Countries urgently need to correct their wayward economic ways; China also needs to act

When I'm not teaching at Peking University or at the Tuck School of Business at Dartmouth College in America, I spend a lot of time with my wife and family in a house in the French countryside. One of the reasons for living in France is that the French have made great efforts (and have spent a lot of money) to preserve their lifestyle. The French air is clean, the French food is of very high quality and French farmers still enjoy large subsidies which allow them to cultivate relatively small and uneconomic areas of ground. The French health system - largely free for French users, and subsidized for non-French Europeans, like my family - is among the best in the world, and the French pension system is one of the most generous.

Our house is about 150 years old. In 2009, we started replacing the old electrical system. It took until the middle of July 2011 to finish the work. I believe that if our house was in China, not in France, the electrical renovation work would have been finished much earlier. The quality of the French electrician's work was good, and he worked hard, starting at 8.15 on Monday morning and working until noon, which, as in China, is lunchtime. At 2 pm he started again, and worked until 6 pm. This schedule was repeated on Tuesday, Wednesday and Thursday. But on Friday, Saturday and Sunday he didn't come, because by European law he was not allowed to work more than 35 hours in a seven-day week. If Chinese building schedules applied to my French house, I think the electrical renovation would have been finished in 2010.

In the French countryside, an electrician earns 36 euros an hour, out of which he pays his tax to the French government. In Paris the cost increases by at least double, to 70 euros an hour. That's a lot more than a Chinese electrician earns for an hour's work - even an electrician who works for a building company which is officially registered and pays government tax. A French electrician may have better equipment and be better trained than a Chinese electrician, and may be able to achieve more in an hour as a result. But is he that much better?

The clean but expensive French lifestyle, combined with the economic recession following the credit crisis have placed increasing pressure on French government finances. In 2000 French government spending exceeded government revenue by a modest 1.5 percent of GDP. By comparison, in 2000, China's budget deficit was 3.3 percent of GDP. But in 2009, the year after the financial crash, the French budget deficit surged to 7.8 percent of GDP. French net debt (borrowing after accounting for French foreign reserves and other assets) rose to 77 percent of GDP in 2009 from 48 percent in 2000, and is projected by the IMF to rise further to 81 percent of GDP in 2011.

It's becoming clear that the French are going to have to make large spending cuts for France to go on paying its way. But it's not just France that has a debt problem. Of the other major European countries, only Germany looks to have its public finances under control, with net government debt at a relatively modest 58 percent of GDP in 2010 and heading down to 55 percent by 2016. The IMF projects net debt as a proportion of GDP for the other larger western European economies in five years' time as follows: Britain 73 percent; France 82 percent; Italy 95 percent and Spain 66 percent.

Among the troubled smaller European economies, in 2011 Greece's net debt is projected to reach 153 percent, Portugal's 102 percent and Ireland's 99 percent - levels normally associated with national insolvency. Outside of Europe, the two largest world economies, Japan and the US, don't improve the picture much. In 2010 US net debt stood at 60 percent of GDP. This ratio is projected by the IMF to increase in five years' time to 89 percent. Japanese net debt is out of sight at 118 percent, and is set to increase even further to 167 percent by 2016.

Faster economic growth is the obvious answer to debt. If Europe and the other G7 economies - the US and Japan - start to grow at more than 3 percent, increased tax revenues will cover debt payments, and allow debt reduction as well. But although the IMF is projecting global growth of 4.4 percent in 2011 and 4.5 percent in 2012, it's the newly emerged countries which are the drivers. For the G7 countries, the IMF projects growth of only 2.6 percent this year, and 2.7 percent next, and those projections seem optimistic. Economic growth needs liquidity and financial resources, and in the G7 economies, the economic machine which creates growth is badly damaged.

Many European and US banks still hold trillions of dollars' worth of bad loans, and are using the profits gained from ultra-low interest rates to remove these, not make new loans. The result is that bank credit is not growing nearly as fast as it needs to - in fact, in some cases it's shrinking. Worse, in the US the housing market is still falling, further undermining bank balance sheets. In Europe many banks are beginning to face much larger write-downs on Greek and other sovereign debt, as national leaders come to the realization that bank shareholders need to shoulder a much larger part of the European economic burden.

The G7 countries are waking up to the reality that the credit crisis of 2008 was not a one-off event that could be fixed by two or three years of easy money and some bank rescues. They can see now that one condition for a successful exit from the credit crisis is a fundamental overhaul of the Western banking system. Another is that G7 debt has to be reduced. This means that spending has to be cut. Welfare spending - including pensions, education, unemployment and sickness benefits - makes up about 40 percent of all European government spending. It's impossible to make significant cuts in government spending without cutting welfare. If growth is weak, the only way to reduce debt is to cut spending - and cut Western lifestyles. But in the G7 countries, only one country - Britain - has recognized that reality so far.

After a long period of low-inflation economic expansion which was driven to a large extent by globalization, Europe finds itself facing very hard decisions. The longer that European countries delay in cutting spending and reforming their economies and banks, the greater the downward adjustment in European living standards that will be required, and the greater the shock of adjustment. Added to the current problems is the fact that Europe is aging. Today, one European worker supports one retired person. By 2050 current estimates indicate that one worker will be supporting two retired people. One way or another, my French electrician will see a reduction in his living standards through a combination of a cut to his government pension, higher inflation, a lower euro, and even unemployment. The question is not if, but how and when. Social unrest in Europe is set to increase, particularly in countries with decades of comfortable living, like France.

Although China's large economic stimulus has raised levels of debt particularly among local governments, the country's overall net debt position remains stronger than that of any European country. But China also has many economic problems to deal with that limit its scope for improving social welfare to Western levels. Over the next two or three years, the Chinese workforce will stop growing. Studies show that between 2010 and 2020, China's retired population will increase by 74 million while its workforce starts to shrink. China's growing army of retired people will start to become a drain on the country's pool of savings, which will start to decline as they are drawn down.

China has only two ways to limit the impact of its aging population: increase the return which savers receive by allowing interest rates to rise significantly, and increase worker productivity. Both require further fundamental reforms which improve the efficiency of China's banking and monetary system, and its State-owned companies. Because China, with its huge population, is playing catch-up with the developed world in terms of per capita GDP, it must continue to carry out fundamental economic reforms in order to provide a stable long-term future.

The author is visiting professor at the Guanghua School of Business, Peking University. The opinions expressed in the article do not necessarily reflect those of China Daily.