A World of Hurt

The G-8's challenge: Stop bickering and craft a growth plan

Every summer, the heads of state from the Group of Eight meet for a summit. Frequently held at picturesque tourist spots -- this year's June 1-3 meeting is at Evian, France, on the south bank of Lake Geneva -- the gabfests are known more for their photo ops than for the policies they produce. Sure, the leaders of the U.S., Japan, Germany, France, Italy, Britain, Canada, and Russia issue lengthy communiqués after their talks. But more often than not, they don't seem to say much at all. And, in the end, it doesn't seem to matter.

This year, though, the stakes for the summit are a lot higher. The confab is coming at a critical time for the global economy. The much-hoped-for postwar bounce in U.S. economic activity is still a mirage. Fears about global deflation are mounting. And relations between the U.S. and its allies, still frayed from a divisive split over the Iraq war, have further deteriorated over trade tensions and the falling value of the dollar. "The world economic outlook is very soft and getting softer," says C. Fred Bergsten, director of the Institute for International Economics think tank. "What's needed is a serious global growth strategy."

Global growth, of course, won't improve much until the U.S. economy gets back in gear. U.S. growth is likely to run at an annual rate of just 1% to 1.5% in the second quarter, nearly two percentage points below the economy's productivity-powered potential. While he sees a pickup in growth as likely, "the timing and extent of that improvement continue to be uncertain," Federal Reserve Chairman Alan Greenspan told lawmakers on May 21.

In response to prodding from President George W. Bush, Congress is scrambling to pass a tax cut and stimulus package intended to give the economy a boost. As BusinessWeek went to press on May 21, House and Senate negotiators were closing in on a roughly $350 billion program that would slash tax rates on most dividends and capital gains to 15% through 2008. Reductions in tax rates on wages and interest that had been scheduled for 2004 and 2006 would also be accelerated.

That should bring some much-needed stimulus to the U.S. But meanwhile, Japan and Europe look to be in danger of dipping back into recession. Gross domestic product in Germany, the euro zone's biggest economy, declined by 0.2% in the first quarter. And given weak domestic demand and the sharp appreciation of the euro, economists are increasingly skeptical about the country's ability to recover later this year.

For a global growth strategy to have much success in reversing these worrisome trends, it would need to be closely coordinated and multipronged. Europe needs to cut interest rates sharply, loosen its tight budget stance, and get to work on reforming and deregulating its rules-ridden economy. Japan must finally clean up its debt-burdened banking system and act even more aggressively to counter deflation. And in the U.S., the Fed should ease credit still further if growth hasn't picked up by the time of its June 24-25 meeting.

Perhaps just as important for reviving business confidence, G-8 leaders need to show that they can put aside their differences over Iraq and act together for the good of the global economy. That means shunting aside vested interests in agriculture and other industries and reenergizing stalled global trade negotiations. It also means working together to ensure that the dollar's until-now-welcome decline doesn't turn into a rout that roils financial markets.

Unfortunately, the chances of such a strategy emerging from the summit seem remote. While the U.S. appears to have patched over differences on Iraq with Russia and, to a lesser extent, Germany, much ill will remains between Bush and French President Jacques Chirac, the summit's host.

What's more, there are signs that the rancor over Iraq is spilling over into the economic arena. Rather than pulling together to rev up the global economy, the U.S. and its industrialized allies look increasingly to be going their own way in what some economists describe as a "beggar thy neighbor" strategy.

Trade relations between the U.S. and Europe are at their worst point in years. The Europeans are threatening to levy $4 billion in penalty tariffs against the U.S. as early as January if Congress doesn't repeal the 30-year-old tax break for exporters. The U.S., meanwhile, is threatening its own action against a European moratorium on imports of genetically modified corn, soybeans, and other crops from the U.S. The growing enmity between the two trading blocs has held up global negotiations for freer trade at the Geneva-based World Trade Organization. The WTO talks "are losing momentum" complains Boeing (BA ) Co. CEO Philip M. Condit.

On top of that, the dollar's steep decline is starting to fan friction, with Japanese and European officials complaining that the U.S. is deliberately trying to push its currency down to boost exports at their expense. At a May 17-18 meeting in Deauville, France, of G-8 finance ministers to iron out an agenda for the summit, policymakers butted heads over how to deal with the dollar and what to do to spur global growth. U.S. Treasury Secretary John W. Snow gave the green light to a further dollar decline by all but abandoning a strong-dollar policy. But his French host at the Deauville meeting, Finance Minister Francis Mer, said the euro has gone as high as it can go without causing pain to Europe.

Yet the U.S. faces risks as well. If the dollar's decline spirals out of control, foreign investors could become unnerved and begin yanking money from the U.S., sending stock and bond markets skidding lower.

At the heart of the increasing economic acrimony: a deficiency of global demand. For years, Europe, Japan, and China derived huge benefits from strong spending by U.S. consumers and companies, where the appetite for imports during the go-go 1990s fired up growth around the world. Now, with the U.S. economy struggling, the paucity of demand overseas is a huge problem. And there's no relief in sight. The scourge of deflation is encouraging Japanese consumers to save rather than spend.

Rising joblessness is having a similar impact on consumers in Europe. That's especially true in Germany, where unemployment has risen to 10.7%, its highest level since unification of the country. Private consumption in Germany fell 0.6% in the first quarter from a year ago, and an early recovery looks unlikely given recent tax and social security contribution hikes.

What's more, the 30% appreciation of the euro against the dollar over the past 17 months is starting to bite. One after another, European companies are complaining that the surging euro is hurting exports and profits. German media giant Bertelsmann says the weak dollar was responsible for the slide in its first-quarter sales, to $4.4 billion from $4.8 billion a year ago. Volkswagen blames the exchange rate for the 3.9% drop in its first-quarter sales in the U.S., which in turn was partially responsible for lopping $470 million off its pretax profits.

Pressure is mounting on the European Central Bank to cut interest rates. That would boost domestic demand in Europe and cushion the impact of the rising euro on the economy. "The ECB needs to go down 100 basis points," says Michael Mussa, former chief economist at the International Monetary Fund.

Japan, too, looks as if it could relapse into recession. Its economy came to a virtual standstill in the first quarter. And the outlook is grim. Diminished export growth, the deflation scourge, overcapacity, and a very sick banking system are taking their toll. The latest blow to the problem-plagued Japanese economy came on May 16, with news of a $17 billion government bailout of Resona Bank, Japan's fifth-largest. The fear is that other banks could follow suit, leading to more costly bailouts. In response to the crisis, the Bank of Japan pumped more liquidity into the banking system on May 20, but may need to do more.

The worldwide dearth of demand is raising fears of global deflation. With companies awash in capacity, the pressure is on corporate chieftains to cut prices to move product. China, too, with its seemingly unlimited supply of cheap labor and factories spewing out goods for the international market, is also dragging down prices globally. And that's putting downward pressure on inflation worldwide. Greenspan acknowledged on May 21 that deflation was a "possibility" in the U.S., though he seemed to downplay the danger.

In fact, it's not the U.S. that's most at risk from falling prices. "Germany is within a few months of being in a deflationary environment," says Nariman Behravesh, chief economist at consultants Global Insight Inc. An IMF study on May 18 put the risk of deflation in Germany at high because of rising unemployment, a weak banking system, and lofty European interest rates.

With demand depressed and deflation a danger, it's no wonder that tensions over trade and the dollar are increasing. And it's in those two areas where the summit could make a big difference by kick-starting the WTO trade talks and by assuring investors that the G-8 is united on the need to avoid wild, disruptive swings in the dollar. At a time of increasing worries over the global economy, the G-8 summit leaders have a genuine opportunity at Evian to adopt an ambitious package to spur growth. Yet the history of G-8 summits suggests that world leaders may well fail to seize the moment. If that happens, the world economy will be worse off for it.

By Rich Miller and Paul Magnusson in Washington, and David Fairlamb in Frankurt, with bureau reports

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