Markets, Marx and Malthus

The Challenge of Rebalancing in a Time of Transformation

Marking 20 years since it established the CEO Retreat, A.T. Kearney's Global Business Policy Council (GBPC) convened senior business and government leaders in Shanghai in June 2011 to examine the sweeping changes under way across the planet. Shanghai is emblematic of the systemic transformation taking place around the world today. The city typifies the high-energy, high-growth trajectory on display in much of East Asia at a time when the rest of the world continues to struggle following the 2008-2009 Great Recession. The Retreat took place in the city's historic Bund district, overlooking a steady flow of barges moving down the Huangpu River. The view was a constant reminder of China's extended period of near double-digit growth.

The Global Business Policy Council's two-day CEO Retreat brought together specialists from around the world to assess the significant global "rebalancing" now under way and the implications for the business environment. Faculty members represented a wide range of organizations, including the American University in Cairo, the Carnegie Endowment for International Peace, the Center for Strategic and International Studies, Chatham House, China Europe International Business School, Georgetown University, the Peterson Institute for International Economics, Renmin University, Stanford University's Freeman Spogli Institute for International Studies, UCLA Anderson School of Management, and the U.S. National Renewable Energy Laboratory.

The Retreat, as always, was held under the Chatham House Rule. Therefore, this paper does not offer specific attributions on points raised, but draws selectively on the many valuable contributions. With permission, however, we would like to make one exception: Moises Nairn, our good friend and a highly valued and longtime member of our faculty, has graciously allowed us to use his imaginative phrase "Markets, Marx and Malthus" as the title of this proceedings summary.

Four critical themes surfaced in the discussion. The first is that the global economic and business outlook is marked by pronounced and growing asymmetries across geographies, economic systems and stages of economic development. This, for obvious reasons, has significant implications for global strategic planning. The second theme is the pronounced need for continued innovation in—and diffusion of—critical technologies. This is especially important in the energy sphere.

No matter what the nature of the global challenges we face, new advances in technology are a vital precursor to solutions. The third theme centers on the precipice of massive geopolitical change and the potential for profound political rebalancing in a number of major countries. The coming year, 2012, will be a time of several political transformations with important consequences for the international business environment. Finally, there is the more general issue of contrasting political and economic systems that have been—and continue to be—stress-tested by a range of "shocks." If we are beyond the "Washington consensus," then what are the key elements in navigating a world marked by relentless and accelerating change and growing volatility?

What follows is a detailed discussion of all four areas. We conclude with the major takeaways for business leaders seeking to position their companies to prosper in today's increasingly complex and volatile global business environment.

1. The Global Economic and Business Outlook

Discussions about the outlook for the global economy took place against a backdrop of key assessments from international financial institutions, which together reflect a general consensus on the economic outlook. On June 17, less than two weeks before the Retreat, the International Monetary Fund (IMF) updated its World Economic Outlook by noting that "[o]verall, the global economy expanded at an annualized rate of 4.3 percent in the first quarter, and forecasts for 2011-2012 are broadly unchanged, with offsetting changes across various economies."¹ More specifically, the IMF asserts that output growth remains unbalanced and that earlier hopes for a more rapid recovery have faded:

"Growth in many advanced economies is still weak, considering the depth of the recession. In addition, the mild slowdown observed in the second quarter of 2011 is not reassuring." ²

In late May, in its 2011 Economic Outlook, the Organisation for Economic Co-operation and Development (OECD) described things similarly:

"[T]his global recovery is taking place at different speeds across countries and regions. Most advanced economies are faced with sluggish growth, high budget deficits and high unemployment: nearly 50 million people remain jobless in the OECD area as a whole.... In most emerging-market economies, by contrast, vibrant domestic demand growth and high commodity prices are generating inflationary pressures and prompting policy tightening. This means that, although the recovery is under way, the outlook is not without risks." ³

To be sure, the challenges associated with the multi-speed economic future predicted by both the IMF and the OECD go well beyond the divergent rates of growth expected between the developed and developing worlds. It also implies considerable differences in the various policy challenges between the classes of economic development (that is, the developed and developing worlds) and also within those respective classes.

These complexities were a point of departure among participants. The generally held view was that there was no global crisis; it was, more accurately, a semi-global crisis. It was argued that the traditional two-track economic model—addressing the differences between advanced economies and emerging market economies—was no longer sufficient. "As always, but more than always," argued one faculty member, "the picture is highly differentiated." There is a need now to divide advanced countries into at least three groups. The first group comprises countries (most especially on the European periphery) now encountering profound difficulties in the wake of the financial crisis. The second category should capture the advanced economies (the United States and the United Kingdom, for example) that are recovering somewhat but continuing to encounter heavy legacy challenges arising from the crisis. Third are the countries (such as Canada and Australia) that managed to sail through the crisis relatively unscathed. For similar reasons, there is a need to differentiate among emerging-market economies. In particular, there is a big difference between economies that are overheating, creating inflationary pressures and other challenges, and those whose output growth is more moderate.

Participants generally agreed that despite the recent slowdown in the global economy, the underlying drivers of expansion are reasonably strong. The abrupt slowdown in global industrial production in the past several months reflects a range of temporary factors, including Japan's earthquake and its aftermath, the hike in oil prices and volatile weather conditions. Absent new shocks (see below), global growth can be expected to accelerate again in the ranges indicated by both the IMF and the OECD (4.2 to 4.3 percent this year and 4.5 to 4.6 percent in 2012-2013). Similarly, world trade volumes are projected to grow at the 7-5 to 8.0 percent level over the next two years.

There are four reasons for this cautious optimism. First, the recovery in the parts of the world affected by the financial crisis is still young. That means these countries' economies are still benefiting from the expansionary monetary policies that were part of stimulus plans. Moreover, the crisis-affected economies continue to have pent-up demand that may suggest the potential for future economic dynamism. Second, generally speaking, the upside potential for many of the recovering economies outweighs their weaknesses. Despite continued vulnerabilities in housing markets, the time required for banks to rebuild their balance sheets and the challenge of high unemployment, among other things, several economies are now turning the corner. Third, several of the temporary elements that have set back growth in global output—the Japan earthquake, the "Arab Spring" and the resulting geopolitical uncertainty and increases in oil prices, and the impact of weather-related volatility on food prices —are now subsiding or moderating. Finally, and by far most importantly, is the massive contribution to the global economy by emerging markets. This historic expansion, fueled by favorable demographic trends and significant investments, has been a crucial source of dynamism for the global economy.

Still, one faculty member observed, just three "cylinders" are fully functioning in the six-cylinder global economic engine: non-Japan Asia, Latin America and Africa. For fundamentally different reasons, the United States, Europe and Japan all continue to face significant obstacles to recovery:

United States. In the case of the United States, participants focused considerable attention on the prevailing fiscal challenges and the prevailing political debate on raising the debt limit. One faculty member highlighted what he characterized as a "dysfunctional" state of affairs that went well beyond the current political tension over fiscal policy. Noting that the United States had fallen to 37th place in life expectancy and 31st in percent of youth graduating from college, he wondered about the country's longer-range outlook. He argued that "people were facing up to their problems in much of Europe" by implementing tough fiscal policies, while the United States, in contrast, was marked by an absence of structural reform, a highly parochial political debate and, therefore, a far less certain future. "It is no way to run a government," he concluded. Multiplying the problems is the way in which the housing bust has stopped America's once-famous labor mobility dead in its tracks, as people are unable to sell their homes and move to new jobs. Paralysis, unfortunately, has become highly descriptive of many aspects of the United States.

Europe. Europe faces different challenges, starting of course with the serious fiscal challenges facing its Southern and Western periphery. A number of countries overspent prior to the crisis and therefore were left without "policy ammunition" to fight the cyclical downturn. The operative question now is whether those countries can summon up the political will to implement structural reforms. One faculty member contrasted the current situations in Greece and Portugal with the recent experience in the Baltic countries. He noted that in 2009, Latvia, Estonia and Lithuania had carried out fiscal adjustments of about 10 percent of GDP. In the case of Latvia, this translated into reductions in average public wages of 26 percent, reduction of the public employee workforce by 29 percent, and the closure of 50 percent of hospitals and 12 percent of schools.

Another member of the faculty asserted that the problem of Greece is simply that the debt-to-GDP ratio is too large. This implies the need to reduce debt or increase output, but neither of these options is possible without generating higher unemployment and political instability. Political figures in Europe have failed to look at the situation from a cost-benefit standpoint, he argued, which means voluntary debt restructuring instead of debt rollover. The contrast between these policy responses was evident in South America a decade ago. By rolling over debt, Argentina went through the most devastating crisis the region has ever seen. This is in stark contrast to the voluntary restructuring of debt in nearby Uruguay, which made a quick recovery and avoided political populism.

The prognosis now is for a two-speed Europe, with higher growth rates of 4.0 to 4.5 percent in Northern Europe (led by Germany) and Eastern Europe, and substantially lower levels in the Southern and Western periphery. It could take five to 10 years for the non-performing part of Europe to adjust against a backdrop of what one faculty member called "integration fatigue." Certainly, Europe's economic trajectory will depend on the outcome of the current financial turmoil. By definition, the evolution of the current European financial crisis will be extremely uncertain. On the one hand, the current threat could be contained through a restructuring of public debt. On the other, especially if Spain and Italy were to be enveloped in the financial instability, it could become a global credit event of the first magnitude—even more significant than the Lehman Brothers collapse.

Japan. Recovering from the tragic earthquake, tsunami and nuclear emergency, Japan's outlook is for revived growth through the end of this year. One participant emphasized the resilience of the Japanese economy and its capacity to restore growth.

Six Wild Cards

Members of the faculty suggested that all three of these non-performing cylinders were negatively affected by their dysfunctional politics and policies. Several participants agreed that there was a pronounced "disconnect" between the respective political and economic communities in these countries. When considering this global economic outlook, we need to superimpose the following six wild cards.

Oil prices. The recovery of the global economy has translated into a massive increase in demand for energy and a substantially tighter market for oil. Ironically, the second quantitative easing (QE2) policy in the United States, by injecting $600 billion to stimulate the U.S. economy, may have pushed up the price of oil and caused its own economy to slow down. In a post-QE2 environment (no further quantitative easing is expected), oil prices are nevertheless expected to stay high—perhaps higher than they ever have been. This raises the possibility of a repeat of 1982-1983, when higher energy prices drove up inflation and interest rates and cut short the global economic recovery.

Overheating and inflation. Currently the signs of growing inflation are limited. In fact, in half of developing countries, the level of inflation remains below pre-crisis levels. Nevertheless, the symptoms of high inflation in the largest and most dynamic emerging markets (India, China and most especially Brazil) are serious. If left unaddressed, these pressures could intensify and spread. More generally, faculty pointed to the massive liquidity overhang that could fuel a large increase in prices once confidence in the global economy is restored.

Volatility in the Middle East. The volatile Middle East continues to be a major uncertainty.

Restoring economic dynamism. As already mentioned, there are significant risks with respect to the capacity of government in the advanced economies to restore economic dynamism. The challenge is to sustain expansion simultaneously while addressing fiscal imbalances and normalizing fiscal policies. This implies a careful balance in timing and sequencing that is difficult to achieve even in the absence of polarized political conditions. According to one faculty member, "We will need a lot of luck to avoid inflicting yet another shock on ourselves."

Longer-term questions about China. The meteoric rise of China after reforms were implemented in 1978 is significant in historical and commercial terms. But China's rapid rise, the result of which is that it is now the world's leading exporter and creditor, also has generated asymmetries. The massive accumulation of foreign exchange reserves, the country's high saving rate, and the interest rate rises generated by concerns about inflation are in sharp contrast to the record low interest rates and debt pressures in the United States, Europe and Japan. The challenge, then, is to manage the significant differences between China and the rest of the global economy. How will it complete its sudden transition from backward agrarian nation to global manufacturing power?

The Brazilian bubble. Finally, two faculty members agreed that Brazil currently looks very much like it is experiencing a bubble. In the context of the less-than-smooth political transition that has occurred there, will the new government be able to promote stability?

Outlook for the Chinese and Asian Economies

Reflecting on 30 years of growth since the beginning of the liberalization of the Chinese economy, DOUG J. ARENT, Executive Director, Joint Institute for Strategic Energy Analysis, National Renewable Energy Laboratory the faculty discussed the causes of such rapid growth and the challenges for the future. Three key themes surfaced in this discussion:

Changing the economic formula for growth. For years, China relied on investment, in the form of infrastructure and foreign direct investment, and export growth for economic expansion. Export growth depended on low wages, cheap oil and extensive government intervention in the economy, three variables that have changed and, most likely, won't return. Beijing appears to accept this new reality, and also recognizes that it needs to change in order to reduce carbon emissions, even if it protests such notions publicly today.

Addressing creeping inflation and exchange rate pressures. It may appear on the surface that China's growth story has been an easy one, but it's been anything but. China faced serious inflationary pressures in the middle and late 1980s; the 1989 Tiananmen Square protest was not only political, but also was about economic strife. In the wake of those difficulties, China built up its reserves, creating unsustainable global imbalances. After a pause in the wake of the global financial crisis, China has once again embraced a "managed float," and any sudden currency revaluation is not expected. This gradualist approach to Chinese economic policy remains important, especially when considering the "shock" approach of the People's Republic's early days, when it instituted its devastating Great Leap Forward.

Mobilizing the private sector. It was only in 1992 that the government allowed firms with more than eight employees. Today, the private sector accounts for 65 percent of output and over 60 percent of employment. Private firms have also changed dramatically in this time and are now more focused on establishing capabilities and resources, and less on having the right connections. Innovation is acknowledged as the most important new capability by the private and public sectors.

Today, only about 3 percent of the value added for an iPad is captured in China, underscoring why it is important for China to move from low-cost manufacturing to capturing high-value products and services. We expect a heightened emphasis on sustainability from the private sector and new investment in energy, biotech and advanced materials. This will be reinforced by a youthful entrepreneurial culture in a country where the eagerness of young people to learn and compete is intense.

Building on the discussion of China's prospects, there was also a valuable dialogue from participants on the resilience of the Japanese economy, which is recovering from the tragic earthquake, tsunami and nuclear emergency that struck earlier in the year. The theme of the comments —particularly from a business leader with firsthand knowledge of the situation— was that the recovery was moving quickly, and that the Japanese people were showing the strong nature that has helped them persevere in past tragedies.

2. Continued Innovation in — and Diffusion of—Critical Technologies

Over the years, the CEO Retreat has focused on the impact of cutting-edge technologies. This year was no different. A leading scientist and entrepreneur gave a presentation in the area of 3D printing—otherwise known as "personal manufacturing." The key feature of the technology is the capacity to "print" a three-dimensional item layer by layer in various materials (see photos of 3D Printing). The presenter distributed what he called printed objects made from plastics and metals (in particular, titanium), including surgical parts (knee and hip replacements), car parts, shoes and shoe inserts.

The technology represents the fusion of the printing process, on one hand, and advances in programming, on the other. The samples revealed the remarkable degree of precision. In addition, the technology allows for efficiency gains that previously were difficult to realize. For example, participants saw a paper cup that only uses degradable paper products but still maintains its strength and heat insulation qualities. More generally, through "additive" rather than "subtractive" manufacturing, the technology offers significant possibilities in resource conservation.

CHAIN-MAIL GLOVE

The implications remain to be seen, but the general view is that there is considerable upside potential in 3D printing. For one, 3D printing will contribute to the growing phenomenon of customization, which suggests the end of the one-size-fits-all approach in a number of industries. And the scope of materials that can be printed is growing. The scientist highlighted the eventual possibility of biological printing— for instance, the development of skin or other biological materials that could be used to improve human health. Furthermore, the changing economics of the technology are at the core of whether there will be a period of personal manufacturing through the 3D printing process. The key questions were "How big can we get in manufacturing?" and "What are the thresholds for cost-effectiveness?"

In the end, it was clear that participants would put 3D printing on their watch lists of potential step-change technologies.

The Outlook for Global Energy

Discussions turned to the outlook on global energy, focusing on several areas, including the following:

LIGHTWEIGHT LOAD-BEARING ENGINEBLOCK

Rising global demand for energy. Revived economic growth is increasing global demand for energy and stressing the energy infrastructure. Among other things, oil price pressures have returned—oil hovers near $100 per barrel and could rise even further. The price of oil, of course, is contingent on a number of factors:

• Supply and demand fluctuations. Oil prices start at the intersection between supply and demand, but other factors can play a major role—for example, refining assets (the "kit" can be disrupted by geopolitical developments, such as the current instability in Libya, or weather-related disruptions). Bottlenecks can and do occur, and certainly they push up the price of crude. On the exploration and production side of the business, developing a major new resource base can take five to six years, a major timing delay that contributes to price imbalances.
• Government intervention and regulation. Environmental requirements on fuel (such as ultra-low sulfur requirements in gasoline) force companies to make capital investments and drive up the prices of the types of crude they source. This, in turn, puts pressure on oil supply and affects overall refining capacity.
• Delays in exploration. Constraints that delay exploration and up-grades in refining capacity will result in higher prices. Oil and gas companies are taking incremental profits from higher prices and investments. Unfortunately, all sectors compete for many of the same technical resources (such as engineering talent, construction resources, fabrication capacity, process equipment and raw materials) and draw from the same resources for major capital build-outs.

FINGER IMPLANTS

Demographics and an aging population. The challenge of aging applies heavily in the energy work force, where human capital is the most important strategic challenge. What are the consequences? Oil companies are deferring and delaying capital projects that they know will bring on incremental production because they cannot get engineering talent or supply-chain professionals to secure raw materials. In Australia, the expansion of the northwest shelf and the gas infrastructure to supply Asia is putting enormous pressure on the labor market. In Canada, pressure on input costs on the material side and the mobility of engineers to go to other places has increased the cost of that asset from $40 a barrel to more than $60.

Technology breakthroughs. The combination of horizontal drilling technology with multi-stage fracturing into hydrocarbon-rich shale are having an impact on the energy sector. Simply put, this is a major technology disruptor. Estimates in the United States are that the reserves available from current technology are 300 trillion to 1,000 trillion cubic feet—the equivalent of one to three times the largest hydrocarbon deposit found on the planet (300 million to 400 million barrels). While some argue that development at this level would create an oversupply of natural gas in the United States, and that oil companies would go back to conventional oil exploration, one participant argued that oil companies will continue to develop shale gas to put reserves on their balance sheets. The big wild card for the development of this energy source is government regulation.

The changing energy infrastructure. The changing physical environment is affecting energy infrastructure in ways that could create disruptions in extraction, refining and delivery, and could eventually affect stability in the global energy system.

Across the world are examples of systems (ranging from ancient fortifications to modern-day cities) that have been and continue to be vulnerable to changes in the physical environment. In many ways, we have similarly built global infrastructure. Indisputable, for example, are changes in the physical environment. Take, for example, hurricanes in the Gulf of Mexico. Why did Hurricane Katrina do the damage it did? Authorities took a vulnerable area and made it completely indefensible with bad levees, a lack of planning and large-scale subsidence. They literally engineered the Katrina disaster, and similar failures are occurring all over the world.

Shanghai, like New Orleans, is on a delta, a typhoon pathway. The name Shanghai means "above the sea," which implies that everything around it is not. In days past, the other side of the Bund was green space (an absorption area for flooding), but it has now been paved over with concrete, and water that can no longer be absorbed creates a flooding problem like the one that occurred in 1990. Another example raised by a faculty member was a chemical company on the north coast of China. The local government built two other plants nearby and would like to build high-end residential houses in the vicinity. If struck by a typhoon, it is possible that the plants could breach—putting thousands of people in jeopardy. Officials there recognize the problem, but they simply are not taking this kind of environmental contingency into account. This issue is not limited to China; it is happening across the world.

The economic consequences, of course, can be significant. Hurricane Katrina, for example, caused extensive damage to the oil and gas sector in the Gulf, as more than 100 platforms were destroyed and 450 pipelines damaged. This precipitated a significant drop in production, which in turn caused a massive spike in cost. "If one node goes down," a faculty member observed, "it can affect the entire system." In 2008, Hurricanes Gustav and Ike went through the area again. They did not generate as much damage as Katrina because the insurance sector was activated and there was a preventive shutdown of the platforms. Still, production was disrupted even without damage to the installations.

The same kinds of observations apply to hydro and nuclear plants. When hydroelectric power plants are built, planners generally look at the past 50 to 100 years. That, however, says nothing about the next five to 10 years. Nuclear reactors need an enormous amount of water for cooling and are usually built near the sea and rivers. In France, this is an issue because river temperatures are rising and are therefore not delivering expected cooling capacity. In 2003, 17 reactors had to power down or shut off because of high temperatures.

While our physical infrastructure is not designed for these kinds of disruptions, our legal and regulatory systems also fall short. Consider risk assessments. There are a lot of things that simply should not be built but proceed nevertheless because the risk assessments have been distorted. Insurance should be our best friend.

Alternative energies. Discussing the status of alternative energies requires acknowledging that alternatives are a very small part of today's energy mix, yet significant in a number of economies. Moreover, they are a key feature on the roadmaps countries are charting for their energy futures.

The clean technology sector has grown from $30 billion (in terms of global transactions) in 2002 to $250 billion in 2010. It represents 46 percent of all new power investments globally: $95 billion in wind, $85 billion in solar and $75 billion distributed across other areas (including fuel efficiency and smart grids). It also represents about $200 billion in stimulus obligations and commitments, including $50 billion in China, $42 billion in Germany and $35 billion in the United States—all in the past few years. The venture capital and private equity engines still reside predominately in the United States. Primary technologies—wind, solar, biofuels—have all increased their cost-effectiveness, leading to 80 to 90 percent reductions in the cost of energy delivered in the last 15-20 years. Patents in the clean technology sector have grown threefold since 1978, while energy patents generally have dropped by a factor of 20 percent.

There is a strategic dimension as well, as there is global competition for clean energy. In China, for example, the 12th Five-Year Plan has very aggressive goals just for wind energy: about 150 gigawatts over the next 11 years, a $1.5 trillion to $2.5 trillion investment. Countries such as India and Germany, the latter recently announcing the decommissioning of its nuclear plants, are examples of other countries with strong alternative energy programs.

The move toward alternative energies is being driven not only by global climate change, but also by competition, local environmental issues, a desire for intellectual leadership, and other co-benefits, such as the positive impact on health and efficiency.

In the future business landscape, leaders will want to take advantage of the alternative energy sector's remarkable capacity for innovation—measuring, monitoring and monetizing the delivery of energy systems and services (including mobilization, heating, cooling and information). Similarly, alternative energy presents an opportunity to rethink the links between information technology and energy technology—to make it "smart"—and to rethink system solutions. Public sector leaders across the world want systems (at the regional and local levels) that are reliable, cost-effective, resilient and able to deliver heat and power.

3. The Precipice of Massive Geopolitical Change

Discussions turned to the massive geopolitical "rebalancing" act taking place around the world—with a closer look at Asia, Europe, Russia and the Middle East. This shift in the geopolitical balance, it was argued, means a corresponding shift in values and cultural and political approaches to the future. The fairly predictable form of governance in the G7, for example, is being replaced by a much more multifaceted system of the G20.

Asia: The Challenge of Security
The single biggest challenge in global politics right now, it was argued, is dealing with the rise of China. Beijing's new position is reminiscent of the rise of Germany after 1871—which followed German unification and a fundamental change in the European balance of power. We can be somewhat more relaxed when comparing China to other rising powers. The China of today (compared to Maoist China, for example) does not have universal ideological motives—in other words, it is not trying to export its model. Until two years ago, leaders in Beijing followed a cautious course, minimizing the threat they posed to other countries.

Realist international theory, however, is predicated on the belief that ambitions rise with power. The symptoms of such a shift may be appearing in China, evident in tensions with Japan over the arrest of the fishing boat captain, a conflict with Korea after the sinking of a ship, disputes in the South China Sea, and tense relations with India and the United States. Although Beijing has pursued less aggressive policies in recent months, these earlier events could be a precursor of the future. Since the global financial crisis, China has gained self-confidence, as the crisis reaffirmed the strength of its political and economic model. There is a growing view in China that U.S. influence is waning and that the crisis served, among other things, to discredit its system.

The security architecture in Asia is both under- and over-developed. It is under-developed because the United States has a legacy system of bilateral security relationships with Japan, South Korea and Australia—not to mention an understated one with Taiwan. Whatever their nature, these bilateral ties are not terribly functional when it comes to dealing with China. The regional architecture is over-developed because there are too many multilateral organizations that do not deal with the security issues. In addition to these weak regional forums, there is a "spaghetti bowl" of bilateral trade agreements. Against this backdrop, China is insisting to the smaller and weaker countries that surround it that Beijing be a part of all these discussions.

How, then, should the United States deal with the rising China? In the past, it has relied on a policy of engagement—dealing pragmatically with China on economic terms and adjusting to political and military challenges as they arise. This has included an implicit containment policy in which it develops security relationships with key democratic allies and some non-democratic allies in the area. But two things have changed. First, the strategic balance in the region has deteriorated drastically, and second, the Obama administration has shifted to a multilateral approach.

Korea and Taiwan will continue to be critical to Sino-American relations. On North Korea, China has been of little help in addressing the deteriorating situation because it wants to avoid the possibility of a unified Korea that is a military ally of the United States. According to a faculty member, this suggests that there is a potential deal in which Korean unification is traded for withdrawal of U.S. forces from the Korean peninsula. Similarly, a faculty member asserted that because Taiwan is indefensible, there is a potential deal in which it goes back to China in a Hong Kong type of arrangement. Of course, neither of these solutions is on the radar scope either in Beijing or Washington, but they are strategic adjustments that the two countries are going to have to address eventually.

Europe in an Age of Uncertainty
Europe has the largest GDP in the world and a combined population and military force larger than the United States', a fact often overlooked. The European economy outside of Germany has been experiencing anemic growth and unsustainable deficits. All of Europe has been exposed to Greek banks and a "bad" European Central Bank (ECB) that has been accepting triple-Crated (CCC) Greek bonds in collateral. These last points—exposure, undercapitalization and the ECB—explain why Europe has been underperforming since the Portugal-Ireland-Greece-Spain (PIGS) crisis started in 2010. Regarding the looming default in Greece, the situation has bounced back and forth between reality and panic. On one side is the potential of a Greek default, on the other lurks a potential Lehman Brothers II and the fear of worldwide contagion; and in the middle are German Chancellor Angela Merkel and French President Nicolas Sarkozy. Merkel has been harsh on austerity, while Sarkozy has been tougher on paying. The problem for Merkel is that 60 percent of her electorate is saying "no" to more welfare for "Greeks bearing debt."

According to one faculty member, Europe's Economic and Monetary Union (EMU) is as ill-conceived as its critics suggested it was 15 years ago. It presumed convergence of the member economies, but in fact encouraged divergence. Why? "With the Euro," it was argued, "the PIGS could spend like Italians and borrow like Germans." Economic logic, therefore, would demand an immediate breakup, but political logic suggests otherwise. As far as the eye can see, Euroland will not become a convergence union but rather a transfer union. This will not make Europe as a whole more competitive, and its GDP share can be expected to continue to shrink.

Together, Europe and the United States represent the largest economic power in the world with more than half of global output. What's striking, however, is that the United States and Europe have not seen such challenging circumstances since the Great Depression. Certainly they have different challenges. Unemployment in the United States continues to hover around 9 percent, the deficit remains a challenge punctuated by a debt ceiling that is unsustainably high, and the dollar is falling along with real estate prices. In macro terms, the challenges facing the bigger EU countries (other than the United Kingdom) are not as large as those facing the United States. Europe is lagging, however, and productivity is falling. "The real drama," asserted one faculty member, "is both macro and micro — macro has to do with unsustainable deficits and inflationary money overhangs, and micro has to deal with mountains of debt [and] sticky social contracts."

In both Europe and the United States, all of these deficits come with deficits in leadership.

The Contradictory Picture in Russia
Some 20 years after the collapse of the Soviet Union, Russia has reemerged on the global stage. Yet, as one faculty member argued, there is "an element of unreality of the future of Russia."

Moscow's global goals come in four categories: (1) maintaining respect to ensure that no important international decision is made without consulting Russia, (2) preserving the status quo as Russia regards itself as a status quo power in the Euro-Atlantic region and the United States as a "revisionist" force, (3) preventing any U.S.-or European-style democratization in Russia or neighboring countries and (4) conducting foreign policy in a way that promotes the business interests of the elite.

To achieve these goals, which it has done successfully over the past few years, Russia has worked with the United States on the Obama administration's "reset" policy in a number of areas, including concluding strategic arms agreements (the new Start Treaty) and cooperating in policy initiatives aimed at Afghanistan and Iran. Despite these areas of progress, Russia-U.S. relations are not smooth. Accession to the WTO agreement has not yet been achieved, and security relations continue to dominate ties between Moscow and Washington.

Beyond its relations with the United States, Russia is engaging in a number of major countries. In fact, Prime Minister Vladimir Putin says there are only five countries that are important: Russia, the United States, China, India and the EU.

Next year's elections will be an important turning point as conditions in the country are deteriorating. Russia is not investing in human or physical infrastructure, the population is declining, male mortality from 18 to 20 is the same as that in Botswana, and there continues to be a challenge from the North Caucasus.

Implications of the "Arab Spring"
The key takeaway from the various revolutions that have occurred (and continue to occur) in the Middle East and North Africa over the past six months is that there are no one-size-fits-all conclusions. The important story is neither about "globalization of the norms of civic engagement" that shaped the positions of the respective protestors, nor about the rapid dissemination of ideas and tactics through technology (as popular as it has been in the media to suggest). Rather, the critical issue is why these movements resonated in different local contexts. For this reason, it is very important to see the variations in circumstances across the region.

The conditions that spurred the protests were varied, the responses from the regimes were equally diverse, and the future challenges to countries across the region and their post-revolution regimes are fundamentally different. What are the differences? And what are the implications? In very different political and social contexts, the overarching theme is renegotiation of the social contract—citizens claiming their rights as citizens.

That Tunisia was the epicenter for the ongoing redefinition of the region is significant. Because the country is regarded as one of the most highly developed, best educated and sophisticated in the Arab world, the revolution there had a powerful amplifying effect that might not have occurred if developments had occurred in another country. Our faculty member noted that "if the Tunisians were unhappy, then everybody else should have been unhappy."

The patterns of the "Arab Spring" reflect the diversity of the conditions. The two countries that removed their leaders, Tunisia and Egypt, were strong states with well-organized apparatus. They could afford to get rid of their regimes without jeopardizing the integrity of the state. In countries such as Libya and Yemen, if the regime disappears, the state collapses. Jordan and Morocco represent governments that were sacrificed for the stability of the regime, which has remained stable. In essence, they acknowledged problems and reformed to preempt revolution. Finally, in Syria, the regime's project is to build a state and therefore it will not give up unless defeated.

Where will things go? In Tunisia, we can expect to see a Europe-like set of parties and political movements, including a strong labor movement. It is likely that there will be a conservative Muslim democratic party and a social democratic movement. Over the course of time, the politics there will seem familiar. The outcome in Egypt could be less familiar—in part because the protestors there were not prepared for the aftermath of the revolution. One thing is clear: How Cairo navigates will be important not only for the legacy of the revolution but also for regional stability. Libya, where the government was dedicated to preventing development at any level, will resemble what one faculty member characterized as "an empty jar that broke." The longer it takes to remove the current regime, the smaller the shards of the jar. The tribal politics and mistrust are no foundation upon which to build a future political system.

The Arab Spring, like the fall of the Berlin Wall, revealed a great deal of variety (behind the Wall, or behind a seemingly stable and authoritarian Arab world). Some countries, such as Tunisia and Egypt, have brighter prospects, while the futures for others—Libya and Syria—appear dire.

The Clash of the Middle Classes
One defining feature across all of these countries and others will be the clash of the middle classes— the emerging middle class in poor countries and the shrinking middle class in rich ones. In varying political, social and economic contexts, we are now seeing an intensifying struggle between those with benefits and newcomers with less affluent backgrounds.

The Arab Spring is a case in point. The normal narrative is that it is the "Facebook Revolution." Behind the scenes, however, is the story of a middle class driven by the desire for more prosperity—a "more" revolution (more of everything) and a mobility revolution.

The middle class is growing everywhere. The 7 billionth child will be born later this summer, and while there is a greater probability that the child will be born poor, the probability it will be born middle class is higher than at any other time in world history. In the next 20 years as the total global population adds one billion more people, the middle class will double. This leads us to the challenge of how we deal with a middle class that is going to create new demands in terms of resources and politics. Success, after all, can be very destabilizing and complicating. The stress on resources is going to be huge.

Contrast the Malthusian view that says we are growing in population and consumption at a faster rate than we can support. Contrast that, too, with the market view that supply-demand forces without intervention from governments generate more efficiencies. The Marxist view, of course, suggests the problem is not production but distribution. The rise of the middle class will bring new pressures in all of these areas, creating substantially higher demands on resources and consumption. It will exert unprecedented pressures on markets and governments, and raise fundamental issues about equity and distribution of social benefits.

4. Contrasting Political and Economic Systems

The foregoing elements of global rebalancing—in economics, technology and geopolitics—will be conditioned by a single bilateral relationship. How the United States deals with a rising China, and how a rising China deals with a United States during a period of duress, could be the defining factor in the evolution of relations at the regional and global levels. The outcome of this complex set of relations between Washington and Beijing—cooperation, confrontation or both—depends not only on the objective conditions and issues at work, but also on two political systems with radically different origins, traditions, operating structures and social expectations. It would be a serious mistake to discount the stark differences.

One way to look at these dissimilarities is through the prism of three critical institutions that make up a modern political order: the state, the rule of law and accountability.

The state. The state concentrates power and uses it to enforce rules. A modern state treats citizens with some degree of impartiality, rather than via ties of friendship or kinship.

The differences between the political origins of the United States and China are profound. The U.S. tradition of dispersion of political power, as manifested in today's checks-and-balances system, is an outgrowth of Europe in the 16th century. Monarchs at that time wanted to have centralized bureaucratic dictatorships, but in one country—England—they failed to achieve this. Parliament was sufficiently cohesive that it fought a civil war with the king, deposed a second king and established the principle of parliamentary accountability—that the king could not raise taxes or go to war without Parliament's permission. This chain of events—what faculty members characterized as a "peculiar" set of circumstances and a "historical accident"—is at the core of modern-day politics in Washington. Beijing, by contrast, developed a modern state during the Chin dynasty in 221 BC. It was impersonal, bureaucratic, based on functional specialization, and marked by a merit-based system of promotion and the invention of the civil service exam. Some 2,000 years before similar systems appeared in Europe, China controlled a country the size of the Roman Empire through a sophisticated public administration apparatus. Today's manifestation of this system is a Chinese Communist Party that exercises authority without the constraints of a democratic system.

Rule of law. The rule of law reflects the concept of justice held by the broader community. In the United States and elsewhere, the rule of law is the outgrowth of religion. In ancient Israel, in the Christian West, in the Islamic world and in Hindu India, law emerged from religious texts and is administered by a hierarchy of priests, judges or jurists separate from the government. The notion that the government should be limited by moral rules is deeply rooted in these four traditions. China, by contrast, never had a transcendental religion (Confucianism is not a religion but an ethical doctrine), so it never had a similar set of laws or a religious hierarchy that limited what the emperor wanted to do.

Accountability. The concept of accountability can range from a notion embedded in multi-party democracies and free and fair elections, for example, to a form of "moral accountability" in which leaders are educated to feel a sense of responsibility to the people they govern even in the absence of a democratic system.

Between China and the United States, similar differences exist in accountability, going well beyond democratic institutions and procedures. The Chinese have developed a high-quality, centralized bureaucratic government, one faculty member maintained, as a means of managing such a large country and making the significant economic decisions they have.

It now remains to be seen how these two divergent systems will stand the test of time—with the challenges and opportunities of global rebalancing discussed throughout the Retreat. The lack of basic freedoms in China has generated continuing concerns in the United States and elsewhere. Yet, it can be argued that the U.S. system of checks and balances is paralyzing and that the system prevents making clear decisions for the long-term benefit of society. For this reason, voices in China are now vigorously supporting "the China model" and suggesting it is superior.

This faculty member concluded by saying that although checks and balances can be highly dysfunctional in the short run, they are a much more sustainable basis for a political system. The reason is the problem of the "bad" emperor, who unconstrained by dispersion of power, absent the rule of law, and without accountability, could precipitate far worse outcomes. For the Chinese, the issue is whether or not they can keep their current high-quality authoritarian system. For the United States, the issue is whether or not it can deal with a dysfunctional system. The country should remember that being a democracy does not guarantee that it can continue to govern effectively.

Final Analysis: Seven Key Takeaways for CEOs

1. Neither government nor business leaders should overreact to the slowdown in the global economy because a number of temporary factors are at work. Still, leaders must be vigilant to the transformational changes taking place around them.
2. One-size-fits-all approaches do not apply to the economic and economic-commercial challenges and opportunities. Leaders need to think judiciously about differentiated policy responses.
3. Caution is the byword for governments and business. In today's volatile environment, it is necessary to have adequate foreign exchange reserves and a strong lender of last resort. In this context, preemptive policies carry a premium.
4. Monetary tightening should come sooner rather than later, with the possible exception of Europe.
5. China's speed of entry into the global economy will be a crucial indicator. The economic and monetary transition in China (exchange rate, liberalization of the financial sector and capital account) should happen more rapidly.
6. 2012 will mark crucial political transformations in a number of important countries. Many stand at vital decision points that will define their future political and economic trajectories.
7. The middle class is an important harbinger of stability and prosperity in diverse societies.

What Now?

As the world continues to experience a period of rapid transformation, the implications for countries and economic planning have been, and will continue to be, significant. Already, we are witnessing asymmetries across countries, economic systems and stages of economic development. A shift in the geopolitical balance means a corresponding shift in values and cultural and political approaches to the future. How will countries and international businesses react to the transformation? Innovation will be crucial, especially in the energy sector as new advances in technologies will mark the difference between winners and followers. And we will watch closely how the United States deals with a rising China, and how a rising China deals with a United States during a period of duress. The ways in which these two countries manage their relationship—considering the stark differences of their two political systems—could define the evolution of all relations at the regional and global levels.

At the Retreat, A.T. Kearney's Global Business Policy Council outlined key areas of research that it would undertake over the coming year. Two priority issues surfaced as part of the Council "Strategic Narratives" initiative. The first was an assessment of the debt overhang in the advanced economies. The implications, it was argued, went well beyond the ongoing debate in the United States on increasing the federal debt ceiling and the corresponding debate in Europe on cascading financial crises in the peripheral economies of the euro. These debates reflect more significant and fundamental weaknesses that could not only constrain longer-range growth but also create the possibility of various "sudden decompression" economic scenarios, including the possibility of a double-dip recession or a "lost decade" similar to what Japan has experienced. The second area of emphasis is the outlook for continued resource volatility. The complex interrelationships between food, water and energy—and the relationship between this resource triangle and the rate of global economic growth (and subsequent resource demand)—is a core variable as we survey the future economic environment.

In the final analysis, no matter what contingencies arise from this global transformation, international business will have to adapt. And while no one is suggesting quick reactions—caution is necessary as situations are very fluid—staying informed by and armed with preemptive strategies will carry a premium. With rebalancing upon us, the precepts of Markets, Marx and Malthus must be close at hand.