How to Get Growth Back on Track

Fixing the worldwide liquidity crunch has revealed a deep-seated and disturbing problem: What looked like fast growth in recent years was in part an illusion created by excess borrowing
Guy Billout

Take a deep breath. The global bank rescue plan is in place, and though the stock market has dropped sharply, the world seems to have avoided another Great Depression for at least the next week or two. Now we have a moment to step back and assess how we got here and where we're going next.

Let's put it this way: The U.S. and global economies were traveling at high speed along a clear track, like an economic bullet train, when we ran into the unexpected credit crunch. Yes, we took quite a bit of damage, but we didn't derail. Now we come to the big questions: Should we simply clear the track and fix the engine—that is, tighten up government supervision and improve financial regulation—and go on our way? Or were we on the wrong track to begin with?

The bursting of the credit bubble suggests that the U.S. and global economies have a growth problem as well as a debt problem. According to the official numbers, economic growth in the U.S. has averaged 2.7% over the past 10 years. But by BusinessWeek's calculation, U.S. consumers have run up about $3 trillion in excess borrowing and spending over the same period—consumption that was not justified by income growth. Without that boost, which translated into new homes, cars, furniture, clothing, and the like, U.S. economic growth would have come in considerably lower. The global boom, too, was artificially fueled by out-of-control borrowing by consumers and businesses. "There was a sense of a bubble not just in real estate, but in that the underlying fundamentals were not supporting the market," says Michael Frantz, a Seattle-based managing director at project-management firm Point B, based on his conversations with clients.


The upshot? A multitrillion-dollar bailout of the global financial sector will still leave us with sluggish growth. George Magnus, senior economic adviser to UBS (UBS), says the industrialized countries would do well to average 1.5% annual growth over the next five years, compared with 2.6% over the previous five. Magnus pegs world growth at 3% a year over the next five years, down from the International Monetary Fund's latest forecast of 4.3%. Those declines are the difference between prosperity and tightened belts.

Can the U.S. and global economies get off the slow-growth track? Yes, but it won't be easy. One key is that U.S. companies have to pay more attention to sustaining productivity growth and innovation at home rather than resorting to outsourcing as their main source of cost savings. That would boost wages and incomes for U.S. workers and reduce the need for the U.S. to take on huge debts to pay for foreign-made goods.

The good news is that the private sector may be moving in that direction already. Dan Warmenhoven, CEO of NetApp (NTAP), a data storage company in Sunnyvale, Calif., says his customers are still buying, but they've shifted their behavior. "They are focused on making investments that reduce costs and increase efficiency," says Warmenhoven.

But the private sector can't do it alone. Policymakers around the world have to help, and that means doing more than simply fixing the global financial system. No matter how counterintuitive it seems today, with markets being bailed out by government action, China and other developing countries must take steps to encourage competition in their service sectors. Lowering prices would boost consumer demand and lessen the dependence of those countries on exports. And when the U.S. and other developed countries try to boost their economies by pumping up government spending, they must direct this fiscal stimulus toward spurring investment and innovation rather than consumer spending.


In many ways, the strong period of growth that just ended was a surprise. After the dot-com bust of 2001, info tech investment plummeted in the U.S. and took years to recover.

The fall of Enron, among others, led Congress to pass the Sarbanes-Oxley Act of 2002, an extra layer of costly regulation for businesses. On top of that, the 2001 terrorist attacks forced the country to spend hundreds of billions on security.

Despite that triple whammy, businesses continued to pump out big productivity gains—or so it seemed. According to the Bureau of Labor Statistics, output per hour rose by 2.1% from 2002 to 2007, a solid performance by historical standards. In the absence of strong investment, economists guessed that the gains were the result of companies learning to make better use of the info tech gear they already had.

Meanwhile, the global economy was undergoing its own improbable surge. Powered by China's expansion, global growth zoomed from an average of 3.1% per year during the 1990s to 4.6% per year in the five years from 2002 to 2007, its strongest showing since the late 1960s and early '70s.

But cracks appeared in the great growth trend as early as 2003. That's when real wages and salaries peaked in the U.S. From that point on, most workers saw their buying power drop. For example, adjusted for inflation, the usual weekly earnings of a worker with a bachelor's degree, supposedly a beneficiary of an information-driven economy, have fallen by 6% since 2003.

That drop in real wages offered the first clue that something was wrong. Historically, real wages have gone up in an economy with rising productivity. So either the productivity growth wasn't as strong as it looked or something else, perhaps competition from overseas, was holding down wages. In part, cost cuts from outsourcing were being reported as productivity gains because of a quirk in the economic statistics (BW—June 18, 2007).

In any case, here's where American lenders made their big mistake. When real wages started falling, they should have tightened their mortgage and consumer-credit lending standards and made it harder for households to borrow. Instead, they threw money at people whose real incomes were shrinking, not rising. Why did they do this? Greed, stupidity, and a genuine belief that a growing economy would enable Americans—even those with subprime loans—to pay back their debt. Under that scenario, the mountain of debt-linked securities would have been immensely profitable to financial institutions.

Looking back, it has become clear that rampant borrowing and spending by U.S. households concealed fundamental weaknesses in the rest of the domestic economy. U.S. economic growth, outside of personal consumption, averaged only 1.3% per year in the 10 years ending in 2007, the slowest rate since the 1950s. In other words, if consumption had not been pumped up by excess borrowing, the economy would have looked a lot weaker. From this perspective, the debt, like a fever, was a symptom of a deeper problem.

Not everyone agrees with this analysis. In a set of forecasts released in early October, economists at the IMF predict that global growth will return to 4% or greater after 2009. And Lexington (Mass.) forecasting firm Global Insight is still predicting long-term growth of 2.5% to 3% for the U.S. "If well handled, a financial crisis like this doesn't necessarily have a negative effect on long-term growth potential," says Nariman Behravesh, chief economist at Global Insight.

Others, however, believe the global economy has embarked on a long-term trend of slower growth, especially given the damage to the financial system and the need to finance the rescue. "There will be less innovation [in finance] and less credit expansion, so the speed limit for the growth of the economy will be lower," says Mohammed El-Erian, co-chief executive at Pimco, the giant bond-fund manager. "This will be the regime for several years." Adds Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University: "This credit problem, whenever it's solved, will have its fallout on the future growth rate of the economy. It is going to cost resources that could have been used for other things."


Some economists have an even more dire view. In the near term, "it may not be as bad as people think. The economy may recover and governments still have some ammunition," says Masaaki Kanno, Tokyo-based chief economist at JPMorgan Securities Asia. But as growth bumps along the bottom, he notes, the economy will dip back into a downturn, just as it did in Japan—and governments will find it harder and harder to stimulate growth.

A slow-growth world has big implications for companies. For one, it's likely that the prices of commodities such as oil and copper, already well off their peaks, will continue to fall. In the past, oil had its sharpest declines in years when global growth was slowest.

Similarly, industries that require long-term investment—aircraft, semiconductors, and cars—may find themselves squeezed by slower long-term growth. Air travel, for example, and demand for airplanes are highly sensitive to a slowdown in global growth. Recent forecasts suggest air travel will grow at 4% to 4.5% or more per year over the next 20 years. But if those optimistic projections don't come to pass, demand for planes will slow, which will affect not only aircraft manufacturers but also major leasing firms such as International Lease Finance, a unit of American International Group (AIG), and GE Commercial Aviation Services, a unit of General Electric (GE).

Similarly, sluggish auto sales, which go hand-in-hand with a slow-growth world, would be especially painful for Japan. Cars account for nearly 20% of the shipment value of Japanese manufacturing, and the auto industry employs about 8% of Japan's workforce. Unsurprisingly, Japan's exporters are hurting because of the slowdown in the world economy and the sharp appreciation of the yen. Even before the latest crisis, Toyota Motor (TM) projected that its operating profits will shrink 30% in fiscal 2008—the first drop in nine years. Given the global slowdown, Toyota may have to revise that projection downward.

Some companies are holding their plans steady, looking ahead to the post-crisis world. Samsung Electronics spokesman James Chung says the company has no plans to cut capital investments, research and development, or marketing spending. "We see the current crisis as an opportunity to expand our presence in an upturn," he says. Chung adds that Samsung is still seeking a $5.85 billion takeover of SanDisk (SNDK), which makes flash-memory products.

One question is whether a global slowdown will hit industries that have been resistant to downturns in the past, such as medical care. An ominous sign: Royal Philips Electronics (PHG), one of the world's three biggest players in hospital and medical equipment, reported that a drop in orders for medical gear in the U.S. hurt the profitability of its normally strong medical business in the third quarter. "In the U.S. there is a higher dependence on capital markets at hospitals for their financing," said Chief Financial Officer Pierre-Jean Sivignon during the Oct. 13 conference call announcing third-quarter earnings. "With the financial crisis continuing, we have no idea how long this situation will persist."


One imponderable is the effect of slow growth on state and local governments. Tax-revenue growth will surely drop off as income and business-sales growth slow and property values decline. And big costs such as Medicaid will escalate as people lose their jobs and get bounced from employer health care rolls.

But because they have the option to raise taxes and fees, state and local governments will feel less of a pinch from a slowdown than the private sector will, argues W. Bartley Hildreth, a public finance expert at Wichita State University.

Several things need to happen to get the economy off the slow-growth track. First, the private sector in the U.S. must concentrate on generating more productivity gains at home. In recent years, American multinationals took advantage of globalization to move more and more of their operations abroad. That made sense for the companies, but it created an unsustainable situation in which the U.S. had to keep borrowing from overseas to buy the goods made overseas. That accounted for a big portion of the excess-debt problem.

In addition, U.S. companies need to focus on creating more innovative goods and services that can be produced in this country and shipped abroad. Alas, in recent years the best examples of such exportable "innovations" were new financial instruments such as credit default swaps. The U.S. isn't likely to be exporting that sort of thing anytime soon. What's needed is more breakthroughs in areas such as biotech and energy.

Equally important, policymakers need to think beyond responding to the immediate crisis. Sure, fixing the financial system is essential to prevent demand for goods and services from collapsing, since many consumers and businesses need short-term borrowing to stay afloat. In that sense the solutions to today's crisis echo those of the Great Depression, when factories were idled because of lack of demand.

But unlike the Great Depression, there's a problem on the supply side of the global economy as well—one that requires a different policy response.

In particular, the location and mix of production has to change. Developing countries, with China as the leading example, must build up their ability to supply consumer goods and services to their own populations. "If we do not expand domestic consumption, it is highly likely that gross domestic product growth will be severely limited," says Cao Xuefeng, an economist at China Jianyin Investment Securities in Beijing.

In China, part of that effort requires additional reforms in the service sector, which won't be easy. "The key is for all the innovation, competition, and copying that has taken place in the manufacturing sector to be allowed to break out in services—things like health and education, telecom and finance, law and media," says Stephen Green, head of research for China at Standard Chartered Bank. "If manufacturing slows, only services can provide the employment and productivity you need to grow fast sustainably."

The other half of the equation: When the U.S. government undertakes fiscal stimulus measures, as it inevitably will, the money should be directed toward funding infrastructure, education, and innovation rather than consumer spending. Politically, maintaining a focus on investment and innovation in the U.S. may be almost as difficult as China opening up its service sector to international competition.

In the end, we may look back at fixing the banks as an easy task compared with changing the direction of national economies. As Japan discovered in the 1990s, notes JPMorgan's Kanno, "until the people really feel the pain, it's difficult to implement the radical policies." Let's hope we move more quickly this time.

With Peter Coy in New York, Ian Rowley in Tokyo, Kerry Capell in London, and Chi-Chu Tschang in Beijing

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