After retail sales posted a record decline in October, preliminary reports show that sales of appliances, shoes and clothes continued to fall dramatically in the first two weeks of November. After decades of doing her level best for the global economy by shopping till she maxed out all her credit cards, the US consumer has finally been hit with the bill.

It’s difficult to overestimate the impact this will have on the global economy.

Today’s economic system, known as Bretton Woods 2, can be described, without straying too far from the truth, as one where the US consumes and China produces. What happens to that system if one of its main pillars—the US consumer—decides not to consume? What will happen to all those economies that busy themselves by producing the things needed by this consumer of last resort?

For decades, the economies of Asia have grown and prospered by exporting goods to the rich nations of the West. Japan was the trailblazer, followed closely by South Korea, Taiwan, the South-East Asian “tigers" and finally China. These economies have been transformed and millions lifted out of poverty by following the strategy of export-led growth. Now that the Western nations are on course for a prolonged downturn, is it time for a shift in that strategy?

Not all economists have been enamoured of the export-led growth model.

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Economist Thomas Palley, for instance, has for long been writing about the need to make growth more oriented to domestic demand. Writing in 2006 in an article on Yale Global called “Export-led growth: the elephant in the room" this is what Palley had to say on the consequences of declining US consumption: “Once consumption spending falls, the US economy will slow, possibly even falling into recession. Imports will fall, ricocheting back to emerging market (EM) countries whose exports will tumble. On the financial side, EM countries’ trade surpluses will fall. On the industrial side, there will be excess capacity and lost jobs. Excess capacity will discourage foreign direct investment, while rising unemployment risks a return of political instability. The depth and duration of such a downturn is the next $64 million question. That will depend on the extent of excess capacity and the scale of US household over-indebtedness. It will also depend on whether emerging economies can replace exports with domestic sales, but don’t count on that as their record is poor."

The export-led growth model owes its success to the abysmal failure of the system that preceded it, the “import-substitution" model of growth, which concentrated on building up domestic manufacturing capacity to cater for the local market. We all know where that model led to in India.

Producing for the world market, on the other hand, encouraged economies of scale, forced companies to adopt the latest technology and helped make them truly competitive. It wasn’t until the Asian crisis, therefore, that the critics of the export-led growth strategy began to resurface, with some of them arguing that one of the reasons for the crisis was the strategy of relying on exports by too many countries at the same time.

Robert Blecker, professor of economics at American University in Washington DC, pointed out: “This flaw is the ‘fallacy of composition’ of so many countries simultaneously relying on export-led growth policies and the resulting over-investment that has created an overhang of excess capacity in key export industries. While these policies did not directly cause the financial crisis, the competition of an increasing number of developing nations for a limited range of export markets in similar products was a source of underlying vulnerability to a crisis. In fact, the location and timing of some of the recent financial crises can be associated with situations of disappointing growth in countries that were counting on export booms to propel their development."

The argument was that while export-led growth was a perfectly feasible strategy for Japan or for a handful of East Asian nations in the 1970s and 1980s, it started giving diminishing returns in the 1990s, as more and more countries joined the exporters’ club. Some have pointed to China’s devaluation of the renminbi in 1994 as having set the stage for the Asian crisis. Since that crisis, the solution seems to have been to artificially inflate consumer demand in the advanced economies through a massive ramping up of debt. This kept consumption going, led to sharply rising US imports and US current account deficits and kept the export factories humming in Asia. That artificial stimulus has now collapsed.

What’s the remedy?

Consumption should go up in countries such as China, where it accounts for a mere 35% of GDP and the Chinese government has already announced a massive spending programme. As Becker points out, “the only way forward for the Asian countries (and for developing countries in other regions as well) is to pursue more internally oriented development. This means less reliance on export markets especially in the US, and more acceptance of the need for rising domestic wages in order to create a mass consumer market."

That doesn’t mean exports should be neglected, because competing in world markets brings plenty of benefits. But perhaps the developing world will see a greater balance between export-led and domestic demand-led growth in future.

Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at