Michael Spence: Five Steps to Fix Economic Policy

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What would a coordinated set of global economic policies look like? First, it would include credible plans in Europe and the U.S. to restore fiscal balance. In Europe that means agreeing on burden sharing for recapitalizing countries where deficits and debt have cut off market access or led to prohibitively high borrowing costs. Restructuring damages the euro, and fiscal consolidation in the distressed countries, while necessary, is probably not sufficient. That leaves Europe's stronger countries, particularly Germany, with the residual liability. Greater fiscal centralization and political unification seem inevitable, but it may take time to muddle through to that outcome.

In the U.S., the main challenge is to restore fiscal balance without damaging the recovery and future growth. Getting the balance correct is complicated by the fact that the right fears the left will use fiscal stimulus as a path to permanently larger government, a path that the right (and apparently the general public) is unwilling to follow.

Second, a pullback from quantitative easing (QE2) in the U.S., which is subjecting the emerging economies to a flood of capital, rising commodity prices, inflation, and asset bubbles. Intervention may be needed in fragile sectors of the U.S. economy, like housing, where faltering performance could produce another downturn. But this must be far more precisely targeted than QE2. America's reluctance to target areas of fragility leaves the impression externally that QE2's real goal is to weaken the dollar.

Beyond that, it is unclear how QE2 will produce much growth. Its proponents argue that it is the main policy instrument left, and that it will work by increasing credit or lowering the discount rate, which will raise asset prices, and hence consumption, via balance-sheet effects. But do we really want to see the U.S. leveraged up to its ears again?

On the balance-sheet side, even if a temporary decline in long-term interest rates pushes up asset values, debt-burdened households with uncertain employment prospects are unlikely to rush to consume. After all, the wealth effect works only when people believe that the wealth is permanent.

Third, advanced and emerging economies that are running chronic surpluses must get rid of them. The policies needed to do so vary by country and involve structural shifts. In the case of China, a key part of its 12th five-year plan is to shift income to the household sector, where the savings rate is high but still lower than the corporate rate. The economy can then use household savings to finance corporate and government investment, rather than the U.S. government. That structural shift, in combination with the renminbi's strengthening relative to the dollar, offers hope that China's surplus will fall.

Fourth, the global economy will be out of balance as long as the U.S. runs large current-account deficits. With the post-crisis resetting of domestic consumption and savings, U.S. aggregate demand will remain depressed. In the longer run, that gap needs to be filled by higher foreign demand and increased export potential.

The U.S. tradable sector is growing. Its major subsectors—increasingly, high value-added services—are highly competitive and growing. But they are not big enough to fill the employment gap. Imports could fall, as they did during the crisis, but that was due to declining demand, not to a shift in demand in favor of domestic producers.

The tradable sector accounts for just 30 percent of the U.S. economy (by value added), and employment growth in the tradable sector is negligible. If employment growth in the nontradable sector—dominated by government and health care—falters, the tradable sector will have to take up the slack. The problem is that it can't, even with a depreciating currency. If exports are to grow substantially, the scope of the tradable sector must expand.

Fifth, and finally, major holders of reserves must agree to deploy them so as to maintain global financial stability and prevent excessively volatile exchange-rate and capital movements. With periodic bouts of contagion in the euro zone and residual uncertainty about America's commitment to a strong dollar and fiscal discipline, major reserve holders in Asia and the Gulf need to become a stabilizing counterweight.

None of these steps is easy. They will take time. But, taken together, they would help reduce uncertainty and restore a pattern of stability and inclusive growth to the global economy.

Spence, a 2001 Nobel laureate in economics, is a professor at New York University's Stern School of Business and a senior fellow at Stanford's Hoover Institution.

Michael Spence: Five Steps to Fix Economic Policy | World