THE CENTRAL problem now facing the world economy is not the next recession but a prolonged slowing of the world's economic train. We are already in unknown territory. As a result, the way into the next recession -- when it comes -- may be so unfamiliar that we will not realize where we're heading. And the climb back to prosperity is likely to be unusually difficult.
For a decade and a half now, the world's economic growth has been slowing down. The slower growth of the 1970s was supposed to have been produced by the rise in world oil prices and the need to fight inflation. But it has been followed by even slower growth in the 1980s despite falling oil prices and no inflation. Remember the boom that was so confidently predicted when oil prices plunged in January of 1986? It did not happen. Instead, the world's economic growth performance became even worse.
All of this has been little noticed inside the United States because the slowdown has been less here than elsewhere, unemployment has continued to fall and the country has been living high on borrowed money. But with the performance of the U.S. economy now inexorably linked with that of the rest of the world, a stagnant world economy eventually drags the United States down with it.
In the distant past (1945-1961), recessions arrived by accident. Some element of aggregate demand (defense spending in 1954, autos in 1957) would fall and the government would rush to the rescue with Keynesian economics -- more money, lower interest rates, tax reductions or increased government spending. In the more recent past (1962-1983), recessions became instruments of macroeconomic policy-making, deliberately started by government in an effort to stop inflation. The recession now on the horizon, however, starts neither by accident nor by deliberate government policy. It is a recession that starts abroad because of the imbalances in world trade and then spreads back to the United States.
America's trade deficit represents a $170-billion addition to foreign demand. As a result there are at least 4 million foreign workers dependent upon the American market for their livelihoods. When America cures its trade deficit, these 4 million workers will lose their jobs. Take $170 billion worth of demand and 4 million jobs out of the economies of the rest of the world and the rest of the world is instantly plunged into a recession.
The falling dollar has now begun the process of curing the U.S. trade deficit. The improvements are as yet small; the dollar has much farther to fall. But the only uncertainty is how far the dollar will have to fall -- and how long it will take -- before the U.S. trade position swings from its current deficit to a surplus big enough to earn the funds necessary to pay interest on Amer- ica's foreign indebtedness.(Right now the United States would have to be running a trade surplus of about $28 billion to meet its international interest obligations.)
Foreign exports into the American market are not yet falling rapidly, but both Germany and Japan already seem perched on the edge of recession. In both countries the confident economic forecasts made at the beginning of the year are now being revised downward. For the past 42 years both countries have relied upon U.S. growth and U.S. countercyclical policies to rescue themselves from recession. Neither country has been able to grow unless exports were rising. Yet if the U.S. trade deficit is to shrink, both countries must face a sustained period of declining exports.
This means that to fight their recessions, Germany and Japan will have to restructure their economies to be internally rather than externally led. Japan, for example, will have to make a major shift away from export industries, such as consumer electronics, toward domestic industries, such as housing and public infrastructure investments. Such structural shifts require time and generate internal political opposition. Major export industries don't want to become smaller and less important. As a result the incipient recessions that now loom in Japan and Germany are apt to be lengthy. The economic processes necessary to turn them around quickly just aren't in place.
These foreign events generate a variety of economic pressures inside the United States. If the rest of the world slips into a recession, the United States must cure its balance of payments by importing less rather than by exporting more. This means that the dollar must fall to the point where imports are so expensive that Americans cannot afford to buy the $170 billion in foreign goods they now consume. But rising import prices mean a rising rate of inflation. The trick will be to keep the necessary import inflation from spreading to domestic wages and prices.
To keep import inflation from spreading, import prices must not rise too rapidly -- which means that the dollar must not fall too rapidly. The only effective policy for retarding the dollar's fall is higher U.S. interest rates. Yet higher interest rates lead to slower U.S. economic growth and increased probabilities of defaults by Third World debtors, small banks, farm debtors and over-extended domestic oil or real estate operators.
Suppose that these pressures are enough to start a recession inside the United States. Once started, the Japanese, German and American recessions will interact in perverse ways. A U.S. recession leads foreign exports to this country to plunge still faster, and this intensifies those foreign recessions. If foreign recessions get bad enough, U.S. exports can fall despite a falling dollar. To correct the U.S. trade deficit, the dollar would then have to fall farther and faster to reduce imports by even larger amounts, making those foreign recessions yet worse. This would in turn intensify inflationary pressures in the United States and lead to yet higher interest rates.
Once simultaneous recessions have gotten underway and started to interact, how would one stop them? None of the classic remedies is available in the United States. Monetary policies and interest rates must be used to defend the dollar and keep import inflation from spreading. Taxes must be raised, not cut, and expenditures reduced, not increased, to prevent the crowding out of the private investment upon which the future success of the American economy depends. A betting man would give odds that the next recession is likely to be lengthy; the institutional mechanisms and policies necessary to make it a short recession either aren't in place or don't exist.
The recovery from the 1981-82 recession was the last gasp of the old system. Because America was large, because the dollar was the world's reserve currency and because America had accumulated a cushion of $152 billion in net foreign assets at the end of 1982, the United States could and did play economic "locomotive" for itself and the rest of the world in 1983 and 1984. It could expand and simply tolerate a balance-of-trade deficit for three or four years before its currency started to fall, before it was faced with the situation that smaller, less wealthy countries face almost instantly. But the net foreign assets that provided that flexibility have now been expended. Instead of being the world's largest net creditor nation, as it was in 1982, America is now the world's largest net debtor nation with debts of about $340 billion in mid-1987.
The standard economists' prescription for the current economic situation does not meet the world's political realities. In the prescribed scenario, the American locomotive would be replaced by a hybrid vehicle made up of the three biggest economies -- Germany, Japan and the United States. By carefully coordinating their monetary and fiscal policies, these three countries could do for the world economy what the United States did by itself for the last 40 years. Together they are just as large relative to the world's gross national products as the United States used to be, and if they agreed on a set of economic policies the rest of the world would have little choice but to follow along.
The new track prescribed for this locomotive would reflect the realities of both history and technology. It should lead to a much more integrated world economy. Trade should continue to expand faster than the world's GNP as more markets are opened up to foreign producers. Multi-national and trans-national firms should continue to move technology and capital around the world to wherever it can best be used. The communications and computer technologies that have created a world capital market should be further expanded to create a world economy in which the very concept of an American, Japanese or German economy would be obsolete.
But these economic recommendations imply a willingness to give up national economic sovereignty that simply is not there. Coordination is easy to say, even easier to praise, but it implies a willingness on the part of each of the coordinating countries to do things that they do not want to do. To reduce its demands on world capital markets, the United States would have to raise taxes. Americans don't want to raise taxes. To help pull the world economy, the Japanese would have to fundamentally restructure their economy to emphasize domestic consumption rather than exports. The Japanese don't want to restructure their economy. To play their role in the world economy the Germans would have to take a chance on generating inflation. Given the history of the 1920s the Germans don't want to take that chance. The result is economic summits like the Venice Summit where the heads of state spend very little time talking about economics, agree on nothing, issue a communique at the end of their meeting praising coordination, but then go home and do none of the things that coordination would require.
Modern human beings like to think that economic progress is inevitable and that prolonged stagnation or decline is simply impossible. But human history is marked by many more years of stagnation than of growth. Once, as an educational joke when I was a student at Oxford, a don set me the task of writing an essay on the "optimal" rate of decline -- the rate of economic decline that would lead to cessation of economic growth. I argued in the essay that if the decline were too rapid, it would set in motion economic and political forces that would lead to an economic rebound much as a basketball rebounds when it hits the floor. To end in complete stagnation, the slowdown had to be very gradual with substantial ups and downs to hide the fact that the downs were bigger than the ups. One slips into stagnation by not noticing that one has slipped into stagnation.
Thinking back on it, my optimal rate of decline looked very much like the actual slowdown that has occurred in the world economy over the past 17 years. In Europe for 17 straight years, the unemployment rate at the end of the year has been higher than it was at the beginning of the year. In America, the hourly wage rate after correcting for inflation is no higher than it was in 1970. In the Third World, per-capita GNPs are 10 percent below their peak values of a decade ago.
Yet there is remarkedly little protest anywhere. Governments that presided over stagnation regularly get re-elected to preside over more stagnation. People are adjusting to the fact that they will be unemployed for longer periods of time and that their children will not have a higher standard of living than they do.
To say that we are smart or well-educated is not to say that we are smarter or better educated than those Romans who watched the economic vigor of Rome decline in its last 100 years. For the truth about the Roman Empire is that it did not "fall" on any given day or in any given disaster. It very gradually declined as a result of many decisions made, many decisions not made, an inability to build new tracks when old ones ended and an unwillingness to rebuild its locomotive when it needed a new source of propulsion.
It is equivalent to the highest heresies of the Inquisition to even suggest that modern man could slip into a prolonged period of economic stagnation. We are too smart. I will probably be burned at the intellectual stake for even suggesting that it is a possibility. But think upon that possibility as I go up in smoke.
Lester Thurow is Dean of MIT's Sloan School of Management and professor of management and economics.