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9th Hellenic Observatory Annual Public Lecture London School of Economics and Political Science “Europe, the Crisis and the Global Economy” by George Alogoskoufis Minister of Economy and Finance, Greece London, November 13, 2008 Ladies and Gentlemen, Recent events in financial markets have suddenly reminded to all of us that we live in a highly integrated and risky world. The revolution in information technology, the globalisation of trade and finance and the progressive spread of democracy have brought about a global economy and society that is more interdependent than ever before. Many have referred to a new global economy in the past, but now, because of the global financial and economic crisis, every citizen in every country of the world is taking notice. At the same time, and despite this close interdependence, our economies and societies remain extremely diverse. This diversity is cultural, political and economic. The gap between rich and poor remains as wide as ever, and effective democratic institutions still do not exist in large parts of the world. The new global economy may be more integrated than ever, but cultural, educational, social, political and economic discrepancies remain significant. The financial crisis that we are experiencing started in the US economy - at the heart of the global financial system. Following the collapse of Lehman Brothers on September 1 the 15th, the global financial system entered a phase of severe deleveraging, malfunctioning credit markets, unprecedented write-downs in asset valuations, generalised risk aversion, and threats to the stability of the banking sector. The crisis has rapidly spread to the real economy in the US and the rest of the world. The financial crisis is affecting trade and investment, consumption, jobs and living standards everywhere. It may not be the first financial crisis of the new global economy, but it certainly looks like the most severe and widespread crisis that the world has experienced since the great depression. This crisis bears no comparison to the other incidents of financial and stock market turmoil that we have experienced since 1987. Many argue that this crisis is likely to prove a severe test not only for financial institutions but also for global economic governance and even for many other national and regional political, social and economic institutions and policies; that no region or country will remain immune; that no institution or policy rule will escape a reexamination; that both the developed and the developing world will need to re-assess their policies and institutions. There also those who argue that what we are experiencing is not only about financial markets; that it is about the way our capitalist system is organised. They conclude that it will not suffice to re-evaluate rules about executive pay, financial market regulation, budgetary, monetary and social policy; that a new anti-globalisation agenda is what is now called for. Up to now, many have been viewing globalisation in solely positive terms and have been expressing few reservations. According to this line, globalisation contributes to economic benefits for everybody. The assertion is that poor countries and low income groups come out as winners from globalisation in absolute terms, even when they may lose out in relative terms. It is furthermore argued that traditional societies benefit from the modernisation of their institutions and the abandonment of traditional social and economic models. The crisis has strengthened the hand of those sceptical or in straight opposition to 2 globalisation and the line of thought just outlined. A number of people have been arguing that the benefits of globalisation are not shared equally among countries or citizens; that there are clear losers in relative terms, and even in absolute terms; that poor countries and low skilled workers in rich countries are left behind. In addition, those sceptical of globalisation have always highlighted that social and economic dislocations associated with modernisation may lead to social unrest. There is no doubt that without broad popular acceptance no economic or social model can eventually be sustainable. Everybody would agree that if globalisation were to indeed result in growing inequality, continuous social and economic dislocations and social unrest, or in recurring financial and economic crises it would indeed be eventually undermined. Is this what the current crisis is proving? Or is it something less fundamental and therefore susceptible to less severe corrective action. It is yet toο early to draw definite conclusions. A lot will depend on our responses to the current crisis. Have we really learnt the lessons from the Great Depression? Are we avoiding the policy mistakes that led the world to a prolonged period of economic hardship and stagnation in the 1930s? Can we ensure the necessary economic and institutional adjustments that will shield the global economy from a global credit crunch and a severe contraction in consumption and investment? The crisis has, indeed, unveiled serious weaknesses in the functioning of our global financial and economic system. Serious regulatory and policy mistakes that have persisted for many years have contributed to the severity of the problem. Economic risks have been seriously underestimated in the pricing of financial assets and asset bubbles have persisted for too long, supported by an abundance of liquidity. Macroeconomic imbalances have developed in a global economy without any serious attempt to address them through coordinated action. The emerging economies have not been integrated adequately to the system of global economic governance. These weaknesses were apparent in minor crises that have taken place in the past. What makes today’s crisis 3 unique is that it has affected the core of the US economy and the global financial system, with huge repercussions everywhere. It is not about the sovereign debt of an emerging economy, like previous episodes, but about the core of the new global economy. When a financial bubble bursts, it does not make for a pretty sight. When a huge and global financial bubble bursts the world economy is in deep trouble. Appropriate policy responses are called for in order to limit the damage and restore confidence. It is not enough to correct the shortcomings that caused the crisis in the first place. Policy responses are called for to deal with the aftermath of the crisis; appropriate and coordinated monetary, fiscal and trade policies to deal with the risk of a prolonged global recession; appropriate social policies to cushion the impact of the crisis on the poor and the unemployed; appropriate policies to restore confidence in the financial sector. No country or region can respond to the crisis in isolation. What is needed is a coordinated policy response. Without coordination, even the best national policies are likely to prove “beggar thy neighbour” policies and thus ineffective. Global problems require coordinated global solutions. The solutions do not lie in a “fortress US” policy, or a “fortress Europe” policy, or, even worse, in a “fortress Britain” policy. The solutions must be sought in the context of an open world trading and financial system, without even a hint of a return to protectionism. Monetary policies and responses must continue to be coordinated at a global level. Coordination of financial regulation must be strengthened. Fiscal policy coordination is also a necessary prerequisite. No country in isolation can spend its way out of trouble. If we were to embark on a Keynesian expansion of demand, this has to be coordinated at a global level. Despite some initial shortcomings, Europe has been responding to the crisis in a manner that inspires confidence. The European Central Bank has been extremely active in providing liquidity since the summer of 2007, although for a number of months the thrust of monetary policy was addressed to containing inflationary expectations. In coordination with the Federal Reserve, it responded adequately to both the first and the 4 second manifestation of the financial crisis. It is true that we initially failed to anticipate the full extent of the crisis on the European economy. The initial assessment at the beginning of 2008 was that the European economy would escape the worst. This assessment has been fully revised since last summer. The European economy is now expected to remain stagnant, if not enter a recession, in 2009. The crisis has affected a number of banks in a variety of European countries. Unemployment is now expected to increase. The only positive sign is that inflation is falling, but again this is mainly due to weak global demand. Events have confirmed that Europe can take a leading role in promoting an adequate global response to the crisis. In a period when the US was primarily preoccupied with the elections Europe has coordinated its own response to the financial crisis and taken initiatives for a coordinated global response. In the ECOFIN Council of the 7th of October a number of important decisions were adopted, that are leading to a coordinated support of financial institutions across the European Union. It was decided that support should be coordinated around the following principles: - Support for financial institutions must in principle be temporary - Member states must take full account of the interest of taxpayers - Existing shareholders of financial institutions should bear the full consequences of any intervention - Governments should be in a position to bring about a change of management in troubled institutions - Management should not retain undue benefits. Governments may have the right to intervene on renumeration - The legitimate interests of competitors should be protected through the application of state aid rules - Negative spillover effects from country to country must be avoided. 5 The objective was to ensure the adequate capitalisation and liquidity of European financial institutions affected by the crisis and to ensure that adequate liquidity would exist in Europe to avoid a credit crunch. In addition, the maximum amount of guaranteed deposits was raised to 50,000 euros and the EU Commission was urged to revise certain accounting rules relating to Banks. Finally, the European Investment Bank was urged to mobilise an additional 30 billion euros to support European small and medium sized enterprises. A few days later these conclusions were strengthened in an extraordinary summit of Eurozone heads of government and a special European Summit on the crisis. Since then a number of EU countries have adopted financial market support plans based on the agreed principles. European leadership was not confined to the coordination of European responses. European leaders took the initiative for a global conference to address the reform of global financial governance. The G-20 Washington summit will take place shortly. In another extraordinary meeting on the 7th of November, European leaders agreed on a common approach to this problem. They agreed both on common principles and some specifics. The principles that have been agreed are the following: - No financial institution, no market segment and no jurisdiction must escape proportionate and adequate regulation, or at least oversight - The new international financial system must be based on the principles of accountability and transparency - The new international financial system must allow risks to be assessed so as to prevent crises - Give the IMF a central role in a more efficient financial architecture 6 Wishful thinking one might say. However, the European agreement included a number of specifics with regard to rating agencies, accounting standards, codes of conduct and an initial role for the IMF. We now have to wait and see what the G-20 Summit will be able to produce. To conclude, Europe has in the last two months been proactive in promoting a coordinated approach to the financial crisis both within its borders and at a global level. A lot will now depend on other global players: The new US administration, the Japanese, the Russians, the Chinese, the other emerging economies. However, coordination on measures to support and reform financial markets will hardly suffice to deal with the effects of the crisis on the real economy. Much more is called for. In the recent forecasts of the EU Commission, growth in 2008 would be 1.4% in the EU and 1.2% in the euro area – half what it was in 2007. In 2009 the EU economy is expected to grind to a stand-still at 0.2% [0.1% in the euro area] before recovering to 1.1% [0.9% in the euro area] in 2010. The avoidance of a credit crunch and the restoration of normalcy in financial markets is an important and necessary first step. However, it is not a sufficient condition for dealing with the effects of the crisis on the real economy. More coordinated responses are required in the fields of fiscal policy, structural policy and trade policy. Discussions in Europe have also addressed the problem of how to apply the Stability and Growth Pact. The Stability and Growth Pact requires all economies in the Euro Area and the European Union to maintain fiscal deficits below 3% of GDP at all times, to strive to achieve fiscal balance in the medium term and to ensure that public debt is no more than 60% of GDP, or tending towards this objective. The Pact envisages corrective action for those economies that do not meet these fiscal objectives. The Pact was revised in 2005, after a number of economies failed to correct their excessive deficits promptly. The revised Pact is more flexible regarding the time available for the correction of excessive deficits, but more demanding regarding the 7 attainment of fiscal balance. Those economies that have not attained fiscal balance are required in so called “good times” to reduce their deficits by at least 0,5% of GDP per annum. The EU Commission has proposed and the ECOFIN Council has determined to apply the pact flexibly in the current circumstances. Economies that have fiscal room for manoeuvre could use it to try and counter the slowdown or contraction in aggregate demand, either through the operation of automatic stabilisers, or through limited discretionary measures. Those that do not should take care not to exceed the 3% limit. In case that a country exceeds the 3% limit, the deviation should be small and in any case temporary. The flexibility envisaged in the revised pact will be utilised. Attainment of medium term fiscal balance is implicitly postponed for better times. The rules of the Pact are well defined. The problem is that a number of countries have been, or are expected to be close to the 3% threshold. Some Euro Area economies such as France, Italy, Portugal and Greece have only recently exited from the excessive deficit procedure and their projected deficits are close to 3%. Other economies, such as Ireland and Spain are experiencing a recent widening of deficits because of the crisis. Germany is the only large Euro Area economy with fiscal room for manoeuvre. Among those outside the Euro Area, the UK is expected to have an excessive deficit in both 2008 and 2009. The EU Commission estimates are for a deficit of 4,2% of GDP in 2008 and 5,6% in 2009. Thus, although there is flexibility in theory, in practice this flexibility is of limited practical importance because the economies in the Euro Area did not create sufficient room for manoeuvre in previous years. Fiscal policy appears to be a heavily constrained instrument for countering the contractionary forces that have been unleashed by the financial crisis. According to the latest estimates of the EU Commission, budget deficits in the EU are expected to reach 1,6% of GDP in 2008 and widen to 2,3% of GDP in 2009. Corresponding estimates for deficits in the Euro Area are 1,3% of GDP in 2008 and 1,8% in 2009. 8 At the same time the US is expected to run huge budget deficits: 5,3% of GDP in 2008 and 7,2% of GDP in 2009. Japan’s deficits are projected to be relatively modest. Europe and the Euro Area cannot adopt a US style fiscal expansion without jeopardising the credibility of the Stability and Growth path. This is a severe constraint which may cause the real effects of the financial crisis to persist much longer than in the US, or for that matter the UK, which is not a member of the Euro Area. An ideal coordinated fiscal response would probably call for lower fiscal deficits in the US and the UK and higher fiscal deficits in the Euro Area. Under the current circumstances, the only option is for Germany to adopt a sufficiently large fiscal stimulus package that would pull both the German economy and the rest of Europe out of trouble. It is highly unlikely that this option would be adopted. In conclusion, the room for fiscal coordination at the European level is in practice extremely limited and obviously so is the scope for better fiscal policy coordination at the global level. In Europe, we cannot expect much from fiscal policy in the current circumstances, although in principle a measured European Stimulus Package could prove quite effective. Other options to boost the European economy also have important shortcomings. Structural reforms to increase productivity, such as those envisaged under the Lisbon agenda would imply long lags, even if they were to be promptly implemented. However, it is important to persist with the Lisbon agenda, as this would prepare the European economy to take better advantage of an eventual global recovery. It is also extremely important to allow the European social model to function. The existence of provisions and institutions that can soften the impact of the crisis on the more vulnerable sections of our societies, is an important advantage of the European social model. Within the available budgetary limits, the European social model should be allowed to work. It is in periods of crisis such as the one that we are experiencing that its importance becomes more apparent. 9 It is also extremely important to strive in order to revive the Doha round on trade and development, so as to strengthen the momentum for an open global trading system and avoid protectionism. The protectionist spiral of the 1930s was a major contributing factor to the Great Depression. We seem to have drawn the right lessons from the mistakes made in the monetary field during the Great Depression. Monetary policy has responded adequately to the crisis and important initiatives are currently under way to restore appropriate regulation, liquidity and confidence in financial markets. Europe, to the surprise of many has shown remarkable leadership. Because of high levels of public deficits and debts the room for a fiscal stimulus is limited. Despite a poor track record on previous occasions, we must not abandon the effort for better coordination of fiscal policy at both the European and the global level. The role of the incoming US administration may be instrumental in this respect. If we manage to negotiate a coordinated measured fiscal stimulus package for the global economy, we will have taken an important step towards a swift recovery from the slowdown in the global economy. At the same time, we should not lose sight of the medium term. Structural reforms that would increase productivity and protect the environment must continue if not accelerate. We must undertake new initiatives to further liberalise international trade and integrate emerging economies to the global economy. We must continue to pursue the Millennium Development Goals. Finally, long overdue reforms in global economic governance must be brought forward to integrate Russia, China, India and Brasil. An economic crisis is not only a threat but also an opportunity. Let us continue with the pro-active approach that European leaders have adopted in recent weeks. Let us encourage the incoming US administration to follow a similar path. Let us correct the shortcomings of the previous model of globalisation and produce a new model that will work for the benefit of all the peoples of this globe. 10