How the export addiction started

NEW YORK (Fortune) -- The April 2 meeting in London of the major world economies known as the G-20 could be the most important global economic gathering since 1944, when the Bretton Woods conference reshaped the old order near the end of World War II.

But it won't be.

Another Bretton Woods is not in the cards because U.S. and European officials, like ships passing in the night, can't agree on their response to the financial crisis. This is a tragedy because the world's policymakers are failing to deal with many fundamental issues, including the question of how we got into this mess.

Someday, historical archeologists will sift through the rubble of this ugly financial period. They will conclude not only that our regulators were asleep at the switch, the big global banks deployed reckless amounts of leverage, and gluttonous American consumers spent a lot more than they earned.

Historians will also discover the flip side to this morass. The entire world was out of balance. While Americans became dependent on massive leverage and over-consumption, large parts of the world, primarily the emerging markets, became dangerously dependent on exports - either goods and services or high-priced oil.

Today, with the industrialized economies in trouble, the emerging-market economies based on this export model are crash landing. Why is that important for the rest of the world? The collapse of emerging markets from Hungary to South Korea could have consequences far beyond their borders.

Conventional wisdom oversimplifies the cause of the financial crisis. Somehow the bursting of a mere $300 billion U.S. subprime bubble in August 2007 brought a global financial system worth hundreds of trillions of dollars to its knees. Actually, the seeds of financial turmoil were planted much earlier - as odd as it sounds, with the 1989 fall of the Berlin Wall. Today's financial crisis all began as an unintended consequence of the collapse of the state-run economic model.

Within several years of that momentous event, emerging economies including China, India, Eastern Europe, and commodity producers like Russia burst onto the scene. They wanted to be like us - capitalists. As they liberated their economies and financial systems, making them more efficient, the resulting new productive capacity led to a global ocean of capital. There suddenly was more money globally than there were investment opportunities.

A lot of this new capital poured into the U.S., particularly into the U.S. Treasury market. In the process, most emerging market economies adopted a new model for growth. Fixing their currencies in one form or another to the dollar, they revamped their economies as export platforms and spent little time enhancing the consumption bases of their own economies.

The goal: to export consumer and capital goods to the industrialized world. And the target of choice: the gluttonous, debt-ridden American consumer. At one point in the process, Americans became the world's consumer of last resort, spending an incredible $1.10 for every dollar they earned.

For a while, the new system worked beautifully. As emerging markets exported goods and services, and oil, to the industrialized West, they built up mountains of excess savings. At one point China alone had compiled a mountain of foreign exchange reserves, mostly in U.S. dollars, approaching $2 trillion.

As emerging markets recycled that capital back into the debt-ridden U.S., Americans took a financial magic carpet ride. This Niagara Falls of foreign capital inflows caused real U.S. interest rates to drop drastically. This abrupt financial distortion is how today's financial crisis began. With such an abundance of capital, the price of financial risk plummeted. Families, woefully under-qualified financially, were allowed to purchase homes far beyond their means.

Thinking they had discovered riskless risk, large global financial institutions added insult to injury. Through reckless borrowing from that ocean of capital, the global financiers leveraged their own capital to dangerous heights. The failed Wall Street firm Bear Stearns, for instance, deployed irresponsible amounts of leverage at a ratio of 34 to one. But the prize goes to the German bank Hypo Real Estate which, at 112 to one, deployed the leverage of a lunatic.

Of course, no one ever imagined the U.S. economy and financial system could collapse as it has. Nor did anyone expect the emerging markets' over-dependence on exports to become one of the world's Achilles Heels.

Over the last year, what began as a U.S. mortgage crisis has mushroomed into a collapse in global demand. The resulting crack-up of the emerging-market growth model has exposed the world to serious potential protectionism, currency wars and rampant bank-credit defaults.

Collapsed global trade has already been devastating for China, America's current banker. In response, Beijing has implemented a massive fiscal stimulus plan to try to stimulate domestic demand. But convincing an aging population with no social security safety net to consume dramatically more while saving less is no easy task. The collapse in global trade has plunged Japan's economy into the deepest recession in decades. Europe's banking sector is massively exposed to emerging-market bank defaults - particularly in Eastern Europe - far more than U.S. banks are exposed to subprime toxic waste.

As global trade keeps dropping like a reverse tidal surge, the worst may still be over the horizon. And in today's globalized economy, there is no place to hide because the financial system is interconnected. If, for example, a major European bank collapses as a result of massive defaults on Europe's trillions of dollars of emerging-market trade financing, the effect on a U.S. financial system already on life support would be devastating.

The emerging-market export model was not something invented by economic policymakers. It is a model the world fell into by the force of an historic event, the fall of the Berlin Wall. That model needs to be rethought. The world clearly needs a Manhattan Project to reduce our financial system's exposure to complicated securitized assets and derivatives. But that project cannot stop at reforming issues related to financial architecture. We also need a comprehensive - and interactive - global financial doctrine that never allows such imbalances to develop again. World leaders, now fixated on domestic firefighting, need to address the fundamental elements that brought about this great catastrophe in the first place.

David Smick is the author, most recently, of the book, "The World Is Curved: Hidden Dangers to the Global Economy." He is chairman and CEO of the Washington, D.C., financial advisory firm Johnson Smick International, Inc., and founder and editor of The International Economy magazine.