By Thomas I. Palley
Special to Press Associates

WASHINGTON (PAI) - For the past five years the global economy has been flying on one engine. That engine is the U.S. consumer, who has been on a consumption binge financed by borrowing, in turn backed by a housing price bubble.

This situation poses the threat of a serious hard landing when that engine eventually stalls, as it must.

Ever-inflating house prices and rising debt-to-income levels are not sustainable. And as the late Herbert Stein, Chairman of President Nixon's Council of Economic Advisers, wryly observed: "If something cannot go on forever, it will stop."

This view, regarding the global economy's excessive dependence on the U.S. and the financial fragility of the U.S. economy, is not just held by progressive economists. It is also shared by Wall Street.

Thus, Stephen Roach, Chief Economist for Morgan Stanley, recently wrote in the Financial Times (Nov. 4, 2005): "There is now about a 40 percent probability of a hard landing in the next 12 months." And in a research brief, Roach singles out China as being particularly dependent on the U.S.: "China's export prowess is balanced on the head of a pin - a pin made in America. Fully 35 percent of Chinese exports go to the United States."

Roach's Wall Street warnings are sobering. But they miss a more profound
point: The global economy is headed in the wrong direction, hollowing out the U.S. middle class while failing to create a big enough middle class in the developing world.

That hollowing-out process has long been visible in U.S. statistics on wages and family income distribution, and it has been rendered keenly concrete by Delphi Corp.'s recent bankruptcy filing. It is only because of successive stock market and housing price bubbles, combined with a massive increase in consumer access to credit, that the hollowing-out has not been worse.

A major cause of these dangerous trends is the flawed structure of the global economy. Spurred by our own policy makers, the International Monetary Fund, and the World Bank, developing countries adopted an export-led approach to manufacturing growth and development.

This approach has two critical features. First, countries rely on selling in foreign
markets rather than their own domestic markets. Second, countries use under-valued
exchange rates to subsidize their products, thereby making them hyper-competitive.

China exemplifies this model, exporting over half of its manufacturing output and having an exchange rate that is up to 40 percent undervalued. And focus on export-led growth distorted the global economy. First, it created the global financial imbalances that Wall Street is so apprehensive about, manifested in the record U.S. trade deficit.

Second, U.S. manufacturing has been undermined by unfair competition subsidized by undervalued currencies. This in turn accelerated the hollowing of America's middle class.

Third, export-led growth promotes the global race-to-the-bottom, since countries look for international competitive advantage however possible. Consequently, workplace standards, wages, and the environment are all subject to persistent retrograde pressures, impeding the development of a middle class in developing countries.

The implication is that the global economy must shift from export-led development to domestic market-led development. In an export-led world, higher wages undermine employment. In a domestic market-led world, higher wages can promote employment. This is where labor standards and unions enter.

The challenge is to establish a system that has wages rising with productivity so that workers can buy what they produce, rather than dumping it on world markets. Setting wages by government edict does not work. Labor standards and unions are the way forward, since they provide a decentralized mechanism that links wages and productivity through collective bargaining.

History supports this. Every country that has ever made the transition to developed industrialized status has traveled this route.

China is the poster-child for export-led manufacturing growth. It has the most under-valued exchange rate, the worst labor repression, and is by far the largest developing country exporter. As such, China is the gravitational attractor for the race to the bottom. Other countries must change, but can only do so if China changes so none lose relative competitive advantage. If China revalues its exchange rate, other East Asian countries can do so. Likewise, if China raises wages, so too can the others.

One area where China shows leadership is its stated commitment to increase social spending. This will be good for China's citizens, and it will also contribute to incomes and domestic demand there, which will be good for the global economy. However, there is a problem unique to China: Labor standards and trade unions are key to domestic market-led development, but China's political system prevents them. That creates an additional political roadblock that must be solved. Democratic reform in China is not a nicety. It is a necessity for the global economy to work.