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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
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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
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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
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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
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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:
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Support for financial institutions must in principle be temporary
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Member states must take full account of the interest of taxpayers
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Existing shareholders of financial institutions should bear the full consequences
of any intervention
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Governments should be in a position to bring about a change of management in
troubled institutions
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Management should not retain undue benefits. Governments may have the right
to intervene on renumeration
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The legitimate interests of competitors should be protected through the
application of state aid rules
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Negative spillover effects from country to country must be avoided.
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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:
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No financial institution, no market segment and no jurisdiction must escape
proportionate and adequate regulation, or at least oversight
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The new international financial system must be based on the principles of
accountability and transparency
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The new international financial system must allow risks to be assessed so as to
prevent crises
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Give the IMF a central role in a more efficient financial architecture
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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
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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.
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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.
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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.
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