While we need to worry about the long-term effectiveness of stimulus spending, the short-term effectiveness is not yet secure. With global banks still mired in toxic assets, they won’t be able to lend normally. If stimulus pushes up economic activities, businesses that want to invest to meet new demand may not get loans. In an upward virtuous cycle, rising demand leads to investment that leads to more jobs and more demand. Without a functioning banking system, this virtuous cycle is not possible. Instead, stimulus just perks up the economy temporarily.

The immediate task is to repair the banking system, especially in the U.S. The U.S. Treasury is promising overwhelming force now and details later. This may be a stalling tactic. The prices of big bank stocks and toxic assets already assume nationalization. The U.S. government is right to be concerned of the permanent damage to its financial system from nationalization. But to avoid it, the government has to grossly overvalue toxic assets. The U.S. taxpayers wouldn’t agree to throw taxpayers money at failed banks. If the U.S. doesn’t fix its banking system, the US$ 780 billion fiscal stimulus will be wasted.

The right approach is to nationalize these banks, separate the toxic assets into a different entity, and relist the healthy halves. The proceeds from selling down the healthy banks could be used to pay for absorbing the losses from disposing toxic assets. This is what China did to repair its banking system. It may be the only way out for the U.S.

Second, the West must contain the cost of its entitlement programs, beginning with healthcare in the U.S. If the U.S. doesn’t institute radical reforms to contain its healthcare cost, it will go bankrupt, possibly within a decade. If Europe doesn’t reform its pension and unemployment benefits, it will have to raise taxes or run bigger budget deficits permanently, and its economy would stagnate.

The biggest economic challenge among developed economies is aging, which leads to escalating pension cost and exponentially rising healthcare cost. While the wrong policies allowed the credit bubble to happen, the desire to defend an old lifestyle while social overhead grows higher was a major contributing factor. It allowed the western economies to delay the hard choices. The current system was set when aging was not a big challenge. The only viable course forward is to increase the retirement age and ration healthcare access.

Third, emerging economies must decrease export dependency. Export-led development usually reflects weaknesses in the political economy – the inability to efficiently turn savings into investment. The causes are usually lack of the rule of law and income and wealth concentration. Export orientation is to import the global system. From Japan a century ago to the Asian Tiger economies fifty years ago and China thirty years ago, the model has made fast development possible. 

The problem with the model today is that it is crowded. Developing economies are already 30 percent of the global economy at current price and nearly half on a purchasing power basis. The export model cannot thrive for shortage of customers. Developing countries have to trade more with each other and develop domestic demand. But this would require painful reforms to their political economies. The key is property rights and income distribution. The two must go hand in hand. Lack of domestic demand tends to result from income concentration, which is due to uneven playing field in opportunities. Many developing countries, like South American and Southeast Asian countries, have stagnated in the past decade due to their inability to reform their political economies.

Bursting of the credit bubble is triggering the biggest recession since the World War II. Repairing the global economy requires complex and difficult reforms. Simple stimulus can’t bring back prosperity. While stock markets may improve in the second and third quarter, it is merely a bear market rally. When inflation concerns hit the market towards the end of 2009, stock markets could fall sharply again. Indeed, the ultimate bottom in the current cycle could happen in 2010.

Full Article in Chinese: http://magazine.caijing.com.cn/templates/inc/chargecontent2.jsp?id=110075450&time=2009-03-02&cl=106&page=1