March 20, 2011

Diversifying Economies: A Continuous Quest for Balance

As the economic crisis dies down, it’s becoming possible to see just what cracks the storm revealed in the foundations of national economies. Although countries around the world have experienced the crisis differently, a single unifying element has left them vulnerable: Their economies are not sufficiently diversified. This has led to the realisation that only diverse economies are truly stable—and diversity must be more broadly defined.

The recent global crisis revealed an unexpected global fact: countries’ economies were and are not sufficiently diversified. That statement would probably come as a surprise to most of the national leaders responsible for economic development. After all, economic diversification has traditionally had a fairly narrow definition referring only to a country’s mix of industries. Discussion of insufficiently diverse economies usually centers on countries whose entire industrial base relies on oil or another single resource, such as some nations in the Middle East, Africa, and Latin America. However, even countries that appear extremely diversified—such as the United States—may still be vulnerable to unexpected events.

Diversification Explained

Imagine that every country in the world falls along a continuum. At one end is a country with just a handful of companies producing a limited number of commodities, and sharing them with very few trading partners. Although such a country would be at severe risk of external shocks—for example, a sudden glut of one of its key products in global markets—the parameters of its economy are simple to track, and such threats are easy to predict. At the other end of the continuum is a country with a fully diversified economy in every possible sense—in its exports, investments, industries, sources of spending, labour pool, technology, and knowledge. It has anticipated and accounted for every possible risk and diversified its assets so thoroughly that even a complete collapse in one area cannot significantly damage the whole.

Both of those countries are pretty safe from global economic risk. The exposed countries are those in the middle of the continuum; at present, that includes every country in the world. “No single country has diversified its economy so completely that it will be protected from all shocks, but nearly all are so diverse, complex, and globally connected that they cannot fully anticipate each potential source of risk. In other words, although most nations aren’t aware of it and most economic leaders believe the opposite to be true, global economies are simply not sufficiently diversified,” says Richard Shediac, Partner, Booz & Company.

Exposing Over-concentration

At present, there is little statistical data to prove the correlation between lack of diversification and economic instability, but the recent economic crisis has provided a plethora of anecdotal evidence that countries can be over-concentrated in any number of ways—with too much reliance on consumer spending, exports, small business, large companies, or foreign investment. Additionally, for countries, such as the U.S. and U.K., the problem is another form of over-concentration: Rather than too much trade, these countries have an overdependence on domestic consumers whose purchasing activities are largely financed by debt. “In the early days of the crisis (2008), consumption made up 71 percent of GDP in the U.S.—roughly six times the share of exports. During the economic contraction, household incomes declined and consumer confidence plummeted with devastating effects. Today, the U.S. economy is still bogged down with high unemployment and low confidence. A perfect case in point of the dangers of over-concentration,” said Chadi N. Moujaes, Principal, Booz & Company.

Other countries find their economies overly dependent on one kind of company, with their enterprise bases either consisting primarily of small businesses or dominated by a few large conglomerates—each of which presents its own problems. Italy, for example, has a preponderance of small and medium-sized companies. Roughly 95 percent of Italian companies fall into this category, and they employ more than 80 percent of the Italian labour force. These companies are the first to shed jobs during a recession, making the country less able to ride out downward trends in the business cycle. And then there are countries with a disproportionate amount of economic activity tied to a few large companies, as demonstrated by the U.S. banks that undermined the national economy in 2008.

Achieving Balance

It is important to note that policymakers should not attempt to undermine or eliminate the elements that are at the heart of their countries’ success. Instead, policymakers should seek out counterbalances to these dominant influences to ensure they do not play a disproportionate role in the economy. The fundamental question is whether the key elements of an economy are varied, flexible, and readily applicable to a variety of economic opportunities. The imperative for policymakers is not only to monitor these elements but also to continually seek out potential areas of over-concentration, including those that may not yet be evident. However, this task is not an easy one.

This effort is an unending quest rather than a single hurdle. Seeking out the next potential source of over-concentration requires policymakers’ continuous energy, attention, and action as they attempt to shield their economies from unnecessary risk. Even as policymakers take a broader approach to diversification, moving beyond their industrial base, they must also take a deeper approach. For each single element of economic diversification, multiple ways to diversify can be found within that arena and the permutations are very nearly endless.

Although no country has achieved complete diversification, some are farther along the continuum than others. Australia is a good example of a country that emerged relatively unscathed from the economic crisis thanks to its economic balance. Perhaps because of its geographic proximity to China and India, Australia saw the potential of these countries and began trading extensively with them and with other emerging markets prior to the economic crisis. As a result, Australia’s trade portfolio was sufficiently diversified when the crisis began, allowing it to avoid the shock of being undermined by the collapse of a single trade partner.

In Conclusion

Comprehensive diversification is not simple to implement, because it requires ongoing calibration of every aspect of the national economy. Policymakers will need to be resolute in their determination to keep these risks under control, because properly managing the risks of over-concentration is critical to sustainable, long-term economic development. “The global economic system is overly complex and becoming more so by the day. It may be difficult to begin the process of diversification now—but it could well be impossible in the future,” concluded Dr. Mazen Ramsay Najjar, Principal, Booz & Company.