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(originally published by Booz & Company)


A Continuous Quest for Economic Balance

Only diverse economies are truly stable — and diversity must be more broadly defined.

As the economic crisis dies down, its full ramifications are still unclear — but 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, and are recovering at varying rates, a single unifying element has left them vulnerable: Their economies 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. 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, labor 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.

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.

For example, in 2007, as the global crisis was about to break, Ireland’s foreign trade (i.e., imports plus exports) was equal to roughly 150 percent of its GDP. The credit crunch of the following year and the recession in the economies of Ireland’s major trading partners resulted in the collapse of its export growth. Real GDP contracted by 3 percent in 2008 and about 7 percent in 2009, and unemployment increased from 4.5 percent in 2007 to 12 percent in 2009. Today, it’s clear that Ireland is doubly burdened: Its economic crisis has turned into a fiscal crisis, with over-concentration in the banking sector translating into major liabilities for the government as it was forced to bail out major institutions.

For other 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, in 2008, consumption made up 71 percent of GDP in the U.S. — roughly six times the share of exports. Even during times of expansion, such economies are subject to seasonal swings and the whims of consumer behavior. During periods of economic contraction, when household income typically declines, consumer confidence plummets, with devastating effects; the fact that the U.S. economy is still bogged down with high unemployment and relatively low confidence is a case in point.

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