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Hard Truths About Global Growth

NEW YORK – The world’s high-income countries are in economic trouble, mostly related to growth and employment, and now their distress is spilling over to developing economies. What factors underlie today’s problems, and how appropriate are the likely policy responses?

The first key factor is deleveraging and the resulting shortfall in aggregate demand. Since the financial crisis began in 2008, several developed countries, having sustained demand with excessive leverage and consumption, have had to repair both private and public balance sheets, which takes time – and has left them impaired in terms of growth and employment.

The non-tradable side of any advanced economy is large (roughly two-thirds of total activity). For this large sector, there is no substitute for domestic demand. The tradable side could make up some of the deficit, but it is not large enough to compensate fully. In principle, governments could bridge the gap, but high (and rising) debt constrains their capacity to do so (though how constrained is a matter of heated debate).

The bottom line is that deleveraging will ensure that growth will be modest at best in the short and medium term. If Europe deteriorates, or there is gridlock in dealing with America’s “fiscal cliff” at the beginning of 2013 (when tax cuts expire and automatic spending cuts kick in), a major downturn will become far more likely.