November 2, 2011
Leaders of the Group of 20 big industrial and developing countries first convened almost three years ago to address the financial crisis. As now, there were deep doubts about the financial fundamentals of a major economy. As now, authorities were struggling to bring Main Street the financial stability it needed, without going too far beyond what it wanted. As now, the immediate task was to contain financial panic and the deeper challenge was to lay a foundation for renewed and inclusive prosperity.
The depression that looked possible then has been avoided but the outlook is hardly satisfactory. What can be learnt from the past three years as the G20 gathers in Cannes? The world’s leaders, especially the Europeans, will ignore the following lessons at their peril.
First, programme announcements that are vague and try to purchase stability on the cheap are more likely to exacerbate problems than to resolve them. Examples include the abortive super-SIV plan of former US Treasury secretary Hank Paulson; the first financial crisis resolution plan presented by his successor, Tim Geithner; and Europe’s successive attempts to resolve the eurozone’s crises. Where policy has succeeded – as with the original Tarp in the US, China’s stimulus measures or Switzerland’s recent effort to stabilise its currency – it has been based on clear actions exceeding the minimum necessary to stabilise the situation. This implies that only specific announcements going far beyond existing proposals will lower European spreads to the point where countries such as Italy and Spain can be seen as solvent.
Second, dubious assertions by policymakers end up undermining confidence. Like the 13th chime of a clock, policymakers who deny the obvious or claim to know the unknowable call into question all that they say. Examples include regulators’ assertions in 2008 that large banks had enough capital, claims that the US was enjoying a summer of recovery, and recent claims that Greece is not in default. Why should any investor rely on any default insurance from European authorities who heatedly deny that Greece is in default? The sooner it is recognised that the ideas advanced so far for leveraging the eurozone’s bail-out fund are incoherent, the sooner the crisis may be resolved.
Third, containing systemic financial risk is not enough to restore growth. US credit markets had largely returned to normal by the end of 2009, but because of weak demand, growth has not been sufficient to reduce unemployment. Even if Europe restores its finances, it is hard to see what will drive growth in countries pursuing austerity programmes that will cut incomes and demand. A faltering European economy will cut demand for exports and, if banks achieve higher capital ratios by shrinking, the supply of credit will contract.
Fourth, the greatest risk of sovereign credit crises comes not from profligacy but slow growth and deflation. Four years ago Spain and Ireland were seen as models of fiscal rectitude. Their problems come from a collapsing economy and financial system. For very indebted countries, a prolonged period when the rate of interest on debt far exceeds the nominal growth rate makes reducing debt to GDP ratios all but impossible. Analyses of austerity measures consistently overestimate their efficacy by neglecting their adverse effects on economic growth and inflation and hence on future tax receipts. If reasonable growth in the global economy is restored, deficit problems will be manageable. Without growth, it is likely to be impossible to ease debt burdens.
Fifth, the doctrine of expansionary fiscal contraction is an oxymoron in the current context. It is often said that determined efforts to cut deficits will boost growth. This is sometimes true. Canada in the 1990s – which started with very high interest rates, had a rapidly growing large neighbour, and let its currency depreciate – is a classic example. Now, safe interest rates are already very low; reliance on fast-growing neighbours is not viable unless big surplus countries such as China and Germany change policy; and eurozone deficit countries cannot depreciate against their main trading partners. Instead, as Britain is now demonstrating, fiscal contraction leads to economic contraction. This situation is made worse if, as in Europe at present, the central bank does not act to offset the adverse impact of austerity on demand.
These are hard lessons to heed. It would be much easier for the G20 to celebrate the recent European agreement, despite market turmoil, and vow to maintain the current global trajectory with lip service to adjustment in surplus countries. This would be a disaster. For the final lesson of the crisis is that confidence and complacency are self-denying prophecies. Only if policymakers feel the alarm appropriate to dangers as great as any the world economy has faced over the past 30 years will they take the necessary action.
The writer is a former US Treasury secretary.
Copyright The Financial Times Limited 2012.