Tamed Tigers, Distressed Dragon

    EDITOR'S NOTE: To boost economic growth, Asian countries should promote higher domestic consumption and establish a sustainable economic model, write Brian P. Klein and Kenneth Neil Culkier. Klein is a fellow based in Japan for the Council on Foreign Relation International Affairs. Cukier is the Tokyo business and finance correspondent for the Economist. For the full essay, please visit the Foreign Affairs magazine's Web site. A few excerpts:

    The cause of Asia's current economic despair, ironically, is the very development model that was the source of its prior success: its heavy dependence on exports. By deciding to hitch their wagons to manufactured exports, Asian leaders left themselves inherently vulnerable to a dropoff in Western consumption. The growth was also built on weak social and political foundations, from underinvestment in public education, health care, and social services to poor governance and a weak rule of law. These concerns were ignored by the business and political leaders who benefited the most from rapid economic growth, and the masses generally did not quibble so long as their incomes increased year after year.

    The core of Asia's economic problems is structural, not cyclical. Government stimulus programs, albeit vital, have largely focused on short-term fixes, in an environment in which the quality of spending is as important as the quantity. Asia's business model has atrophied, and it is unclear what will replace it.

    The end of the miracle?

    By emphasizing exports, Asian countries simply replaced a reliance on foreign capital with a dependence on foreign demand. In Hong Kong, Malaysia, and Singapore - because of the high volume of reexports - the value of exports equaled or exceeded their GDPs before the current economic crisis started in 2007. In Taiwan, Thailand, and Vietnam, it totaled over 60 percent. For China and South Korea, exports represented nearly 40 percent of GDP. Viewed as net exports (when imports are subtracted), the contribution to GDP is more modest. But these exports were still critical to Asia's economic success.

    It is a harsh way to begin what was heralded as "the Asian century." Asia's postwar industrialization appealed to an ethos of nationalism and self-sufficiency. But the export-led model Asian countries adopted has ironically left them more dependent than ever on the whims of the West. Now, that growth model is shriveling. The economic slowdown is not responsible for this; it merely exacerbated problems that already existed due to the weak economic, social, and political foundations on which the model was built.

    Inconspicuous consumption

    Domestic demand in Asia has been held back by several other factors, including a persistent misallocation of resources. Misguided investment has led to a blind pursuit of real estate development despite often weak real (nonspeculative) demand. New office construction continues in Beijing and Shanghai despite rising vacancy rates. At the same time, access to capital remains severely restricted for small and mediumsized enterprises. Banks generally favor larger projects and those backed by government initiatives, which are considered at lower risk for default and can provide better collateral. This is a particular problem considering that small companies generally use capital more productively, are more innovative, and disperse wealth more widely.

    Ultimately, pursing export-led growth entailed hidden costs. It distracted policymakers and business leaders from the hard work of building and strengthening the institutions necessary for sustainable domestic economies. Much of the new wealth was used inefficiently or simply squirreled away. Meanwhile, those countries that acted to keep their currencies weak in effect subsidized exporters at the expense of other domestic producers and consumers. Glaring weaknesses in some countries were also ignored - from corruption and an inadequate rule of law to environmental degradation. Indeed, as the export model proved successful, structural reform became even more difficult, since vested interests grew more influential. The region as a whole is now ill prepared for a drawn-out period of slower growth. Asia is left with some very hard decisions to make in a decidedly more difficult economic environment.

    No saving grace

    In the West, the economic crisis has ushered in a period of great deleveraging. Financial institutions that ratcheted up their earnings by taking on huge quantities of debt have had to scale back their exposure, which has contributed to the huge fall in asset prices. It is a painful but necessary adjustment. Likewise, a similar process needs to take place among Asian economies - a great rebalancing - whereby the reliance on exports is reduced in favor of stimulating domestic consumption.

    Asian countries will also have to improve the structure of their labor markets and increase minimum wages. Although a recession does not seem like the right moment to increase the cost of business, there never is an ideal time, and in good times the pressure is off. Depressed wage growth is one reason why household income as a proportion of GDP has actually declined across Asia in recent years. Likewise, the high savings rate in the region is due in part to income insecurity. Most job arrangements in Asia are informal. The share of formal salary and wage employment is only around 40 percent of total compensation in Indonesia, the Philippines, and Thailand and as low as 15 percent in China. (By contrast, it is around 90 percent among g-7 nations.) This provides flexibility to companies but means uncertainty for workers.

    Changing the structure of the labor market and paying workers more would boost the overall economy and fuel domestic consumption. This was the experience of the United States in the early 1900s, when Henry Ford declared that he wanted to pay his workers enough for them to be able to buy one of the cars rolling off his assembly lines. Starting in 1914, Ford raised the minimum daily wage from around $2 to $5 and established the two-day weekend - actions for which he was heavily criticized by other industrialists. Ford's goals were to reduce employee turnover, increase productivity, and create a massive new market for his cars. Ford's idea of "welfare capitalism" was copied by others, helping to create a broad-based consumer class in the United States. The same sort of consumer revolution needs to take place in Asia, and increasing wages is a necessary first step.

    Most important, Asian countries must establish viable social safety nets. The lack of basic economic safeguards is the biggest reason why Asians save so much, and reducing those savings would unlock consumption. However, in addition to taking a long time to set up, genuine social welfare systems would require adequate initial funding and testing by citizens before they changed their savings behavior.

    In the end, overhauling Asia's social model over the next half century will be a task of the same magnitude as reforming its economies during the past half century was. It will be an equally difficult and long process - but it must begin now.

    Exporting instability

    If the downturn is prolonged and countries in the region fail to reform, the consequences for Asia will be profound. Trade protectionism could easily undermine globalization, as it did during the Great Depression, when hefty tariffs led to the contraction of global trade by two-thirds. Since October 2008, some 66 restrictive trade measures have been proposed worldwide and 47 have been enacted. They run the gamut from the aborted "Buy American" legislation to India's ban on Chinese toys. Such legislation will slow the economic recovery for everyone, and Asia will bear the brunt of the pain.

    Asia's export model of growth was never meant to be the sole answer to how the region's economies would develop. But once it was under way, it was hard to make the shift toward a better balance. The model largely worked, and the last quarter century saw global trade grow at twice the rate of global GDP. Yet the model has served its time.

    It is in no one's interest to see Asia in disarray. A prosperous Asia can increase global economic growth, provide regional stability, and help with trouble spots, such as North Korea. How the region responds to the current crisis - and how the West helps it cope - will determine the depth and duration of Asia's economic woes. The region will still boast powerful economies in this century, but a more sustainable economic model, one entailing higher domestic consumption, must be found. If the root cause is not addressed, Asia's problem's will become the world's.

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