The world stopped in 2008—and it was a full stop for the era of excess. Belatedly, the authorities have been extraordinarily aggressive in coming to the rescue of a system in crisis. But as in the case of Humpty Dumpty, they will not be able to put all the pieces back together again. The next era will be very different from the one we have just left behind.

In large part, that is because this is a profoundly different crisis. It stands in sharp contrast to earlier disruptions, such as the Latin debt crisis of the 1980s, the Asian financial crisis of 1997–98, or the bursting of the dot-com bubble nearly nine years ago. In those instances, the pressures were confined largely to a region or asset class, while the rest of the world benefited from insulation and resilience. This time, there is no place to hide. An unbalanced world is now in the midst of a painful but necessary rebalancing.

Steeped in denial during the days of froth, policy makers, financial markets, the business community, and Main Street all reached the same erroneous conclusion—that an increasingly sophisticated and globalized world had learned to live with its imbalances. Some called this the Bretton Woods II era, cemented by a new symbiotic relationship between China (the saver and producer) and America (the borrower and consumer). Under this arrangement, most observers came to believe, unprecedented saving and current-account disparities could be finessed indefinitely, as could record debt burdens and currency misalignments. Some day, went the argument, the world would have to face up to its imbalances, but the day of reckoning was always assumed to be in some far-off, distant future. That was the fatal mistake made by a world in denial. The day of rebalancing is now at hand.

The implosion of 2008 was very much an outgrowth of the unique character of the world’s imbalances, which visibly manifested themselves in a succession of ever-larger asset bubbles. The United States lies at the root of this phenomenon. Starting with the dot-com bubble of the late 1990s, the country went down a path littered by a succession of asset bubbles—from equities to property to credit. Bubbles are bad enough in and of themselves. They become all the more treacherous when they infect the real economy. That, indeed, was the most dangerous and destabilizing aspect of the era of excess.

In the end, the US consumer was engulfed by the biggest bubble of them all. US consumption reached an astonishing 72 percent of GDP in 2007, a record for the United States and, for that matter, any major economy in modern history. This consumption spike was fully five percentage points above the 67 percent share that prevailed for 25 years in the prebubble era, from 1975 to 2000. Significantly, the consumption binge was not supported by the economy’s internal income-generating capacity; labor compensation—the income forthcoming from current production—fell in late 2008 to a level of more than $800 billion (in real terms) below the trajectory of previous cycles.

Instead, America’s consumption binge drew support from two major asset bubbles—property and credit. Courtesy of cheap and freely available credit, in conjunction with record housing price appreciation, consumers tripled the rate of net equity extraction from their homes, from 3 percent of disposable personal income in 2001 to 9 percent in 2006. Only by levering increasingly overvalued homes could Americans go on the biggest consumption binge in modern history. And now those twin bubbles—property and credit—have burst, and so has the US consumption bubble: real consumer spending fell at an unprecedented 3.5 percent average annual rate in the two final quarters of 2008.

While the original excesses were made in America, the rest of the world was delighted to go along for the ride. With the United States lacking in internal saving, it had to import surplus savings from abroad in order to grow—and ran massive current-account and trade deficits to attract that capital. This fit perfectly with the macro-imbalances of the export-led developing countries of Asia, whose exports exceeded a record 45 percent of regional GDP in 2007—fully ten percentage points higher than their share ten years earlier, in the depths of the Asian financial crisis. China led the charge, taking its exports from 20 percent, to 40 percent of its GDP over the past seven years alone. The export-led growth in developing Asia could well be described as a second-order bubble—in effect, a derivative of the one in US consumption.

Sure, there are destinations for end-market demand other than the United States, an observation that mistakenly led many to believe that Asian exporters were insulated by an increasingly diversified mix of external demand. That was wishful thinking. Once again, China is an important case in point. Yes, the United States now accounts for only about 20 percent of total Chinese exports. Shipments to Europe and Japan collectively account for another 30 percent, while the bulk of the remainder shows up in the form of sharply growing intraregional Asian trade. But there is a serious problem with the notion that China or any other major economy has successfully weaned itself—or decoupled—from overreliance on US markets. Whether it is Europe, Japan, or developing countries of Asia other than China, all have one critical characteristic in common: insufficient internal private consumption and an overreliance on exports as a major and increasing source of growth. Intraregional trade has expanded sharply in developing Asia, but with internal consumption as a share of GDP continuing to fall, these economies remain hugely dependent on end-market demand in the developed world.

As a result, there can be no mistaking the bottom line of this global recession. When the world’s dominant consumer—the United States—enjoys an extraordinary boom, so do the world’s major exporters. But when the US boom goes bust, export-led economies around the world are in serious trouble. That’s precisely the nature of the adjustment now bearing down so acutely on Japan; developing Asia; Germany; and America’s NAFTA ¹ partners, Canada and Mexico. All of these export-led economies are either decelerating sharply or in outright recession.

There’s an even more insidious aspect of a bubble-dependent world. The Chinese, of course, led the way in recycling a disproportionate share of their massive foreign-exchange reserves back into dollar-based assets. That kept China’s currency highly competitive, as any export-led economy likes, but also prevented US interest rates from rising—thereby keeping the magic alive for bubble-dependent US consumers. In effect, the world’s bubbles fed off each other.

That game is now over. With the US consumer most likely in the early stages of a multiyear contraction, the postbubble world is likely to face stiff headwinds for years to come. In large part, that’s because there is no other consumer to fill the void. Sluggish growth in consumption has long been the norm in Europe and Japan. The same is the case for developing economies, where consumption is constrained by the imperatives of precautionary saving to compensate for the lack of safety nets such as social security, pensions, and medical and unemployment insurance. In China, the poster child for this problem, consumption as a share of GDP fell to a record low of around 35 percent in 2007—less than half the share in the United States. All in all, a postcrisis global economy is likely to struggle for years in the aftermath of America’s consumption boom and in the absence of any dynamism from private consumption elsewhere. This paints a picture of a relatively tepid recovery from the current global recession.

The policy response to this crisis has been disturbing on one critical count: the global body politic is doing its best to resist rebalancing. Near-term tactics are all about containing the crisis, with little appreciation of the strategic implications of these actions. Here as well, America and China are emblematic of the problem. In the United States, Washington has focused on measures that would sustain excess consumption through tax rebates and other types of income injections. There is also growing support for mortgage foreclosure relief—in effect, perpetuating uneconomic levels of homeownership by many people who simply cannot afford their still-overvalued dwellings. Meanwhile, in China, policy priorities remain focused on providing support for investment, through a massive $585 billion infrastructure program, and on exports, through a shift in currency policy and tax rebates for exporters. By contrast, little is being done to stimulate the Chinese consumer.

Such actions suggest a world that has learned little from a wrenching global rebalancing—a world that believes the answer to recession and crisis is a return to the very same strain of unbalanced economic growth that got us into this mess in the first place. Yet in the end, that’s the very last thing the world needs. America does not need to perpetuate its unsustainable consumption binge; it needs to save and recycle its savings into investments in infrastructure, alternative-energy technologies, and human capital. China does not need more hypergrowth led by investment and exports; it needs to shift the mix of its economy toward private consumption. Yet both nations seem unwilling, or unable, to make the tough choices that a more strategic policy response requires.

Sadly, this reactive approach reflects a global body politic that always seems to be focused on the quick fix. This time, that reaction has been amplified by the severity of the problem. It’s as if the crisis is so threatening that short-term tactics must take precedence over long-term strategy, however noble it may be to promote the structural shifts required to rebalance an unbalanced world. This is where leadership could be decisive in shifting the debate: in having the courage to look beyond the valley.

None of this is to say, of course, that policies shouldn’t be acutely sensitive to the plight of the innocent victims of recession and crisis. Unemployed workers need enhanced income support—especially unemployment insurance and retraining programs—and a dysfunctional financial system needs stopgap repairs. However, while the authorities need to backstop a system in acute distress, they must do more. The tactics of crisis containment cannot be the sole focus of the policy response to this wrenching global recession. The world also needs a strategy.

Benefiting from a decisive election victory, Barack Obama has an extraordinary opportunity to provide just that. Early indications pointing to a large public-works spending package—especially for infrastructure and alternative-energy technologies—are very encouraging. But that begs the broader question: does the rest of the world have the wisdom and the courage to shift the policy debate away from tactics and toward strategy?

This global crisis and recession have a deeper meaning: they give us an opportunity to learn the tough lessons about what went wrong and how to avoid similar mistakes in the future. A failure to heed those lessons and to use the resulting insights in framing new policies would be the biggest tragedy of all.

¹ North American Free Trade Agreement.

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