"Global Financial Crisis, European Debt Crisis andReform of International Monetary System
I would like first to thank you for having invited me here to speak in Beijing. It is a good time and thisis most especially a very good place from which to talk about the crisis in the global economy.As everybody knows, the current crisis has remote causes and closer ones. The crisis in Europe islinked to the level of debt. And this I will turn to later.
1. But let's start with the structural problem.
1.1. We are living through a dramatic change in the global economy. Not globalization, which is a fact and a 'given', a part of the way we live, but the ending of a veryspecial time, the closing of a singular period.For centuries, I could say for millennia, economic power was strongly correlated with the size of thelabour force. Of course innovation and technology could temporarily change the balance of power,but after a short period of time those new technologies were available to others and equilibrium wasre-established.? However these last two centuries have been an historical exception to this rule. For the first time inthe history of mankind some countries, not very populous as a proportion of the total, succeeded inkeeping for themselves the new technology they had invented or adapted, and they used it to dominatethe world. The global history of the 19th and the 20th centuries is a story of western dominance basedon proprietary technologies. This was equally the case for industrial as well as for militarytechnologies.? This period, this singularity, is coming to an end. We are back to the long term trend. Technologiescannot be kept secret anymore. Education, voluntary technology transfers, the movement of people,and also industrial espionage (including the use of the Internet) have helped to spread information.Of course this process does not take place overnight. It takes time to get back to normalcy, it may takedecades to complete the change. But the move cannot be stopped. We are contemplating the end of an era of technological exceptionalism.
1.2. Does this mean the beginning of the end of the period of dominance by advanced economies? Does it mean that big countries, like China or India, will unstoppably become the Superpowers of the coming decades? Maybe, but technology alone is not enough to accomplish this changeover. Thewhole of society must be able to take advantage of the process of innovation. The diffusion of innovation throughout an economy relies on there being a more inclusive society where creativity canflourish. It is not likely that the old state-driven technology policies will be appropriate to this challenge. The American success story relies on technology plus entrepreneurship which in turnrequires unbridled creativity.So that is what is at stake today. For two centuries we have experienced an incredibly odd situationwhere some countries (including Germany, France, the UK and, of course, the USA) have been ableto play an outsize role despite the fact that they were small in population and geographic size (trueeven in some respects of the USA).? How long will it take to get back to normalcy? I don't know. But it will happen. And who is thengoing to take the lead? Probably the countries with large populations as has always been the case,providing they are able to catch up on the technological side (and personally I have little doubt aboutthis) and can develop a model of society inclusive and free enough to boost creativity. This is the realchallenge. Both tasks are dual and equal keys to competitiveness.It is competitiveness which is really the issue in the global economy, as long as the linkages betweenthe different parts of the global economy are working well.These linkages have a name - the International Monetary System (IMS).
2. This brings me to my second major point. Is the IMS working properly? And if not, whatneeds to be done to improve it?
Those who would challenge my assertion that the IMS may not be working properly point to thefollowing arguments. They say that, after all:? the current IMS has enabled remarkable progress in the global economy, plus financial integration:- fostering strong global growth in living standards; and- recently surviving a global financial crisis of historic proportions.? but I say that this system has also exhibited symptoms of instability, as seen by:- frequent crises, persistent current account imbalances and exchange ratemisalignments; and also- volatile capital flows and volatile currencies.These symptoms of instability have been - increasingly - the source of tensions which if leftunaddressed will threaten the progress of globalization.We must address the root causes of theseinstabilities. And what are they? I see four: the absence of effective global adjustment mechanisms,the volatility of capital flows, limited access to global liquidity, and the poor supply of 'safe' globalasset classes
2.1. How can we promote more effective global adjustment? Cooperation is an obvious answer. It worked during the 2008 crisis but the momentum behind that isnow gone, despite the effort made by the IMF and the G20.IMF surveillance should be a key instrument in promoting effective global adjustment. But in practicethis has not always been the case. Why? The design of the IMS is not the sole culprit but it is limitingin one important way, namely that (except for exchange rate policy) countries have no obligation torun their policies in ways consistent with systemic stability. This hardly seems sensible in ourinterdependent world. Hence, not only should countries' multilateral obligations be strengthened butalso their accountability for failing to uphold them.These are legitimate issues to raise at both global and regional levels, especially at EU level.
2.2. Can we make cross-border capital flows safer? This issue is often presented as one for Emerging Market economies to worry about. That is true forsure, but in reality it is one that policy makers in all countries should worry about. The bulk of cross-border capital flows actually takes place among advanced economies, and recent years have shownthat advanced economies are not immune to those asset bubbles and busts associated with large andvolatile capital flows. This suggests that the healthy functioning of the IMS depends crucially onorderly cross-border capital flows. But there is no system at all here: flows are driven by policies(monetary, prudential and capital account) which have until now been pursued with the focus on thegoal of domestic stability.Hence it is worth asking whether globally agreed "rules of the road" might be useful? Inflows are notthe only issue, outflows should also be borne in mind. That is why there is an urgent need for bothsource and recipient countries to cooperate (bearing in mind that most countries are both source andrecipient).What do I mean by "cooperate"? We need mechanisms for coordinating macro policies in times of stress, just as we did in 2009. Why not consider mechanisms to bring together originators andrecipients of capital flows? This is precisely the sort of international cooperation which the IMF'sfounders had in mind.
2.3. How can we enhance global liquidity? This is the question of the so-called 'global financial safety net' that the IMF together with the KoreanGovernment raised during the G20 meeting in Seoul in November 2010.
Since the 2008 crisis we have come a long way in enhancing the provision of liquidity in times of extreme volatility. The central banks have done
their job and the IMF's resources have increasedsignificantly.But the size of global output, trade and capital flows now dwarf the Fund's resources. These must beincreased dramatically. In the absence of IMF resources correctly scaled to the challenge, manycountries are justifiably not convinced that the global financial safety net is strong enough. So thecostly accumulation of reserves continues.What else can be done?- one important avenue to explore is the strengthening of partnerships, of Regional FinancialArrangements like the EU or the Chang Mai Initiative (CMI); and- another is to improve the predictability of systemic liquidity provision more generally, instead of leaving this task exclusively to the central banks, which always face the contradiction between theirdomestic and global targets.
2.4. How can reserve asset diversification be promoted? The demand for safe global asset classes has been growing much faster than potential supply. Thisreflects the fact that global monetary and financial assets are less diversified in currency terms than isglobal GDP.
There could be scope for enhancing the stability of the system by encouraging greater internationaluse of currencies other than the four currencies currently in the SDR (Special Drawing Rights) basket.A multi-polar system would by no means be a problem. There may also be other changes worthconsidering for the SDR including:
- increasing the global stock of SDRs to help meet demand for precautionary reserves;- using SDRs to price global trade & denominate financial assets;
- issuing SDR-denominated bonds by sovereigns and international financial institutions; and
- even, the "crazy idea", as I call it, of issuing bonds in SDRs in the public markets. The idea is for theIMF to issue its own bonds denominated in SDRs to increase its own resources, de facto creating anew market in SDRs. On this road, we will encounter a large number of technical hurdles. But the main obstacle remainsthat it requires a major leap in international policy coordination.
Let me wrap up this section. The IMS we have is not broken, but it has serious holes in it. Left unaddressed, they leave the whole system vulnerable.
3. Turning now to my last point, the epicenter of the current crisis: Eurozone Debt.
3.1. This crisis is of course a debt crisis. But it is even more a growth, banking sector, and, for somecountries, a competitiveness crisis. The high level of public debt would be a problem by itself eventhough, for many European countries, the debt ratio remains in the same range as in the USA. But theparticular European structural weakness comes from the fact that during the good years growthrevenues were spent, rather than being used to reduce the debt. Hence the question is whether or notthe European core countries will be able to reduce their level of debt using resources coming fromfuture growth? And moreover whether there will be growth at all? The prospects are not good, to saythe least.
3.2. On top of the debt problem sits the 'austerity policy-setting problem' - that the austerity policieswhich seem to be the current European mantra will serve to make the debt ratio worse not better. Addin a financial sector which has still not been fixed, is further endangered by the holding of largeamounts of public debt of questionable value, and which in conforming with the ratio-based approachof the new Basel III capital requirements is, in practice, reducing the value of the denominator(lending less) rather than enlarging the numerator (recapitalizing), and you have the perfect storm.The storm which now besets the Eurozone economies.
3.3. Against this background, the posture of European political leaders has, first, been denial of the problem.
The IMF was initially not welcome as the Europeans believed they were able to fix theproblem alone. They seemed to have moved a long way since May 2009 when it appeared that theIMF was not only useful but essential. But the IMF was at that point treated by them as a juniorpartner, and when the Fund argued that the maturity of Greek loans should be longer and the interestrates lower, in order to avoid killing growth, its point of view did not prevail. Each and everyEuropean leader focused on the debt level and no one wanted to pay enough attention to thecompetitiveness problem - the real key to growth. As is so often the case, the long term solvabilityproblem was hidden behind the short term liquidity problem. Attention was focused on the politically"easiest" issue at the expense of the fundamental.The political leaders were in denial. They are still in denial.Because of policy mistakes made by Greek governments (and this is also true for other countriesbeyond Greece, like Portugal) billions of euros have been lost. But the responsibility for this losscannot be attributed to these countries alone. Eurozone surveillance is also called into question bywhat has happened, as is in some respects IMF surveillance. Hence, it is simply fair to share the costbetween all the members of the zone. It is the right thing to do. But not only is it fair, it is alsorealistic. For it is quite unrealistic to think that the other choice is in any way workable. The loss is too big to be repaid by the Greeks alone. Alternatively, because Greece's GDP is only about 2% of Eurozone GDP the costs could be shared among the members, if not without pain. But the basic idea,the default setting chosen, was not this. It was not to consider the Eurozone as a zone of solidarity asany monetary union should be. It was rather to ask the Greeks to pay for their sins, and hence to payyields exceeding the cost of the loans made by the European partners.Why? Because nobody wanted to acknowledge the loss even if the results of the denial could be, andhave been, to increase this loss.European countries are now swinging from one plan to another, from one last ditch summit to thenext, still not accepting or acknowledging their losses, nor making it possible for growth to restart,and as a consequence failing to restore confidence in the future.
3.4. The last episode in Brussels on December 9th was just one more example, bleeding away day byday the remains of any confidence investors and potential lenders may have in politicians to solve thecrisis.? For the short term, the Brussels plan does not solve the liquidity problem.The role of the ECB is still the one defined in the Treaty. It is fair to say that the ECB has played welluntil now, but the ECB remains the only central bank that is not a lender of last resort. Hence the risk is a risk of default not a risk of monetization.The opposite may happen of course. It is possible that faced with an imminent crisis in Eurozone bank and government debt refinancing, the ECB may decide simply to "print money" through non-conventional measures and act as a quasi Federal Reserve.
If the Eurozone really is at the edge of thecliff nothing will be wrong with this. But of course this policy will have other important drawbacksand moreover will not solve any of the structural problems. The cliff moves away but does notdisappear.In trying to avoid this, a firewall (EFSF + ESM + IMF) close to one trillion euros (without leveraging)has been announced but:- the 500 billion euros from the ESM will not exist before at least six months time, which is fartoo late;- the 200 billion euros which are supposed to come from the IMF are in limbo as long as theBundesbank argues that it cannot go along without US involvement, which is not going tohappen; and- a possible complement could come from Asian countries which are ready to help because theyunderstand that decreasing trade and deleveraging by European banks are damaging their owneconomies. But the counterpart will probably be in the area of quotas and voice at the IMFBoard, and here we face another kind of European denial.? As far as the long term is concerned, it does not look any better.What the Eurozone needs is real fiscal union. It is not news that the euro is sitting still in the middle of the river. A monetary union without a central budget just does not make sense. This question wasextensively discussed in 1998 at the launching of the euro, but without successful resolution. Duringthe really rather calm first half of the last decade the raft survived comfortably enough on a placid sea,but with the recent gale it appears clearly that the raft is not strong enough to avoid sinking.Hence what the Eurozone needs is both a unified bond market and a fiscal union with strong centralinstitutions, not a "super-stability pact". But what has been set up in Brussels today is indeed only a super-stability pact, as Jens Weidmann, the President of the Bundesbank, recently made clear. Thismay be good news for German domestic politics, but it is bad news for the European population.Even the super-stability pact is lame. The so-called Golden Rule is confusing because it has alreadyattracted different interpretations and definitions, and because it is unclear how the sanctions wouldwork in any case. Let me put a straight question. "Just what will happen, do you think, if a 'punished'country refuses to pay?" And if it pays this will obviously be pro-cyclical. Don't get me wrong. I amnot saying that rules are useless but what makes the German rule credible for Germany is that the manon the street there thinks it is a good rule, not the rule itself. Now I am afraid that the same ruletransposed to other Eurozone countries will not have the same legitimacy and respect among the menand women on the streets in cities and countries west, south and east of Frankfurt.
4. So where do we stand?
None of the main problems has been addressed: no central budget, no institutional centre, no lender of last resort, no expansion of monetary policy (which would help solve the competitiveness problem if inflation were comparatively lower in the debtor and problem countries), not to talk about the lack of labour force mobility.The only good news is that Eurobonds have not been banished. This is helpful even if they are onlyone tool among others and not the essential political step forward which is required.This inability to solve the Greek and other similar cases reveals essential European politicalweaknesses. I do not buy the argument that if the Greek case were solved then the problem would goto Italy, not least because of the fact that the Italian economy can live with current borrowing rates fora rather long time thanks to the long maturity of its debt. I believe that if for once the Eurozone showsthat it has correctly understood the problem, that the markets would follow. But not before. Lenderswill not return in the absence of that act of political recognition.Day after day the choice becomes clearer.We Europeans can try to stay put in the middle of the river, attempting to roll forward an everincreasing snowball of debt and inevitably bringing on ourselves a long period of low growth with itsaccompaniment of social unrest. Or we can try, as many are beginning to suggest, to go back to theoriginal river bank and accept the dismantling first of the Eurozone, and afterwards as I believe of theUnion. In this case our future is decline and submission to our powerful cousins from overseas. Or wecan decide to make the crossing to the far bank and this is the right thing to do. It means going furtherin building the European Union, it means understanding that although we may belong to the French,the German or, dare I say it, to the British tribe, that from the perspective of a globalised world, andindeed from Beijing where you and I are today, we are seen as Europeans. Then the challenge will notbe technical, it will be democratic.