce debt burdens.

In time, the long and tortuous deleveraging process is also set to collide with accelerating health and pension costs of ageing populations.  Reducing the scale of these benefits will be unavoidable, and will provoke domestic social and political tensions.

Japan is the big bogeyman with gross government debt now over 200% of GDP (the highest of the OECD countries), with no serious plans for getting this under control.  Observers are wont to note that almost all of this debt is held domestically, much by public organisations or organisations over which the government has substantial influence.  But Japan's rapidly ageing and declining population will push the country's current account from surplus into deficit in the coming years, as retirees run down their savings.  At some point a loss of confidence could provoke capital flight and send the country into a financial crisis.  In contrast to Europe, it is hardly likely that Japan would go cap in hand to its neighbour China.

In short, excessive debt will cast a long shadow over the world economy for many years to come, with the risk of more crises to come -- all the more so given that many of the big debt culprits do not have serious plans in place to tackle excessive government debt.  And all those economies and businesses, especially in Emerging Asia and Australia, that benefited for a long period of debt-driven growth will have to adjust to a dramatically different reality because there will be no return to debt-driven growth.

Emerging Asia in search of a new growth model

It is no coincidence that the big, long boom in China, other emerging Asian economies and Australia coincided with the global credit bubble.  Asia's export-driven growth has mainly targeted Western countries.  Much is made of the rapid growth in intra-regional trade in East Asia.  But a large share of this is trade in parts and components along supply chains whose final products are sold in Western markets.

Hence, there has been the call for Asian economies to "rebalance" their growth away from Western demand to domestic and regional demand.  This is a complex agenda for economies which have sat back and taken Western markets for granted.  East Asian economies responded decisively to the Lehman shock through fiscal stimulus and easier money.  But in some countries this created its own problems in terms of property bubbles, wasted investment and debt accumulation (especially at the sub-national level in China).  And very little reform has taken place to remove the pro-export policy biases, to adopt market-oriented exchange rate regimes, to remove barriers to domestic service sector development, to strengthen financial systems, or to boost domestic demand by putting more money in citizens' pockets (including through social security, pensions and education).

As emerging Asia searches for a new growth model, many challenges will have to be tackled. China, for example, is bristling with social and political tensions due to the wide income gap between rich and poor, labour unrest, human rights' abuses, rampant corruption, land grabs, and environmental damage.  Thus, with a change of leadership coming up, the Chinese Communist Party is increasingly nervous, and social and political repression is on the rise.

In practical terms, this means that the Chinese government is trying not to rock the boat, and will be in a state of policy paralysis for a couple of years, at a time when a new wave of reform is more than necessary.  Countries like Australia, which have been riding on the coat-tails of the Asian tigers, will be much more vulnerable than in the past.

Exchange rate movements

Strong economies have strong exchange rates, and in times of global uncertainty investors flock to safe havens.  This means that the US dollar is bound to strengthen in tandem with the pick up in the US economy, and once the 2012 Presidential elections are out of the way, with the likely reelection of President Obama.  A strong exchange rate will stifle a renaissance of the US manufacturing sector, and also mean that global imbalances remain large and remain a source of contention between the US and China.

Well managed countries like Australia and Switzerland will also remain safe havens.  While high exchange rates provide consumers with lower-priced imports (including for overseas travel), they also mean greater competitive pressure on import-competing and export industries.  For example, Australia, whose exchange rate is mainly driven by a mining boom, may well undergo a hollowing out of its service and manufacturing sectors as more electronically deliverable services like accounting, finance and back-office services are outsourced to India and the Philippines, and uncompetitive manufacturing activities get scaled back.

These new realities will require a positive strategic response by Australian business and government.  Australia has a place in the global value chain, but given its cost structure, it must move further up the ladder.  And given its lack of critical mass, it can only be competitive in niche areas.

Global policy paralysis

The G20 leaders' meetings in the immediate aftermath of the Lehman shock provided hope for a new burst of energy in global governance.  As things stabilised, the fundamental differences between countries re-emerged, and little progress has since been made in areas like global financial regulation.  The response of the European Union to the euro crisis demonstrates the difficulties of international cooperation.  If like-minded countries, whose destinies are so intertwined, have difficulty getting their act together, who can?

Thus, the decidedly unambitious international trade talks (the "Doha Development Agenda"), launched over a decade ago are now as dead as a dodo.  Climate change talks bumble on from one agreement to meet again to yet another.  And when its comes to security issues like the Arab spring, there is a sharp irreconcilable divide between Western countries and the leading emerging countries.  The latter are reluctant to side with the West, and some like China and Russia are worried about the risks of revolution at home.

At the domestic level, policy reform is stuck in most parts of the world, protectionist pressures are rising and anti-migrant sentiment is evident.  It is a time when great leadership is needed, but horribly absent.  Barack Obama, Angela Merkel and Hu Jintao are acting more like mediators between different interest groups, rather than leaders.

Bright side of the moon

As gloomy as much of my discussion may seem, we cannot rule out the possibility of some positive surprises.

Recessions and crises can indeed be breeding grounds for entrepreneurship and innovation, and provide new sources of growth.  Companies like Microsoft, Nokia, Google, and Blackberry were all born, or reborn, during an economic downturn. In fact, over half of the companies on the 2009 Fortune 500 list began during a recession or bear market.

Firms based on constant innovation can also become “life-saviors” in times of economic depression and serve as “fast-start engines” during recovery. Both Apple and Amazon, for example, reported the best earnings in their company history of the companies during the 3rd quarter of 2009.

Countries can surprise too.  Some 50 years ago, when Korea was behind most African countries in terms of economic development, no-one imagined that "the land of the morning calm" could become an advanced, industrial democracy in virtually the space of a generation.  Today, Burma (or Myanmar) is opening and changing in ways barely imaginable a couple of years ago.  And one should not rule out the possibility of change in North Korea.  One day, its elite may decide that opening up, rather than repression, represents its best chance for survival.

East Asia's economic development has been driven in a "flying geese" pattern with, at various points in time, a newcomer taking the lead.  In the same way that Vietnam took the lead over from China, Burma and then North Korea could follow suit.  Burma is a very promising case, rich in natural and agricultural resources, and a potentially vital link between East and South Asia.  And peace on the Korean peninsula would generate a massive peace dividend, and prospects for a new growth engine in North East Asia.

Concluding comments

The global financial crisis and the European sovereign debt crisis have brought to an end two decades of hubris after the end of the Cold War and the beginning of the age of globalisation.  It is now time to re-group and prepare for a long, slow haul of recovery, and the next phase of the globalisation journey where there can be no return to the heady days of pre-crisis growth.

As Charles Darwin taught us more than a century ago, only the fit will survive.  It's time for us all to get fit.

References:

International Monetary Fund.  World Economic Outlook Update.  24 January, 2012

http://www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm

McKinsey Global Institute.  Debt and deleveraging: uneven progress on the path to growth.

http://www.mckinsey.com/insights/mgi.aspx

OECD.  Innovation Strategy.

www.oecd.org/innovation