On the surface the global economy is recovering, but in reality it suffers from a severe hangover from overspending, asset bubbles, and overconsumption. The current challenge is to realign global supply with global demand. To do that by increasing demand instead of reducing supply (production capacity) calls for a fine-tuning between strong (creditor) countries and weak (debtor) countries. How this is done will determine the growth and inflation trends over the next decades akin to policymaking in the 1970s and 1980s which opened the door for almost two decades of non-inflationary growth.
 
The strong economies – and they are primarily found in Asia – must maintain an expansionary economic policy and not allow themselves to be cajoled to appreciate their currencies as desired by economies in deficit. The main problem is not that some countries are more competitive than others, but that the weaker economies live beyond their means, apparently not wishing to address the problem, and are allowed to do so because creditors do not pull the handle on them. Currency rate changes do not affect total global demand, but instead reshuffles demand among countries, which does not help much. This carries the additional disadvantage of rewarding irresponsible countries by signalling that whatever that country does, the more responsible countries will shoulder the burden of adjustment.  
 
The weak economies, primarily the US, Japan, and Britain must rebalance by augmenting savings even if this means sacrifices in the short run. Any other policy will aggravate domestic imbalances thus weakening confidence in performance in the longer run. These economies have lived beyond their means and it is no way out of this predicament to continue to do so or even worse, to increasing borrowing.
 
Total debt in the US is approaching 400 % of Gross Domestic Product (GDP) – a figure never seen before, not even under the great depression or when financing World War II. As it stands currently, interest payments flowing from public debt account for approximately 1.5% of GDP and is estimated to hit 6-7% or even more by 2019. As of now, net interest payments account for 8% of US federal expenditure (USD 234 bn). In Japan, public debt is close to 200% of GDP and servicing public debt is one of the major posts on the public budget.
 
The proliferation of CDS (Credit Default Swaps) and the growth in these financial instruments exposes the fear that one or several major countries may ask for restructuring of their debt (a euphemism for writing off a part of the debt) leaving creditors with little choice other than to acquiesce. The number CDS instruments doubled over the last year for ‘solid’ debtors such as the US, UK and Japan informs one that these countries are not regarded as ‘solid’ anymore. In fact, CDS’ are in many ways reminiscent of what happened in the property market (financial transactions took place among institutions concealing the size of debt and its distribution among institutions) threatening financial stability in a new game of merry-go-around among financial institutions.
 
The confidence in the dollar is falling dramatically and creditors have not necessarily been lured by currency alternatives such as the Euro and the Yen. In fact, they have been moving into gold, commodities, and stocks around the world that maintain their values irrespective of US economic policy and possible debt restructuring.
 
A global reserve currency fulfils three roles: supply of liquidity, securing financing of adjustment for countries that reveal imbalances on their balance of payments, and a refuge for global money looking to maintain purchasing power. Until now, the US Federal Reserve System has performed reasonably well, but with the decline of the dollar, a vacuum looms ahead with no one in charge of the international monetary system.
 
Economic policies in debtor countries have no room for manoeuvre. Interest rates cannot be increased, as this will further augment the cost of servicing debt. Fiscal policy is already strained by the need to find resources for debt servicing. Only by turning this around to a sound and stable economic situation can these countries regain a growth pattern. In this regard, the Japanese experience from 1990 until today provides a timely lesson.
 
Asia, ex-Japan has followed a prudent economic policy with small or at least manageable deficits on the public budget and low public debt compared to the US, Britain, and Japan. The majority of the Asian countries also host surpluses on the balance of payments, in contrast to huge deficits of the US and Britain, while Japan maintains some flexibility on that score.
 
The EURO zone is increasing its debt, but remains in a more comfortable situation than the US and Japan, thereby giving Europe more room to manoeuvre. The European economies may be stronger than imagined in terms of job creation over the last decade remain more sound and balanced than both the US and Japanese economies.
 
The temptation to beat around the bush and seek for easy or cheap solutions must be resisted. The plain truth is that the global economy faces severe problems due to misguided policies over the last decade or two. It can be extricated from the dangers above, but only if policy makers realise three fundamental observations.
 
The first is to resist the temptation to lure or push the strong Asian economies into the trap of deficits and borrowing to help the debtors. On the contrary, the countries in deficit should be forced to rebalance their economies by shouldering the burden as they reaped benefits in the past. Only by doing so can the strong economies be sure that they are not being dragged into a dark hole of permanent financing of overspending in other countries. A wrong handling of this with regard to timing and dosage will allow the deficit countries to lead the world into inflation or even worse, stagflation.
 
Secondly, while there is a global economy, there is no global economic policy. The major countries still map out their policies primarily and sometimes exclusively guided by domestic preoccupations. This leads to divergent business cycles acting as a brake on a global recovery because other countries will reap some of the benefits flowing from domestic economic policies. For example, if one country implements strong expansionary policies some of it may spill over into imports from countries doing less, giving rise to the criticism that foreigners benefit more than domestic workers.
 
The third one is that the economy, trade, and investment form a whole, and policy steps in one of these areas cannot be separated from repercussions on the other two. This explains the necessity to package policies that stimulate global demand with trade liberalisation and free capital movements. Only such a coherent policy may support the global supply chain ensuring a win-win development where all countries feel comfortable knowing that in the end, they will be better off. If on the other hand benefits and/or burdens are not distributed in an equitable and acceptable way, countries may slide towards more nationalistic or protectionist policies undermining economic globalisation.