As we approach the Los Cabos summit, it is easy to be downbeat about the state of the global economy. The G20 goals of a full recovery from the Great Recession and putting the global economy on a sustainable growth path, as outlined in the Cannes Action Plan for Growth and Jobs, are not only far from realization, but they have also suffered serious setbacks due to failures of policy and governance. While finance ministers and central bank governors point to a continuation of a modest global recovery in their recent communiqué, levels of economic activity and employment remain well below pre-recession levels in many countries, markets remain unconvinced about the direction of policies, and downside risks and vulnerabilities dominate the commentary of the International Monetary Fund and the Organisation for Economic Co-operation and Development in their latest global economic projections.
But now is not a time for reflection. Instead, efforts need to be redoubled to have the G20 move forward and have leaders coalesce around the gains that can only be achieved through international policy cooperation. The reasons that brought the G20 leaders together in the autumn of 2008 have not disappeared. What have appeared to some to be domestic economic issues, therefore, requiring a purely domestic response, have in fact represented the full extension of the forces unleashed by the global financial crisis, which require global solutions. The G20 remains the most important “game in town” to put in place the right economic and financial policies. This is not just a one-time effort. It is a repeat game that needs to be played at the global level, this time around with some new team players in the lineup. The problem is that the game is currently being played based on a misdiagnosis of economic fundamentals, fed by failures of governance leading to failures of policy. And with these failures, we are now beginning to see economic risks turn into political risks.
Failures have been most evident in three areas: dealing with unsustainable sovereign debt levels; distinguishing between liquidity and monetary support from central banks; and recognizing externalities and the need for collective action. Los Cabos offers the opportunity for leaders to regroup and recalibrate.
Unsustainable debt levels have been at the heart of the global financial crisis. In many countries it first materialized as excessive bank lending and private sector borrowing, especially in mortgage markets, but it quickly became a sovereign debt crisis as a result of government bailouts to the financial sector. In other countries it was a sovereign debt problem from the outset, due to years of profligate public finances. It has become imperative to restore impaired balance sheets by setting debt levels on a sustainable track. The policy question is how best to do that.
There are three ways to resolve an unsustainable sovereign debt situation: inflation, growth or default/restructuring of the debt. Austerity alone is not an answer. At the time of the Seoul summit, many felt that Greece would require some form of debt default/restructuring. Inflation was not an option for Greece given the European Central Bank’s (ECB) euro-zone policy mandate. And the degree of fiscal austerity demanded of Greece, together with the constraints of monetary union and rigidities within the economy, meant there was no hope of growth as the solution. The delay in recognizing the fundamental fact that Greece’s debt obligations had to be restructured has only made the size of the adjustment Greece has had to endure even larger. There remains, nonetheless, a reluctance to accept the fact that in serious debt situations default/restructuring of the debt represents a tool to help countries get back “on side” with policies that will promote growth and have broad social support. The G20 should promote the development and acceptance of a framework for orderly sovereign debt restructuring. [See: http://www.cigionline.org/events/cigi-inet-sovereign-debt] Within the euro zone, authorities need to face the fact that further debt restructuring is inevitable.
These same policy choices apply elsewhere. In the United States and the United Kingdom, the prospect of growth providing the way out of their debt problems is much greater than among the euro-zone countries, given the availability of other tools, especially flexible exchange rates. Still, in both countries a judicious balance between fiscal austerity and the use of other tools to support aggregate demand is required. In the United States, the lack of political cohesion makes this task difficult, while in the United Kingdom the predominant focus on fiscal consolidation is beginning to weigh on the economy. At the same time, given the size of central bank balance sheets in both of these two countries, the risk that inflation will become the “release valve” for reducing debt burdens cannot be entirely ruled out. Given the technical means that the US Federal Reserve and the Bank of England have to exit from expansion of their balance sheets, this risk appears low.
Liquidity Versus Monetary Support
The traditional lender-of-last-resort role of a central bank refers to situations where liquidity support should be provided to financial institutions that are deemed to be illiquid, but solvent. Such support is separate, and different in nature, from central banks’ actions to provide economy-wide monetary policy stimulus. Poor communications and political posturing have greatly confused the situation in the euro zone, where suggestions were made that the ECB should act as the lender of last resort by lending to sovereigns facing a, purported, liquidity problem. Instead, the ECB correctly, though with some delay, took the important step of providing substantial liquidity support (their long-term refinancing operations) to the euro-zone banking system to help avoid a potentially serious negative feedback loop, whereby banks, in the absence of liquidity support, would have had to cut back their lending even more in the process of restructuring their balance sheets.
At the same time, however, discourse about the ECB being seen as lending to sovereigns (monetizing their debt) has, seemingly, made the ECB reluctant to undertake more expansionary monetary policy. With most of the euro zone mired in recession, and the risks on the side of debt/deflation dynamics taking hold, greater monetary stimulus by the ECB must become a policy option. This could involve the ECB operating entirely in secondary markets. With clear communications about its policy intentions and actions, the ECB can do considerably more to shape expectations in support of economic growth.
International Policy Cooperation
While the core functions of public policy continue to be performed at the national level of government, in today’s highly integrated global economy externalities and spillovers must be recognized and evaluated when designing and setting domestic policies. Whether the euro-zone debt crisis, the future course of US fiscal policy or the pace of China’s move to more market-based policies, all have profound implications for the overall performance of the global economy. The depth and breadth of interdependencies that tie countries together demand collective, concerted action on the part of the G20 if we are to have any hope of breaking out of the current economic malaise. To date, G20 leaders have not delivered on their commitments to international policy cooperation. This failure has resulted in policy mistakes that could have been avoided had the gains from collective action to address what are clearly global issues requiring global solutions been forcefully tackled by the G20.
For Los Cabos, there are three priority outcomes that leaders must deliver:
- put the euro zone on a sustainable track by grasping the economic fundamentals at play, including, where needed, further debt restructuring;
- articulate a global growth strategy, where interdependencies are recognized and both advanced and advancing economies play their part; and
- strengthen G20 accountability for commitments already made.
Less than a year has passed since the Cannes summit. In that short period of time, unilateralism and domestic political gridlock has dominated the economic scene. This must change at Los Cabos. Leaders must step up and act in the collective interest if we are to realize what we set out to achieve in the autumn of 2008.