THE deceleration of the world economy is clearly worsening. Second-quarter US GDP data, showing 1.5 percent annualized growth, was lower even than the anemic 2.0 percent in the first quarter. Two of Europe's major economies, the UK and Spain, have respectively reported 2.8 percent and 1.6 percent annualized economic declines for the second quarter of 2012.

The EU economy as a whole will shrink this quarter. Growth in some major developing economies has significantly slowed -- India's year-on-year growth in the first quarter dropped to 5.3 percent and Brazil's to 0.8 percent. China has not been immune, with 7.6 percent GDP growth in the second quarter being seen as disappointing and July's manufacturing Purchasing Managers' Index of 50.1 being week.

In short, after a brief period of global recovery, the world economy is moving into a second wave of the slowdown and crisis which commenced in 2008.

Investment collapse

To understand this process, and the policies being adopted to counter it, it is necessary to grasp clearly what factually happened in the world economy during the financial crisis. On a global scale, particularly in the Western economies, the "Great Recession" was an investment collapse. This is again revealed clearly in the latest US GDP figures.

To illustrate the process Figure 1 shows the change, in inflation adjusted prices, in the main components of US GDP since the pre-financial crisis peak. It may be seen that most components of US GDP are already above pre-crisis levels - for example US household consumption is US$269 billion above its previous peak. What explains weak GDP growth is that US fixed investment remains US$294 billion below its level on the eve of the financial crisis.

The same process characterizes the advanced economies as a whole. Figure 2 shows the change in components of GDP since the peak of the pre-financial crisis business cycle for the combined OECD states, i.e. essentially all developed economies. Again it may be seen that most components of OECD GDP are above pre-crisis levels -- except for investment which remains US$694 billion below its peak in the parity purchasing powers the OECD utilizes for such analysis.

These trends leave no doubt that the economic decline during the international financial crisis is an investment collapse.

This fact also makes clear why the different policy responses to the financial crisis have had such different degrees of success.

EU economies adopted a loose monetary policy with essentially no boost to the productivity economy - the "austerity" policy. The result is clear. EU economies have shrunk by two percent over a four year period - such a policy was incapable of reversing the investment fall.

The US adopted a loose monetary policy combined with a strong consumer stimulus delivered via a large budget deficit. This explains the rise in US consumer spending, but this policy was also incapable of reversing the investment fall as it did not target it. Consequently the US economy has remained essentially stagnant - annual average US economic growth since the beginning of the financial crisis is 0.4 percent.

China adopted a loose monetary policy combined with a stimulus program targeting raising investment. This policy, because it struck at the core of the danger which has characterized the financial crisis, more than reversed any threat of an investment fall. Consequently China's economy has grown by over 40 percent since the financial crisis began.

Unspent cash

The US and European investment falls, in turn, determine other key features of the present economic situation. As companies are not investing their accumulated profits, it generates large unspent cash surpluses which are deposited in the safest possible assets - normally state bonds. This explains the specific combination of very low growth with historically low interest rates for state borrowing in "safe haven" economies such as the US and Germany.

Given such trends it is clear that measures such as interest rate cuts and quantitative easing will not lead to substantial US or European economic growth in any near term. The crisis is in private investment itself, and a few interest rate reductions from already historically low levels are unlikely to alter these trends.

Confronted with this situation the most serious Western economic commentators are therefore calling for a program of state investment to break out of the impasse. For example Martin Wolf, Chief Economics Commentator of the Financial Times, and one of the world's most influential economic analysts, recently explained the situation clearly: "With long-term government borrowing as cheap as in living memory… now is the time for government to borrow and invest. This is not just basic macro-economics, it is common sense... With real interest rates close to zero … it is impossible to believe that the government cannot find investments to make itself, or investments it can make with the private sector, or private investments whose tail risks it can insure that do not earn more than the real cost of funds. If that were not true, the UK would be finished. Not only the economy, but the government itself is virtually certain to be better off if it undertook such investments."

Highly implausible

Lawrence Summers, former US Treasury Secretary, has argued exactly the same point: "the proposition that the global economy is returning to a path of healthy growth looks highly implausible… The question is what should be done?... It would be amazing if there were not many public investment projects with certain equivalent real returns well above zero. Consider a US$1 project that yielded even a permanent 4 US cents a year in real terms increment to GDP by expanding the economy's capacity or its ability to innovate. Depending on where it was undertaken, this project would yield at least 1 US cent a year in government revenue. At any real interest rate below 1 percent, the project pays for itself even before taking into account any Keynesian effects."

But while Western economic commentators are coming to the conclusion that the only way out of the international financial crisis is for the state to undertake a substantial investment program, the long delay in doing so has left the Western economies trapped in recession or economic stagnation. Furthermore so far Western governments have not taken the required policy measures. The US and Europe will therefore remain in economic stagnation or recession for a further significant period

China faced essentially the same choice during the first half of this year - but the policy outcome was the reverse of that in the US and Europe. Despite evident economic deceleration China's government initially hesitated to take the only decision that could effectively stabilize or restart rapid growth - launching a state investment program.

However while in the US and Europe governments still hesitate to take the necessary measures, in China from May onwards the authorities began to speed up the process of approval of investment projects. From the beginning of July China's government has launched a general emphasis boosting investment - including state investment.

Given the fundamental trends in the world economy if the different governments remain on the same policy paths, global economic perspectives for the second half of 2012 are therefore relatively clear. The US and Europe will continue to stagnate. China will begin to recover from its economic slowdown.