Global imbalances driven by large deficits and over-consumption in the United States will lead to inevitable and painful adjustments. Photo Credit: Stock.xchng.com

The world survived 2006 without a major economic catastrophe, despite sky-high oil prices and a Middle East spiraling out of control. But the year produced abundant lessons for the global economy, as well as warning signs concerning its future performance.

Unsurprisingly, 2006 brought another resounding rejection of fundamentalist neo-liberal policies, this time by voters in Nicaragua and Ecuador. Meanwhile, in neighboring Venezuela, Hugo Chávez won overwhelming electoral support: at least he had brought some education and healthcare to the poor barrios, which previously had received little of the benefits of the country's enormous oil wealth.

Perhaps most importantly for the world, voters in the United States gave a vote of no confidence to President George W. Bush, who will now be held in check by a Democratic Congress.

When Bush assumed the presidency in 2001, many hoped that he would govern competently from the center. More pessimistic critics consoled themselves by questioning how much harm a president can do in a few years. We now know the answer: a great deal.

The burden of [economic] stimulation was placed on the Fed, which lowered interest rates to unprecedented levels.

Never has America's standing in the world's eyes been lower. Basic values that Americans regard as central to their identity have been subverted. The unthinkable has occurred: an American president defending the use of torture, using technicalities in interpreting the Geneva Conventions and ignoring the Convention on Torture, which forbids it under any circumstances. Likewise, whereas Bush was hailed as the first "MBA president," corruption and incompetence have reigned under his administration, from the botched response to Hurricane Katrina to its conduct of the wars in Afghanistan and Iraq.

In fact, we should be careful not to read too much into the 2006 vote: Americans do not like being on the losing side of any war. It was this failure, and the quagmire into which America had once again so confidently stepped, that led voters to reject Bush. But the Middle East chaos wrought by the Bush years also represents a central risk to the global economy. Since the Iraq war began in 2003, oil output from the Middle East, which has the world's lowest-cost producers, has not grown as expected to meet rising world demand. Although most forecasts suggest that oil prices will remain at or slightly below their current level, this is largely due to a perceived moderation of growth in demand, led by a slowing US economy.

Of course, a slowing US economy constitutes another major global risk. At the root of America's economic problems are measures adopted early in Bush's first term. In particular, the administration pushed through a tax cut that largely failed to stimulate the economy, because it was designed to benefit mainly the wealthiest taxpayers. The burden of stimulation was placed on the Fed, which lowered interest rates to unprecedented levels. While cheap money had little impact on business investment, it fueled a real estate bubble, which is now bursting, jeopardizing households that borrowed against rising home values to sustain consumption.

Household savings became negative for the first time since the Great Depression, with the country as a whole borrowing $3 billion a day from foreigners.

This economic strategy was clearly untenable. Household savings became negative for the first time since the Great Depression, with the country as a whole borrowing $3 billion a day from foreigners. But households could continue to take money out of their houses only as long as prices continued to rise and interest rates remained low. Thus, higher interest rates and falling house prices do not bode well for the American economy. Indeed, according to some estimates, roughly 80% of the increase in employment and almost two-thirds of the increase in GDP in recent years stemmed directly or indirectly from real estate.

Making matters worse, unrestrained government spending further buoyed the economy during the Bush years, with fiscal deficits reaching new heights, making it difficult for the government to step in now to shore up economic growth as households curtail consumption. Indeed, many Democrats, having campaigned on a promise to return to fiscal sanity, are likely to demand a reduction in the deficit, which would further dampen growth.

Meanwhile, persistent global imbalances will continue to produce anxiety, especially for those whose lives depend on exchange rates. Though Bush has long sought to blame others, it is clear that America's unbridled consumption and inability to live within its means is the major cause of these imbalances. Unless that changes, global imbalances will continue to be a source of global instability, regardless of what China or Europe do.

America's unbridled consumption and inability to live within its means is the major cause of [persistent global] imbalances.

In light of all of these uncertainties, the mystery is how risk premiums can remain as low as they are. Especially given the sharp brake on growth in global liquidity as central banks have raised interest rates, the prospect of risk premiums returning to more normal levels is itself one of the major risks the world faces today.

For the last few years, some bearish economists have warned about America's real estate boom, its consumption binge, global imbalances, and even unreasonably low risk premiums; but somehow America, and the world, has muddled through. Some conclude that this proves that, even with poor political leadership, we can muddle through for still another year. Perhaps so. But perhaps not: muddling through has in some respects worsened the underlying problems, making the inevitable adjustments all the more painful. Indeed, that may be the main lesson we learn in 2007.




Contributed by Joseph Stiglitz, a Nobel Laureate in economics, is Professor of Economics at Columbia University and was Chairman of the Council of Economic Advisers to President Clinton and Chief Economist and Senior Vice President at the World Bank. Reprinted with permission from Project Syndicate.

To read a review of Joseph Stiglitz's new book, see Making Globalization Work.



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