Who should consume, who should invest

Once upon a time (not too long ago) we had a world clearly divided between the haves and the have-nots. The so-called developed economies, buoyed by a period of unprecedented growth, were busy lecturing the rest on everything from politics and financial systems to human rights and climate change. Little did we all realise that there was a price to be paid for this decade of prosperity.

Economic growth was good so governments did not need to raise taxes, deficits were funded, consumers were happy with increasing wealth and low inflation, companies and banks had a record year and so on. The orgy had to end and so it did. The unwinding of excesses will extract a toll from asset-dependent, financially-propelled, bubble-prone economies. The assistance from aggressive monetary policy coupled with the rebalancing of the global economy will not result in a quick-fix of the problems.

Economic policy debate seems to blame the current account surpluses in Asia as a major cause of the financial crisis. The argument: The global imbalance of overconsumption in the US and underconsumption in Asia (mainly China) resulted in excess leverage, asset bubbles and deficit in the West. So, the simple solution would be to reduce consumption in the US and increase consumption in Asia. But as Dr Yuwa Hedrick-Wong, Economic Advisor at MasterCard, rightly points out, the Asian economies would be better served through increased investment to achieve a higher growth rate. Also, the theory of underconsumption applies mainly to China.

Private household consumption in the US accounted for 70 per cent-plus of GDP and it was only 37 per cent in China. For the rest of Asia, private consumption accounts for 55-60 per cent of GDP. Even if we did believe increasing consumption in the East and decreasing consumption in the West was the answer to global problems, we would need to decide what we think is the right level of consumption in the West and the East.

Would this be a balanced current account for all countries? A country's current account surplus is equal to its domestic saving minus its domestic investment, or national income minus the sum of private investment consumption and government expenditure. A continuing current account deficit means a country is living beyond its means (like the US) and a current account surplus means a country is living below its means (China). So, the issue is whether we should have a balanced current account as our main objective or growth, and in the process override the welfare of the people.

Developing countries need to aim for higher real growth, which would require more investment rather than consumption. Investment would mean building factories and improving infrastructure as also healthcare and education. There is a clear link between capital stock per capita and efficiency and growth of the economy. A key characteristic of developed countries as compared to developing countries is the higher capital stock per capita. Workers in developed countries are better equipped in terms of technology, equipment, capital and infrastructure to be more efficient, competitive and enjoy better living conditions.

Therefore, strategically, developing countries must achieve higher growth through higher investment. In the absence of developed capital markets, this would be funded through savings. It's natural that at the margin developing countries will get a higher growth through investment than developed countries. Consumption as a major lever of growth would only kick in at a much higher per capita income in the country. For developed countries, given their high capital stock per capita and high per capita income, an increase in demand through higher consumption would raise capital productivity (provided the economy is not running at full capacity).

The simple solution of reducing consumption in the West and increasing consumption in the East is too simplistic. Developing countries would prefer to grow through increasing investment and developed countries through increasing consumption. Any rebalancing of the globe will need to be sensitive to diverse needs of countries coupled with genuine problems of countries that need fixing. The financial crisis leading to a global slowdown is creating compelling economic reasons for the two leading players (China and the US) to take urgent action. We are likely to see the decoupling of world economies sooner than later—those with 1-3 per cent GDP rate and those with 7-9 per cent. Shabash India!