175 ESC 09 E bis - The Global Financial and Commercial Crisis: Implications for the Transatlantic Community of Nations
SIMON VAN DRIEL (NETHERLANDS) - GENERAL RAPPORTEUR
I. INTRODUCTION: THE ORIGINS OF THE CRISIS
II. THE UNDERLYING MACRO-ECONOMIC PROBLEM
III. THE FISCAL CHALLENGE
IV. THE CRISIS AND UNEMPLOYMENT
V. MITIGATING THE CRISIS IN THE DEVELOPING WORLD
VII. BUILDING A NEW REGULATORY ORDER
VIII. THE CRISIS AND THE INTERNATIONAL SYSTEM
I. INTRODUCTION: THE ORIGINS OF THE CRISIS
1. Any comprehensive explanation of the current crisis must look beyond last year’s sub-prime mortgage catastrophe and account for global macro-economic imbalances, systemic and regulatory lacunae that left the system vulnerable to shocks, political mismanagement, and a widespread theological commitment to free markets that essentially paralyzed policy-makers as markets collapsed. The British political economist Robert Skidelsky has suggested that the financial meltdown reflects three failures: a failure of banking, financial institutions and regulation; a startling intellectual failure originating in a blind faith in global markets and their capacity to achieve stable equilibria over the long-run; and a moral failure, which placed a greater value on growth for its own sake than on other possible ends including systemic stability, or a just and politically sustainable distribution of wealth. The financial order, he writes has “sought to justify fabulous rewards to a financial plutocracy while median incomes stagnate or even fall; in the name of efficiency, it has promised the off-shoring of millions of jobs, the undermining of national communities and the rape of nature. Such a system needs to be fabulously successful to command allegiance. Spectacular failure is bound to discredit it.” In essence, Skidelsky suggests, there has been an uncritical acceptance of globalization and financial innovation on terms established by those who have benefited most from these phenomena at the expense of millions of others (Skidelsky, November 2008).
2. As Skidelsky alludes, the global economic crisis today poses perhaps the greatest political and intellectual challenge Western societies have confronted since World War II. Pressure for decisive action has been intense, while disagreements over what exactly needs to be done have threatened domestic and international comity. In the pressure cooker of crisis politics, many governments have managed to stave off collapse. However unpalatable, bank bailouts have nonetheless kept credit markets alive while stimulus packages have helped prop up market demand. But governments have also contemplated and sometimes adopted policies that have exacerbated already woeful economic conditions. The looming spectre of protectionism, for example, raises concerns that one of the core lessons gleaned from the Great Depression could be sacrificed on the altar of political expediency. Yet, the past can only provide so much guidance, and the current crisis has features that differ fundamentally from those that that characterized 1930’s. Western economies now operate in a thoroughly globalized and far more interlocked system, and new and emerging economic powers like China no longer operate at its margins. These new players have become central players. Thus even the hierarchy of great powers seems to be in a state of flux. The great challenge lies in building robust new structures that are appropriate for the very different circumstance of global integration. This will be a difficult task fraught with potential pitfalls.
3. The current economic crisis began as an asset price bubble in the US sub-prime housing market. Even as credit markets began to freeze up, few were willing to acknowledge that this sector was sufficiently important to imperil the global banking and financial sectors, foster panic in equities markets and finally trigger a sharp decline in labour markets. But some had seen the potential for a crisis. The OECD had long warned that the US housing bubble posed serious financial risks to global growth, although it had also praised Iceland’s ultimately disastrous foray into financial liberalization. Indeed, a massive deterioration in the balance sheets of the world’s leading banks followed soon after the sub-prime bubble burst. It turned out that many of these institutions were holding a range of assets linked to mortgage equity values, or derivatives, the value of which hinged on which direction particular markets moved. When the demand and the price for these assets plummeted, bank reserves proved inadequate to cover the losses, triggering a very serious credit crunch that immediately ramified throughout the world economy.
4. In fact, the global economy withered as lending capital dried up. Eventually firms began to fail, workers were laid off, consumers retrenched in anticipation of hard times, commodity prices fell, and global trade slowed precipitously. The rapid spread of the crisis revealed how integrated global markets have become and how a crisis in one sector and in one country could quickly spread to other sectors in many countries. Yet, the problem was not truly recognized as systemic until the Lehman Brothers Investment firm failed in September 2008. That institution’s collapse generated an international panic, ultimately triggering emergency government interventions to shore up financial and banking systems across the OECD and beyond. But by then, the credit crunch had struck the real economy. Business confidence had plunged, demand was collapsing and new investment opportunities were vanishing into the ether. The initial round of the crisis thus triggered a collapse of the real economy, which, in turn, struck yet another blow to the financial sector. Government intervened massively across the world to prop up banks that suddenly could not meet their obligations. Rescue efforts went well beyond the banking sector. Washington, for example, crafted a number of relief operations for the automobile, housing and other threatened sectors. Meanwhile extraordinary macro-economic measures were adopted across the world and often in a co-ordinated fashion to stave off depression. Monetary easing, increased government spending and, in some instances, tax cuts, had become the order of the day.
5. In hindsight, the signs of an impending crisis were apparent well before the bubble burst. By 2000, capital, much of it global, began to flee from a heavily over-invested technology sector and into the US real estate sector. Housing prices soared as investors perceived real estate as a one way bet for those who, by hook or by crook, could come up with funding for down payments. Even those with little capital were lent money to make down payments and the market naturally soared with so many jumping into it (OECD Parliamentary Forum 2008). Ominously, a range of new and essentially untried financial innovations like mortgage-backed securities helped mask market overvaluations. These instruments allowed banks and other actors to chop up highly risky mortgage loans into ever smaller increments, combine them with other, sometimes equally risky debt instruments, repackage them as triple A debt, and then sell them off. The bonus arrangements of banks and other institutions rewarded those individuals who struck these deals, and a premium was placed on assuming great risk and then swiftly off loading it. Those making inordinately risky real estate loans sought to sell off the loans as soon as they were made, thereby disassociating themselves and their institutions from the risks those loans entailed. These “originate and distribute” transactions were actually little more than legal Ponzi schemes. A kind of short-termism had set in throughout Wall Street, and those who warned that the system was growing structurally and recklessly unsafe were utterly marginalized in a system driven by quarterly earnings and monumental greed. Invariably, bad debt ended up on the books even of firms that had sought to off-load bad debt in the first place. The entire financial order was now vulnerable.
6. In an era characterized by the theological notion that markets are magically self-regulating, government regulation over these markets was sometimes non-existent. Frenetic market activity was further abetted by utterly misleading risk ratings produced by clearly under-regulated firms riddled with conflict of interest problems. Adding fuel to the fire, mortgage-backed securities were also highly liquid, and, in some respects, often treated more as cash than as risk. Bond insurers, who guaranteed payments on these assets, further broadened the risk, oftentimes beyond American shores (OECD Briefing 2009). A toxic mix of moral hazard, asymmetrical information, conflict of interest, market integration, poor regulation, collective irresponsibility, excess credit, and blind faith in virtuous efficacy of “the market” effectively constituted a perfect storm; the worst financial crisis the world has seen since the Great Depression was the inevitable result.
7. It is now apparent that during the long run up to the crisis, regulators had not kept pace with financial “innovation”. This accorded banks and other financial institutions enormous latitude in creating and spreading highly risky credit instruments. Leveraging perilous assets in an already highly leveraged global financial market imbued the system with a higher order of risk than many bankers, regulators, borrowers and politicians had ever imagined. Thus, when housing prices crashed in 2007, the impact on the balance sheets of major lending and insurance institutions was devastating. That many of the institutions holding these assets were multinational ensured that this crisis would be global in scope. Real estate and credit explosions in Spain, Ireland, Iceland, the United Kingdom only magnified the impact. A crisis that began on Wall Street rapidly spread to Europe and beyond. The high degree of financial integration between the two continents and the fact that some European financial systems were equally overextended helped to ensure that the panic was global in scope. Even those countries like Canada, which engaged in highly prudential banking practices, were not spared the brutal secondary effects of the global down turn (NATO PA Mission Report, Canada).
8. Indeed, as the tentacles of bad debt spread through the global financial system, the real economy began its descent: credit lines vanished, demand dried up and trade plummeted. Firms began to release workers and unemployment soared across the developed world. Rising joblessness accelerated the downward trend in developed economies. The United States fell into recession, Japan was soon in the midst of its worst slump in 35 years with GNP falling 12.5% at an annualized rate in the last quarter of 2008. The British economy underwent its sharpest decline in almost 30 years, and Germany’s GDP fell faster at the end of 2008 than it had in nearly 20 years (Tse). The Icelandic government was compelled to take over its devastated banking sector, which during the run up to the crisis had grown disproportionably large relative to the size of the country. Iceland’s imports fell 33% in the third quarter of last year as the Crown collapsed in value. After the first two quarters of 2009, Iceland’s GNP had fallen at an annual rate of 6.5% (Forbes.com, 9 September 2009). Earlier this year, estimates suggested that China’s economy would only grow at 6.8% and India’s at 5.1% in 2009, impressive rates for sure, but rates nearly half the size of trend.
9. Central and Eastern Europe were also hit hard, although credit problems there were on an even higher order than in the United States. Credit growth throughout the region had expanded dramatically in the years preceding the crisis, and much of that lending, fatally, was euro denominated. At the same time, current account deficits were soaring due to rapid growth, a consumption and investment boom, high capital inflows and mounting trade deficits. Credit to GDP ratios rose substantially throughout much of the region. In 2008, Latvia’s bank credit stood at 102% of GDP while in Estonia foreign currency loans were 120% of GDP. In June the World Bank warned that the three Baltic states would face the sharpest economic declines in Eastern Europe. In the first quarter, EU statistics revealed that Latvia, Estonia and Lithuania had the worst performing economies in the 27-member bloc, with annual drops in output of 18.6 %, 15.6% and 10.9%, respectively, and all three have had their credit ratings downgraded (Crossing Wall Street).
10. Global deleveraging fuelled by abrupt requirements for cash due to falling asset values compelled Western banks to call in short term loans made to the region. The ensuing capital crisis and the slowdown in key export markets soon struck the real economy, and growth rates throughout the region plunged as a result. High levels of borrowing had left most of the countries of the region in difficult straits when the global credit crisis hit. It also left a number of West European banks vulnerable as their exposure to the region had risen from $158 billion in 2002 to almost $1 trillion in 2008 (NATO PA Mission Report, Washington May 2009). Sweden’s central bank, has subsequently borrowed from the European Central Bank to help underwrite guarantees extended to its highly exposed banks. These commitments and IMF special credit lines to the region have helped limit but have hardly stemmed the crisis in Eastern Europe (“Stand by Me”). IMF studies now suggest that the crisis for Central and Eastern Europe will be deep and extended. Yet, the depth of crisis has varied throughout the region; it has been most severe in the Baltic States, Ukraine and Russia but less consequential, for example, in Poland, which has so far weathered the storm in reasonably good shape. Russia has been compelled to draw down its once huge reserve fund which had shrunk to $52 billion in the third quarter of 2009 from its peak of $137 billion last March. That fund could be fully exhausted by the end of 2010 (“Here today, gone by 2010”). This has raised questions about the sustainability of Russian fiscal policy.
11. Bleak news not withstanding, the world economy is today clearly if slowly stabilizing after a deep, nerve wracking and protracted crisis. The IMF now projects global growth to contract 1.4% in 2009 but to grow by 2.5% in 2010; this is significantly better than expected. Still, the recovery will be both fragile and sluggish and there are looming risks linked to high government debts. Fed Chairman Ben Bernanke now suggests that the United States will register a second consecutive quarter of growth, officially ending the national recession and putting the United States on a growth path into 2010. He added however, that “If the US recovery is to take place, if the fiscal stimulus must be phased out, and if private domestic demand is weak, then US net exports must increase. In other words, the US current account deficit will have to fall and exports will have to provide more fuel for growth when and if government spending slows. That means that the rest of the world, now in substantial surplus, must reduce that current account surplus” (Blanchard). This scenario, of course, represents a fundamental departure from recent global growth and fiscal patterns and it is not at all clear that either the United States or the rest of the world is prepared for this change. Bernake’s admonition suggests that the recovery could indeed be fragile if structural changes are not made. Meanwhile Asia is recovering more quickly than Western economies. The Asian Development Bank forecasts a 3.4% growth rate for the region this year. Its chief Economist has suggested that these figures may significantly understate regional growth, which could approach 7% in 2010 ("World Economic Outlook Update” 8 July 2009, Brown).
12. Several macro-economic factors differentiate the current crisis from other financial crises like that which consumed much of Asia in 1997. Above all, the world’s greatest economic power has been at the epicentre of the crisis. Secondly, the crisis has not simply been a banking crisis; it has also been the product of fundamental macro-economic disequilibria. In the run up to this crisis, the world economy was essentially overheating on a surfeit of credit creation. Persistent and massive US current account deficits, financed by Asian and particularly Chinese lending, generated this credit. The US current account deficits had soared to unsustainable levels above 5% of GDP by 2006. Consumer spending and residential investment in the United States had risen from 67% of GDP in 1980 to 75% in 2007, while house hold savings rates fell from 10% of disposable income in 1980 to near zero in 2007. Household indebtedness accordingly jumped from 67% of disposable income to 132% over the same period.
13. Monetary economists had long warned that failure to lower massive current account and budget deficits would eventually trigger sudden and massive contractions. Those warnings were never heeded in American policy circles, where the privileges of administering the world’s reserve currency meant that the normal rules of international monetary accounting could be ignored. The massive contraction of the past year, however, suggests that America may be losing that particular privilege (Grant). This change has unfolded far more quickly, deeply and widely than most analysts had expected. Worryingly though, the United States continues to run current account and budget deficits while China and other net savers continue to lend money to the US Treasury. This has facilitated continued American government spending and propped up overall liquidity in the United States, but it also suggests that further painful macro-economic adjustments lie on the horizon. This pattern has also had a number of perverse effects. First it funnelled capital from poorer countries to a mature industrial country. Second, the capital that flowed into the United States after 2000 was used to underwrite consumption and to finance a real estate boom rather than to bolster American productivity. Finally, these capital inflows pushed up the value of the dollar, lowering export opportunities for American companies, creating a boom in non-traded goods (real estate in particular), and fostering US corporate off-shoring to exploit cheaper labour elsewhere. The owners of capital accordingly benefited by manufacturing cheaply in China and skimming profit from the boom, while American workers suffered as industrial jobs were off-shored and industrial wages stagnated (Skidelsky July 2009).
14. The United States has become both the world’s greatest borrower and its greatest spender but it could only continue along this path as long as the world believed that this state of affairs was sustainable. By the first quarter of 2008 US foreign debt approached $6.5 trillion (Moirici). The parsimonious Chinese and other Asian Tigers were financing America’s excessive spending binge and were rewarded for doing so by America’s huge appetite for Asian consumer products, which could be had at a discount given fundamental currency misalignments. Because capital inflows bid down US interest rates and cheap imports lowered goods prices, the Federal Reserve enjoyed ample space to pursue an easy monetary policy that, along with lose fiscal policy stoked demand. US productivity growth began to plummet because cheap capital was being misallocated so profoundly. Foreign capital facilitated the American consumption binge while providing Asia and other export dependent economies with a means to sustain their own growth. This symbiotic exchange has essentially become a vicious and unsustainable circle.
15. A genuine macro-economic correction will ultimately require greater savings by countries like the United States that have overspent for years and greater spending by those countries like China that now need to invest domestically in areas like public health and environmental infrastructure. This transition has already begun insofar as American households are now saving 5% of their income, up from nearly 0% last year. But the US government is now dissaving at a record rate and has increased public spending on entitlements, defence and though various economic rescue efforts, tax cuts, and the stimulus package (“After the Fall”). The structural deficit, the large stimulus package and falling tax revenues has caused the US budget deficit to triple to $1.4 trillion in the year to September (BBC, 8 October, 2009). Ultimately the US government will also have to reduce its budget deficits, allow the dollar to fall and begin to export its way to economic health. The Chinese are justifiably worried about a massive fall in the dollars value, particularly given their hoard of dollars. They would certainly like to reduce their exposure to the dollar but it is difficult to do so without bidding the dollar’s value downward. This is one reason why the Chinese are calling for revitalizing IMF issued Special Drawing Rights which consist of a currency basket and could be held by central banks in lieu of dollars (“Promises, Promises”). China’s monetary and trade strategies have led it to over-invest in its own export industries to the neglect of its non-traded sector. Even its growing pollution problem can be partly understood as a consequence of this pattern although it is also simply due to its growth. In any case, China is only starting to engage in the kind of environmental regulation and spending it needs to prevent its people from literally choking on their country’s development. To their credit though, Chinese leaders clearly understand the seriousness of the challenge, which also has implications for domestic security, and are now moving with greater alacrity to address it. This has financial implications insofar as China may begin to invest more of its reserves domestically rather than purchasing Treasury Bills. In practical terms, this means that it will need to allow the renminbi to appreciate and begin to direct some of the wealth it is accumulating toward internal investment rather the purchase of US Treasury bills. When and if it does so, however, the United States will face a range of difficult choices that it has long avoided.
16. At the outset of the crisis OECD analysts suggested that stimulus packages should be front loaded to have the quickest possible impact. Immediate government disbursements rather than tax cuts – particularly for the wealthiest sectors of society – were seen as more likely to generate demand in recession plagued economies. Where possible, these projects should be shaped by social equity and environmental considerations. Efforts were also needed to minimize moral hazard, so that financial recklessness would not be seen to be rewarded – something that has proven particularly challenging. Finally, fiscal sustainability would be essential. Exit strategies are needed so that long-term budgetary sustainability is not undermined. These will be of particular importance in countries like the United States that were already running very high and unsustainable budget and current account deficits even prior to the recession. Despite these significant signs of recovery, there are also growing concerns that Western efforts to employ short-term Keynsyian spending strategies could pose serious problems if longer-term fiscal rectitude is undermined. The recession has not only slashed government receipts, it has also driven up government spending as automatic stabilizers have kicked in and as new programs have been adopted to prop up demand. Over time, rising budget debts could tempt governments to employ inflationary policies to whittle down the burden. This would discourage private sector investment, undermine longer-term productivity and provoke capital flight.
17. Countries like Germany, the United Kingdom and Finland have accordingly announced future measures to consolidate over-extended budgets. Governments must find a way to step off the accelerator without killing the green shoots of economic recovery. That is no easy task. Invariably government spending programs are easier to initiate than to end, and doing so requires political courage, economic finesse and good timing. Having spent $787 billion on the stimulus package and $700 billion bank bailout, the United States has disbursed more funds than any other country to keep its economy afloat. Automatic stabilizers like social welfare and unemployment payments are far smaller in the United States than in Europe so the United States has sought to compensate in its stimulus program. This is one reason why the US stimulus package has been greater relative to GDP than in Europe (OECD Briefing 2009). According to the White House, the total deficit for fiscal year 2009 is forecast to be $1.75 trillion, a $1.29 trillion increase from the 2008 deficit. The deficit is forecast to decline to $1.17 trillion in 2010 and $533 billion by 2013 (OMB).
18. As the director of the US National Economic Council, Larry Summers, suggested early in the crisis, stimulus spending initiatives ideally were to be timely, targeted, and temporary. Unfortunately government spending programs are rarely so well calibrated, particularly when they are drawn up in as hasty fashion as these packages invariably were. Political opportunism can creep into the best laid spending plans, particularly in open democratic systems where government spending is the currency of political barter. The challenge of returning to fiscal health is even greater in those countries where intervention went beyond simple monetary and fiscal initiatives. Where the state stepped in to underwrite the balance sheets of banks, private companies and mortgages, the burdens are even greater, and reducing the state’s role even riskier and more politically problematic. The US government, for example, has become America’s largest lender, insurer, auto maker and guarantor against risk for investors. If one includes the financial rescue programs and the economic stimulus package, government spending in the United States today accounts for nearly 26% of the nation’s economy, more than at any time since World War II. The state is now financing nine out of ten mortgages and owns 80% of the world’s largest insurer, AIG (Andrews, 14 September 2009). Getting those assets off government books could prove a Herculean task.
19. The US government has already initiated a delicate process of exit from a $700 billion program that has directed state funds into banks, insurance companies and two of the Big Three automobile companies among others. The Obama Administration has generally taken a hands-off approach to managing these newly acquired assets and describes its intervention in the market as temporary. The goal was initially to save these institutions from collapse and now it is to exit as quickly as is economically feasible. It recognizes, however, that some of the assets collected under the Troubled Asset Relief Program (TARP) may prove to be loss makers and others may be difficult to offload. Yet, more than thirty financial institutions have already repaid $70 billion in loans to the US Treasury. An estimated $50 billion more will be repaid over the next year and a half, with the government potentially earning a significant profit on many of these loans (Andrews 14 September). Another program, the Temporary Liquidity Guarantee Program of the Federal Deposit Insurance Corporation, has guaranteed roughly $300 billion worth of bonds issued by banks. Earlier this year, this program was extending guarantees at a rate of $90 billion a month, but that figure has now fallen to roughly $5 billion – yet another indicator that the crisis has eased significantly (Andrews, 14 September 2009). Similarly the government’s term auction facility, an emergency business loan program, has halved in size over the past year and the expectation is that this particular intervention will soon end.
20. The US Treasury has poured $95 billion into the quasi public mortgage lender, Fannie Mae and Freddie Mac, to cover losses generated by extraordinarily high default rates and losses linked to plunging real estate values. A number of market watchers suggest that that these huge institutions will require additional funds over the coming years to cover losses. The US government will thus remain highly vested in the US housing market for some time to come. The Federal Reserve has acquired $700 billion in mortgage backed securities, a figure that by some estimates could rise to $1.25 trillion. It has also purchased $200 billion in bonds from Fannie Mae and Freddie Mac. The US Federal Bank currently purchases virtually all the new mortgage-backed securities issued by Fannie Mae, Freddie Mac and the FHA to prevent a catastrophic collapse in real estate values.
21. The United States is hardly alone in managing serious fiscal challenges. Throughout the OECD, greater government spending, tax cuts and falling government receipts have spawned growing and sometimes unsustainable deficits. Budget shortfalls have ballooned – to an average of almost 10% of GDP across the large richer countries – as governments have recapitalized banks, provided fiscal stimulus to bolster demand, and responded to new burdens on government all in the face of falling government receipts. Refraining from enhanced spending would have further undermined already fragile economies paralysed by the credit crunch. It is not surprising, therefore that at the September G20 summit in Pittsburgh, government leaders endorsed continued support for stimulus programs to provide a foundation for growth ("The Other Exit Strategy"). The world economy is not yet out of the woods.
22. Fiscal balances are expected to strengthen gradually as the global economy recovers, but the debt outlook for a number of governments is worrying. Deficits are slated to remain significantly above 2007 levels. Among the G20, fiscal deficits in both 2009 and 2010 could average 5.5% of GDP, significantly higher than pre-crisis levels (Horton et al.). The IMF believes that the gross government debt of the rich world’s big economies will reach an average of 115% of GDP by 2014, and will continue to rise thereafter in certain countries, most notably in America. Debt ratios in the G20 countries as a whole are expected to stabilize at roughly 85% of GDP between 2010 and 2014 – a figure that stands roughly 23% above pre-crisis levels. At this level of debt, interest rates will be pushed upwards, private investment partly crowded out, and growth reduced (“The Other Exit Strategy"). Only a few G20 countries have developed fully credible medium-term fiscal adjustment strategies, although some have announced targets or extended their fiscal projections. In June Germany adopted a new fiscal rule for both federal and state governments that envisages a gradual move to structural balance from 2011, which will require the federal government’s structural deficit not to exceed 0.35% of GDP from 2016 (Horton et al.). Britain’s estimated budget deficit for 2008-2009 stands at ?175 billion (Parker). The government is projecting an annual average fiscal consolidation of 1.3% of GDP from 2010 to 2014, so that debt can begin to decline by 2015-2016 (Horton et al.). The fiscal deficits of emerging and developing countries are also projected to increase by 4.6% of GDP on average in 2009 compared to pre-crisis levels in 2007, with a gradual recovery from 2010 (Horton et al.).
23. Reviving growth is the real key to lowering the debt to GDP ratio. Some analysts, including Paul Krugman, insist that deficits should not be seen as a problem in the current climate (Reich, 31 August, 2009). He has persistently questioned whether the Obama stimulus package has been sufficiently large to boost the economy out of recession. Although he feels that the worst case scenario has been avoided, Krugman argues that failure to inject more liquidity into the system now risks precipitating years of sluggish growth and high unemployment. He argues that the risk of inflation is minimal, given excess capacity in the United States and beyond (Krugman Interview). Other economists are far more sceptical on this point, arguing that mounting budget deficits in the United States and elsewhere will invariably tempt central bankers to print money to erode national debt burdens (Ohanian). The OECD, among other think tanks is also arguing that it is premature for governments to back away from stimulus spending although they should be planning retrenchment strategies.
IV. THE CRISIS AND UNEMPLOYMENT
24. Mass unemployment may be the last economic indicator to rear its ugly head in the midst of a global financial crisis. For obvious reasons, it is also the most politically sensitive. The unemployment rate is known as a lagging indicator not only because it continues to fall months after an economic financial crisis has bottomed out, but also as it is one of the last indictors to return to “normal” levels during an economic rebound. In the current crisis, job losses began to mount only after demand levels in the real economy collapsed; these are likely to persist well into the recovery. Although there are signs of renewed global growth, the rate of job loss has slowed but it has yet to be reversed and will most likely continue to rise at least over the first six months of 2010. US unemployment is now at a 26 year high and could exceed 10% by the end of the year while the figures in Spain and the United Kingdom are 18.9% and 7.9% respectively (Groom). In the euro area, unemployment hit 9.5% in July 2009, which is 2% higher than the July 2008 figures. Across the OECD the young, women, those on short-term contracts, and those working in construction and manufacturing have suffered the highest job losses. According to the OECD job losses across the OECD are likely to rise until the end of 2010 when the rate for OECD members will hit 10% or 57 million unemployed. It will take years to recover those lost jobs (OECD Employment Outlook). A recent multinational survey polled 72,000 companies in Europe, the Middle East, and Africa and concluded that employers from 17 of the 35 countries expected net hiring in the coming three months although hiring is expected to remain sluggish. Only employers in Norway, Poland, Sweden and South Africa reported positive, but modest, fourth-quarter hiring activity. Employers in Romania, Ireland and Spain are the least optimistic about adding employees in the quarter ahead, and further declines in those countries seem likely. Employment prospects are most favourable in India, Brazil, Colombia, Peru, China, Australia, Singapore, Costa Rica, Canada, Taiwan and Poland ("Manpower Employment Outlook Survey: Global").
25. There are, of course, serious economic and political perils linked to rising and sustained unemployment levels. As suggested above it can take years for employment levels to recover after a dramatic fall in employment levels. Workers’ skills erode, jobs are exported and some workers ultimately abandon the job market. Joblessness also leads to poverty, which poses even more daunting social and economic problems. OECD Secretary-General Angel Gurría has said that “Employment is the bottom line of the current crisis” and that it is now time for governments to focus on helping jobseekers in the months to come” (OECD, 16 September 2009). The political dangers are real. When frustration becomes generalized, it can lead to political backlashes or prompt ultimately harmful policies designed to assuage those who have lost their jobs while undermining long-term growth. The temptation can be great to prevent failing companies from entering bankruptcy, but the risk of doing so is that this can saddle the state and its taxpayers with assets that may be of little value over the long run. The judgement that many states have had to make is whether particular firms face temporary challenges or whether they are not viable over the long run. Finally there is a moral hazard risk because when states are perceived to be in the habit of bailing out failing firms, they encourage reckless behaviour in which profits are perceived to be private while losses are nationalized. This is as true for banks as it is for car companies. Economists today are highly concerned about the moral hazard problem but job losses are driving policy. Other strategies may be needed to keep workers on the job. Subsidizing salaries or encouraging workweek reductions offer two possibilities here.
V. MITIGATING THE CRISIS IN THE DEVELOPING WORLD
26. The financial crisis hardly stopped at European shores. Indeed, it has struck the developing world and done so through several channels: the collapse of world demand, the drop in commodities prices and, indirectly, through lower aid foreign direct investment and remittances (OECD, 1 October 2009). The crisis has dried up financial capital and undermined the willingness of financiers to extend credit to any client that might be seen as at risk. Indeed, this crisis has triggered a so-called “flight to quality”, sparking a massive withdrawal of capital from myriad developing countries. The subsequent commercial recession in the developed world rapidly spilled over to the developing world as demand for imports and commodity prices both crashed. Exportled developing countries, in particular, were hit hard as a result. Soaring Western government borrowing is now making capital even more difficult to access in the developing world and most developing countries lack the funds to finance their own stimulus programs. Meanwhile development aid budgets are vulnerable to cuts in the current environment. All of this could widen the income gap between richer and poorer countries.
27. The dramatic decline of capital flows to developing countries has made it very difficult for poorer countries to finance current account deficits. The World Bank estimates that financing shortfalls stand between $270 and $700 billion. It is not yet clear how these deficits are going to be financed and much depends on how the current crisis plays out. If conditions stabilize, the shortfall will lean toward the $270 billion figure; should conditions worsen, greater shortfalls can be anticipated. The precipitous decline in world trade is obviously worsening these balances for many developing countries (NATO PA, Washington DC, 4-6 May 2009).
28. The crisis in the developing world has had grave humanitarian and security implications as well. It is estimated that last year some 150 million people fell below the World Bank’s poverty line of $1.52 a day and more than 50 million more had done so by May this year. Poor people obviously have very little reserves allowing them to cope with worsening economic conditions. Suddenly impoverished families are compelled to sell off assets like farm animals which are crucial to their livelihoods and long-term productivity. Children are withdrawn from school, visits to the doctor are curtailed and the quality of nutrition declines. All of these can have lasting developmental and security effects. Undernourished children are often permanently impaired and their condition becomes an economic and social burden for decades as a result. Developing countries often lack the fiscal tools to deal with these multiple crises, and many development experts now suggest that achieving the Millennium Development Goals will be all the more difficult due to the current downturn. In fact, this is the second grave shock to hit the developing world over the last two years; soaring food and energy prices during the run up to the financial crisis were already pushing millions into absolute poverty (Austrevicius).
29. Developing countries, however, are hardly uniform in their problems and needs and thus require various kinds of support. Some, for example face sharp falls in remittance earnings, some are suffering because of commodity price falls, while others have been hit by declining trade or capital in flows. The World Bank has called on the developed world to set aside funds to help developing countries weather the current storm. Support is needed to maintain social safety nets in poorer countries where many live in highly precarious conditions. Support for agricultural production and small and medium enterprises remains a key priority. The World Bank has tripled lending to the poorest countries and the International Bank for Reconstruction and Development (IBRD) will spend $35 billion this year and in each of the next two years. The Bank has worked to front load these funds so that they can have an immediate stimulus effect in countries without the fiscal resources to adopt expansionary fiscal policies (NATO PA Mission Report, Washington DC, May 2009). The World Bank is supporting efforts to help the most vulnerable and to mitigate the social costs of the crisis. The Global Food Crisis Response Program (GFRP), for example, is helping smallholder farmers in today’s very difficult climate. Another program is supporting social safety nets for the urban poor. Keeping children in school and assuring their access to health clinics remain key priorities for the Bank in this crisis.
30. Over the longer term, advancing the development process may be critical to correcting some of the structural problems underlying this crisis. In the run up to the Pittsburgh G-20 Meeting, World Bank President Robert Zoellick observed that American consumers can no longer function as the engine of global growth and that the developing world, including Africa, should ultimately be seen as a potential source of consumption driven growth, at least over the longer term. To a certain extent this is actually happening. The largest emerging markets are recovering more quickly than the developed world (“Not just straw men”) and they have become key protagonists in advancing south-south economic relations. This holds out new avenues for kick starting growth and development in poorer countries. Development matters have often been cast to the margins of economic discussions in developed countries. But these ought to be placed near the core of national economic considerations precisely for the reasons laid out by Mr. Zoellick. Along these lines it is highly significant that the G20 has endorsed the notion that the governing structures of both the IMF and the World Bank must be reformed to give greater weight to developing countries in decisions affecting global economic policy.
31. Largely due to a range of protectionist government responses to the global financial crisis, there are concerns that the global trading system today confronts a new set of risks. The WTO estimates that trade volumes will shrink by one tenth this year. World trade had fallen by a startling 32.6% in value in the year to January among those countries accounting for 97% of global trade (“After the fall”). The economic historian Barry Eichengreen estimates that trade has contracted by more in this crisis than it had at a comparable stage of the Great Depression (“Unpredictable Tides”). Of course, most of this decline can be attributed to collapsing demand, but rising trade barriers are a concern although not yet a catalyst for falling trade. Some trade restricting measures have been implemented including safeguards, anti-dumping measures and countervailing duties. If more such measures are introduced they could push world trade in the wrong direction (Chad Brown). The lessons of the Great Depression continue to be instructive. Not only did many governments fatally cut spending in the face of a grave recession after the market crash of 1929, they also imposed daunting trade barriers, perhaps best embodied by the highly protectionist US Smoot Hawley Trade bill. Such measures only deepened and broadened that crisis, a development fraught with horrific geo-political implications. Governments today have rhetorically heeded the lessons from that dreadful decade, but they must remain vigilant.
32. Last November the G20 heads of government agreed not to resort to protectionism as a tool for managing the crisis. Nevertheless, a recent study conducted by Global Trade Alert suggests that virtually all of those countries have, in fact, adopted various types of protectionist policies in violation of the pledge taken last November. According to that report: “Conservatively estimated, 121 beggar-thy-neighbor measures have been implemented by G20 governments since last November and every three days a G20 government breaks its no-protectionist pledge” (“Broken Promises”). Many countries are also raising tariffs within the limits of their WTO commitments. The United States, the European Union and Switzerland have all introduced new farm subsidies while the number of anti-dumping cases in the WTO has risen sharply (“Unpredictable Tides”).
33. Protectionist measures today are insidiously more difficult to detect than they were during the 1930s when tariffs and quotas were the weapon of choice. Today protectionism can be hidden in all manner of government policies which nevertheless have the effect of distorting and indeed discouraging trade. The huge stimulus and rescue packages introduced in the most developed countries unfortunately are also sometimes being used to create uneven commercial playing fields which accord clear advantages to domestic firms. For example, mandating that government spending be directed only toward domestic firms represents a subtle but nefarious form of protectionism. What some in one country might call a bail out, might well be seen elsewhere as a subsidy.
34. Trade tensions on these issues have mounted over the past year. President Obama’s stimulus package initially included a highly controversial clause calling for a “buy American” policy on US steel and several other products. European leaders and auto makers have also expressed scepticism of US government transfers to GM and Chrysler as well as measures like a congressional bill that forbids federal agencies from purchasing non-American cars (Mitchell, 27 August 2009). The United States also recently announced that it would slap tariffs of up to 30% on Chinese manufactured tires, to which the Chinese responded with an announcement that it would initiate an anti-dumping retaliation against US exporters of chicken and auto parts. The United States is not alone in pursuing such policies. French President Nicholas Sarkozy has called for a carbon tax on imports from countries that do not follow its cap and trade rules. Many governments have worked to ensure that when their companies restructure, they do so in a fashion that the greatest pain is borne by plants hosted abroad. Belgium, for example, has reacted sharply to a decision to close an Opel plant in Antwerp after the sale of GM’s Opel brand to Canadian part’s manufacturer Magna which purchased Opel with German support. The Belgian government has called for an EU investigation into that decision, charging that Magna was working on behalf of German interests. (BBC, September 11, 2009). A similar dispute emerged between France and Slovakia and Slovakian Prime Minister Robert Fico suggested that if France followed through on threats to close factories operating in Slovakia, the Slovaks would ask Gaz de France to end its presence there. This is precisely the tit for tat response that protectionist stances always seem to unleash (Munchau). So far, most of these disputes have been contained.
35. There is some good news insofar as negotiators are once again seeking to kick-start global trade talks, which have been moribund since the Geneva Summit in July 2008. Negotiators gathered in New Delhi in early September to revive the 8-year Doha Round which has been essentially blocked by key developing countries’ reluctance to open their markets to industrial goods and US and European reluctance to open their agricultural markets. Yet, neither the Obama Administration nor European governments have made trade issues a priority over the past year. Managing the financial crisis and health care debate in the United States has consumed the lion’s share of the Administration’s attention. President Obama was also elected with the support of some constituencies that are suspicious of trade liberalization, and there is a noted air of caution on trade matters in Washington today. Indeed, there has been no movement on free trade agreements with South Korea, Panama and Columbia, and little response to Canadian and Mexican complaints about rising US protectionism. Nor has Europe suggested that the trade distorting elements of agricultural protection is likely to change. Developing countries are equally inflexible on matters related to market access. Ultimately therefore, the key to success in the Round will lie in strong leadership, a willingness to compromise and possibly a reduction in ambitions for the Round itself (Miller and Fritsch). In any case, current protectionist trends are a concern, particularly as more open trade offers one way out of the current malaise. Politics should not push governments in the other direction.
36. Financial deregulation has been a leitmotiv of Western capitalism over the last twenty years, particularly, though not exclusively, in the Anglo-Saxon world. The end of fixed exchange rates in the early 1970’s roughly marked the dawn of an era of capital market liberalization, financial innovation, and monetary as well as commercial globalization. Until very recently the tendency had been to break down old barriers between banks and other financial institutions and to grant markets leeway “to find their own equilibrium” both in domestic and international goods and money markets. Widely shared optimism about this efficacy of wide open financial markets was well expressed by the Canadian Philosopher, John Ralston Saul, who wrote several years ago, “In the future, economics not politics or arms would determine the course of human events. Freed markets would quickly establish natural international balances impervious to the old boom and bust cycles. The growth in international trade, as a result of lowering barriers, would unleash an economic-social tide that would raise all ships, whether of our western poor or of the developing world in general. Prosperous markets would turn dictatorships into democracies” (Skidelsky, January 2009). But it is precisely this kind of a historical optimism that has dragged the world into yet another epic crisis.
37. From where we stand today, unquestioning confidence in the benign efficacy of globalization and deregulation, as expressed, for example, in Tom Friedman’s The World is Flat, seems rather misplaced. That prosperous markets do not necessarily turn dictatorships into democracies is perfectly evident in the case of China. Promising an end to boom and bust cycles through deregulation, meanwhile, borders on pure hubris in light of what has actually transpired in this era of globalization. Indeed one could argue that since the collapse of the Bretton Woods system and broad market deregulation, the international monetary system has only become more unstable. Given the myriad examples of grotesque market manipulation conducted by key financial players, many Western governments now feel compelled to ask what the proper line should be between market and state in matters of finance.
38. One possible explanation for mounting instability over the last thirty years could be that the system has lacked a credible liberal “hegemon” to impose rules embraced willingly by other key players in the global economy (Kindleberger). The rise of new economic power centres has rendered monetary decision making far more complex, and the capacity of the system to police itself and evade financial crisis has weakened. Numerous crises have unsettled global markets over this period, often emanating from developing countries – Mexico, Argentina, East Asia, Russia – to name a few. But the West has also generated crises – Silicon Valley in 2000 and Wall Street in 2008. These crises have all had profound effects on the global real economy. But the latest crisis originated in the very heart of world capitalism, and, not surprisingly, the damage it has wrought to the global economy and to its intellectual underpinnings has been of a far higher order than earlier crises originating in the developing world.
39. One could also argue that innovations in financial markets have helped spread rather than curb instability. In 1999 the US government eliminated the Glass-Steagall Act, which had long prevented commercial banks from operating as investment banks. In 2002 the government opted not to regulate derivatives markets including Credit Default Swaps (CDS). These “innovations” actually made markets more opaque while leaving them even more leveraged than they otherwise would have been. In 2002 CDSs in the United States were valued at $1 trillion but by 2008 that value had jumped to $33 trillion; there is little doubt that the unwinding of those assets helped accelerate and deepen the financial crisis. Meanwhile mortgage-backed securities were sold as vehicles for managing risk; in fact, they often operated as risk accelerants by masking the dangers of sub-prime mortgage lending. This helped spread the risk of default throughout the world financial system. Capital adequacy standards for a range of financial institutions in the United States were also loosened. In 2004, for example, the government allowed banks to move from a 10-1 leverage position to a 30-1 position (Bradley et al.). Worse still, the bonus policies of these institutions rewarded high risk gambling and often penalized those more prudent figures in the industry who warned that risks banks were now habitually assuming were becoming both formidable and unmanageable. This was not true in all banking systems, of course, although similar patterns emerged in countries like Ireland and Iceland. Canada, for example, did not engage in these risky gambits and is all the stronger today as a result.
40. All of this points to the dangers of regulatory inadequacies and negligent risk management practices. Indeed, many financial operators perceived their highly risky forays into the market as one way bets. The insurance giant AIG, for example, had moved from the traditional insurance business into taking extraordinarily speculative positions in dodgy markets. These positions proved crippling when markets soured last year, compelling the US government to undertake a massive bail out of that crucial company, which in the eyes of many had become “too big to fail”. AIG was not alone; many financial firms throughout the world were “bailed out” by governments that understood the dire implications of allowing key institutions to go under.
41. Unfortunately many financiers were perfectly correct in their risk calculation, as least as far as their own well-being was concerned. Indeed many have walked away from this mess all the wealthier for their poor decisions – sometimes because they were able to “pass the buck” before markets collapsed and other times because they were bailed out when the paper they held proved worthless. There is an obvious risk that such behaviour may reappear again in the future because governments were so willing to come to the rescue this last time. The dilemma for these governments, of course, was that the costs of not bailing out certain institutions were so potentially cataclysmic, that they had no choice but to shoulder this “moral hazard” problem.
42. So in addition to the specific problems in the housing market, the macro-economic dimension, the current crisis has also been understood as the consequences of the state’s progressive disengagement from the business of judging the riskiness of prevailing financial practices and establishing the rules of the game. Former Fed Chairman, Alan Greenspan, an icon among those who believe financial markets are best left unregulated, long rejected calls for greater market regulation and mandated transparency, arguing that even highly leveraged and extraordinarily complex and opaque financial products actually lowered rather than increased risk. Not surprisingly the current crisis has provided a desperately needed education to many of the key protagonists of the low regulation, high leveraged era of American financial leadership. In the midst of the crisis, Greenspan told a Congressional Committee that he had simply put too much faith in the self-correcting power of free markets and had failed to anticipate the devastating power of wanton mortgage lending and the way that particular problem exposed grave weakness in an over-borrowed society. “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief” (Andrews). It was a devastatingly expensive miscalculation, to say the least.
43. The crisis has also demonstrated the degree to which international banking practices and rapid and massive capital movements have eradicated distinctions between national and global financial markets. The collapse of land values in Arizona, it is now understood, can directly undercut the financial viability of a municipality in Europe through bond purchases. Likewise, we now know that the collapse of banks in Iceland can directly hit small savers in the United Kingdom and the Netherlands, among others, while housing mortgage problems in Latvia are now threatening the health of Sweden’s banks. This degree of integration points to the need for some degree of global co-ordination that would, at the very least, afford investors a far higher degree of transparency than they have enjoyed in recent years. Yet, sovereignty, widely divergent business and financial cultures and other concerns have made national governments reluctant to give precedence to internationally established regulatory norms over national standards. Yet, the obvious deficits in national rules and the absence of global governance systems were factors in the market’s breakdown and will be again if this problem is not addressed.
44. Markets require transparency and symmetrical information to function properly, and unfortunately no international regimes have fully ensured these ends. The Basel Standards for capital adequacy and capital charges, first negotiated in the 1980s, had long been seen as an insufficient regulatory framework for international banking. It is now evident that Basel 2, like many national regulatory frameworks, is outdated. That system, for example, relied on rating agencies and the banks’ own risk models despite palpable conflicts of interest. Moreover, financial institutions of all kinds exploited myriad loopholes in the Basel framework to push poorly performing or risky assets off regulated balance sheets into the unregulated nether world. This rendered the mortgage-backed securities market all the more dangerous and left the United States and other banks particularly vulnerable to the mortgage market crash.
45. Finance is the most global of all economic activities, and big players are essentially global rather than national in size and scope. This poses a genuine regulatory conundrum particularly given the fungible nature of money. Money naturally flows to where the potential yield is highest, and if regulations drive yields down in one market, even at the margins, money swiftly flows elsewhere. This condition has left the global financial system ever more vulnerable to a regulatory race to the bottom in which governments are constantly pressured to deregulate in order to attract capital inflows and banking business. The crisis has demonstrated that global and national governance has suffered as a result. Even in the wake of the crisis, countries hosting large banking sectors seem reluctant to take tough regulatory measures without guarantees that similar measures are not being undertaken elsewhere. This has led to a certain degree of tension, for example, between France, which has wanted to cap bonuses and the United Kingdom, and the United States which are more reluctant to do so. This is not simply a cultural clash, it is also very much about competition for banking business (Daneschku).
46. Clearly, a range of rules are needed to build capital adequacy into banking books and some degree of international co-ordination here would be helpful. But in practice this has been hard to achieve due to varying national appetites for risk and becaus,, e what is adequate at one point in a business cycle may not be at another. One could argue, for example, that capital adequacy ratios should be allowed to change over time in order to encourage a degree of capital saving during boom times – something which would reinforce the capital base for leaner times. Yet, rules in many countries have been pro-cyclical and thus tended to exacerbate rather than moderate market swings. Regulators must also better deal with conflict of interest problems, which have been an important factor in the current crisis.
47. Central banks may also need to lean more forcibly against the wind to fight the onset of potentially devastating asset bubbles, credit booms and price misalignments. Doing so will not win central bankers political points, but hoarding political credit is not the purpose of these institutions. It is still not clear today what countries are prepared to do to rework the rules governing banking procedures, disclosure and transparency standards and fiscal policies. It is even less clear if they are willing to address these matters in an internationally co-ordinated fashion. Certain international rules could help tame the more savage and destabilizing elements of the global economy. But for this to transpire, the international community needs to conduct a broad political conversation about globalization, its risks, its opportunities, and its impacts on the global and domestic distribution of wealth. A better understanding is needed of what nations hope to achieve out of globalization and what the best means might be to achieve these aspirations.
48. Political leaders must also strive not to throw the baby out with the bathwater. Globalization as such is not the problem. The real challenge lies in building adequate regulatory and governance systems both domestically and across borders to ensure a greater degree of stability while not choking off the gains that can be had through international financial and trade flows. Autarchy is not going to offer any solutions, but there may have to be a balance struck somewhere between building the frictionless but perfectly elusive global economy of Thomas Friedman’s dreams and creating an array of grim and immiserizing autarchic hermit kingdoms.
49. Some have argued that a new Bretton Woods system is now needed to build a more stable global financial architecture. This may be somewhat overstated as Bretton Woods was designed to construct an international financial and trading order after years of autarchy and war. It took two years of planning and an intensive three week long conference in Bretton Woods New Hampshire to lay out the plans for the system of fixed exchanges rates and the central roles the IMF and World Bank would play in holding up the system. The current financial crisis constitutes one of the most politically difficult economic challenges Western governments have confronted in decades, but it is unlikely that we will see the kind of sweeping innovations that Bretton Woods introduced. Nevertheless, change is in the air.
50. This was first apparent at the G20 meeting of Finance Ministers and Heads of government in April 2009. At the Finance Ministers meeting participants agreed on a set of co-ordinated measures to stimulate demand and employment. They pledged to resist protectionist pressures (although many subsequently violated that pledge), agreed to maintain liquidity supplies, recapitalize the banking system, implement stimulus plans, help emerging and developing countries through a strengthening of the multilateral lending bodies, implement appropriate regulation of financial institutions, including comprehensive registration of hedge funds, tighter controls over credit rating agencies, more serious compliance with the Code of Conduct of the International Organization of Securities Commissions, more control over off balance sheet operations, and more pressure on non-co-operative territories permitting opaque banking and financial practices.
51. At the G20 Summit in Pittsburgh, Pennsylvania on 24 September 2009 the focus was more on long-term reforms to prevent a future crisis, particularly in the banking sector. An effort was made to add further detail to the reform agenda, although heads of government tacitly recognized that these reforms will remain largely the preserve of national governments. Heads of governments agreed that by 2012 banks will have to set aside much larger capital reserves to minimise the need for future bailouts, but national regulators will ultimately lay out the specific capital requirements. National regulations will also be put in place on bankers’ remuneration in order to discourage excessive risk-taking, although French and German efforts to agree a cap on bonus payments were rejected. With the strong support of the Financial Stability Board, banks will be required to retain a larger part of their profits, to link pay more clearly to long-term performance, to conduct annual independent pay reviews and to provide greater transparency (Galloni). The final statement also called for provisions that permit clawing back bonuses paid to those whose deals ultimately perform poorly. It also calls for paying some bonuses in stock to provide a longer-range set of incentives as well as limiting bonuses to a set percentage of revenues when banks are operating with low levels of capital. They agreed that tougher regulation of over the counter derivatives markets is needed in order to increase transparency and make firms more accountable for risky operations. The communiqué endorsed the idea of living wills for “systemically important financial firms”; these are plans which outline how they would, if compelled, unwind their operations in order to make insolvency proceedings less complicated (Brunsden). These ‘wills’ would compel banks to plan for their own collapse, making it easier to protect depositors while making creditors, rather than taxpayers responsible for the burdens in the case of bank failure.
52. In once sense, Pittsburgh was a watershed insofar as it acknowledged the fundamental changes that have occurred in the structure of the global economy over the last 20 years, namely the rise of key new economic players like China, India and Brazil. Accordingly it was decided that the G20 would become the permanent forum for international economic co-operation, while the G8 will henceforth deal with matters like security and other matters of direct importance to its more restricted membership. Heads of government meeting in Pittsburgh also agreed, in principle, to give greater representation to China and developing nations on the IMF governing board by transferring at least 5% of representation to these under-represented countries. The details have yet to be hammered out however. In addition the summit agreed to extend $500 billion (£313 billion) to the IMF to fund a renewed and expanded IMF credit program for countries in difficulty (Frean). These are all important initiatives, at least on paper and they registered the profound changes the economic shock has wrought in the global financial system. For many though, they are just a start, and much will hinge on how governments fill in the details. One can anticipate a furious reaction from the financial community on several fronts including bonus payments.
53. There is a newfound sense that societies themselves accrue great risks when national banking sectors grow too large. There are serious discussions around this notion in the United Kingdom, the United States and Iceland among others. That said many banks in the United States have returned to active investment banking and the largest profit engines remain their trading divisions which take short term positions on stocks, bonds commodities, currencies and other financial markets. As of July the top five Wall Street firms had generated revenues of $56 billion compared with $22 billion in the first half of 2008 In that same period the top five firms had set aside some $61 billion to cover compensation and benefits for their employees as opposed to $65 billion for the same period the year before; yet the payout per employee will be much higher given the number of lay offs in the industry (Enrich and Paletta). Some see this as a return to business as usual and worry that some of the lessons of 2008 are already being forgotten.
54. The IMF has warned that although the world economy has turned the corner on the current crisis, deeper banking reform is needed to ensure that a new crisis does not emerge. It estimates that that the number of write downs at banks and other financial institutions has fallen by $600 billion from $4 trillion to $3.4 trillion because of the value of some complex securities at the heart of the crisis have stabilized. It praises the bank rescues and stimulus packages that stemmed the free fall of the world financial system but argues that both banks and households remain over leveraged. The Fund has called on governments to further strengthen bank regulations, provide policies to clear bad loans off bank sheets and exercise care in winding down current stimulus packages which it, like the OECD claims must continue in the short run (Global Financial Stability Report, IMF, October 2009). Indeed, a credit shortage continues to plague the world economy. It estimates that after having written of $1.3 trillion so far, there may be another $1.5 trillion to write off by the end of next year. On this front, the US banks appear to be well ahead of their Europe counterparts; they have written off some 60% of their bad investments compared with only 40% in Europe. It is estimated that banks in the euro zone will need to raise an additional $380 billion to put their Tier 1 capital ratio, a measure of bank reserves, to 10% of total capacity. By comparison US banks need only $80 billion to do so, although rapidly falling commercial property values today could pose yet another problem to US banks (Dougherty). While Germany’s economy is showing signs of recovery, its vital banks remain highly exposed to US originated financial instruments, the value of which has plummeted. The German financial supervisory authority estimates that German banks are sitting on euros 800 billion of illiquid assets. If not properly managed, these bad debts on the books of western banks could trigger another round of crisis and recession (“The risk of another downturn”).
55. This crisis has also had important implications for the broader international system. In the view of some of America’s harsher critics, the problem has been partly rooted in what they see as irresponsible US stewardship of its domestic financial sector, a unilateral approach to the international system as such, as well as fiscal recklessness. Its own leadership capacities and leverage appear to have eroded as a result, and some believe that the crisis has hastened this decline. The fact that the US consumption boom over the past decade has been financed by China certainly hints at a changing global order that may require new institutional structures reflecting this altered reality.
56. This is not necessarily good news, particularly for those who remain dedicated to the preservation of a liberal international order. It is almost a truism among political economists that the construction of a stable international trading and financial order requires a liberal hegemonic power capable of establishing and effectively governing the international trading and financial systems. The United Kingdom played this role in the 19th century and the United States did so after 1945. Both constructed global systems premised on free markets, openness and non-discrimination – structures and practices that benefited both the so-called hegemon and the willing participants that embraced that order. The exercise of hegemonic power without this liberal commitment to the market economy is far more likely to lead to overtly imperial systems and far more burdensome political and economic restrictions on lesser powers. The absence of a hegemon theoretically leads to instability. The economic, financial and political chaos of the inter-war period, for example, was partly due to the absence of a liberal hegemon willing to assume the mantle of global financial and security leadership. The American form of post war hegemony was premised on a liberal ideology and a set of economic political and security interests that it shared with other key participants in the system, especially Europe. This system’s survival required not only American will and vision, but also systemic legitimacy and European co-operation. The leading power earned that legitimacy through its willingness to exercise self-restraint and sometimes self-denial in order to serve the interests of the system itself. That, of course, is a great deal to ask of any great power over a period of time. Partly for this reason, periods of liberal hegemony tend to be brief and begin to erode once the hegemon loses leverage or begins to game the system for national advantage.
57. Because America’s capacity to play this role has waned over the last thirty years, and because the current financial crisis and recession have likely accelerated this particular trend, it does beg the question whether systemic change may be imminent. Undoubtedly we are entering a phase of rough if hardly complete parity among several countries or blocs of countries. This parity is not military in nature. Indeed the United States remains the world’s greatest military power by a long shot. But this military power has not stemmed the general drift to global economic parity and may even have accelerated it insofar as America’s huge defence budgets pose daunting fiscal burdens on the United States. Moreover, United States has found itself bogged down in distant, divisive and deadly wars that some argue may have sapped its strength and its international standing. These trends are also recasting the international system, and there is a stronger sense today that co-operative international leadership, although difficult to manage, may offer the only means to exercise effective stewardship over the global order (Keohane). This logic would justify an ever more profound dialogue and deeper level of trans-Atlantic political and economic co-operation.
58. All of this began to be apparent in the early 1970s when the old Bretton Woods system, no longer capable of containing the inflationary crisis of that decade, broke down. By then the United States, the guardian of the core currency had begun to print money to fund the war in Vietnam and the Great Society at home. In so doing, it exported inflation and thus undermined the system’s and its own credibility. In Europe as well as in the United States the old demand management orthodoxies degraded into reckless fiscal and monetary policies that ultimately triggered a crisis of governability in the 1970s (Skidelsky, “Where do we go from here?”). The return of monetary discipline in the 1980’s helped bring inflation under control, but US fiscal indiscipline posed a serious problem, beginning with the Reagon era deficits. There was a clear imbalance between American governmental commitments and the government’s willingness to tax its people to pay for those commitments. These imbalances endured for many years, largely because the rest of the world was willing to lend the United States funds it needed to cover the shortfall. Except for a short-lived budget surplus during the Clinton presidency, the United States has run large budget deficits while its current account deficits have soared.
59. It is no doubt of great interest and indeed of some consequence that it was the G20 rather than the G7 that was first convened last November 2008 so that key governments could work out strategies for coping with the current crisis. That is a reflection of a changed world and an acknowledgement by the traditional global financial powers that they lack the weight to resolve this problem alone. This change was formally acknowledged in Pittsburgh this past September (“After the Fall”, The Economist, 15 November 2008). This is a far cry from the role Europe and the United States once played in constructing the global financial order and providing the mechanisms to ensure compliance with the rules of the game. The most compelling economic question of our times is whether a coherent and stable global financial and commercial order can be constructed and disciplined by a group of countries rather than by a single rule maker. There is much pessimism about this prospect.
60. There is also a real risk that the financial crisis could present obstacles to addressing global climate change and environmental challenges. In the short run, the fall in energy prices temporarily removes incentives to adopt cleaner and more efficient technologies and have also discouraged the kinds of investments needed to meet future energy needs. The International Energy Agency warns that today’s low prices will not last and that serious future energy crises lie just over the horizon (OECD 2009). There could also be a loss of incentive to encourage firms to transition to cleaner and more efficient technologies because of today’s very poor market conditions. If this problem is not addressed, it will leave the West highly vulnerable to future energy and environmental shocks. Funding for research and development and budgets for environmental enforcement could face serious pressures unless resolving these challenges remains at the top of national and international agenda. The Obama Administration has already indicated that it will seek a weaker framework and less stringent compliance requirements at the Copenhagen climate change talks this December. The burdens of the economic crisis are clearly a factor here.
61. Finally, one must consider the security risks of instability in the developing world linked to a worsening economic outlook. Fragile states have been the object of great concern in NATO member states in recent years. The lack of governmental capacity and resources leaves these countries vulnerable not only to worsening poverty, but also to a range of security challenges including resource wars. As Western budgets come under strain, their financial and political capacities to assist these states could weaken. National security and development assistance could become less of a concern in Western countries plagued by mass unemployment and negative growth. But national security challenges will not go away, and in this particular case certain threats could become even more acute. The US Director of National Intelligence, Admiral Dennis Blair, in his Annual Threat Assessment to the Senate Select Committee on Intelligence, warned that Western failure to meet defence, developmental and humanitarian obligations in the current economic downturn could leave the international system far more vulnerable.
62. George Roberson and Paddy Ashdown recently assessed security risks in a range of fragile states and found that 27 of these are at acute risk of state failure or conflict in the coming years. In their report, high levels of unemployment and sudden severe worsening of economic conditions were characterized as key drivers of conflict and state failure. A number of countries on that list, including Afghanistan, Pakistan, Uzbekistan, Nigeria and Ivory Coast are also seeing conditions worsening. According to Ian Kearns: “we should expect more violent conflict and politically destabilizing spill-over effects on countries neighbouring those in most distress. There will likely be population displacement and further human suffering on a large scale, as well as reduced overall economic activity and lost opportunities for productive world trade. We should also expect a growth in the ungoverned spaces that can be exploited by terrorists and a swelling of the ranks of those willing to turn to transnational crime, principally through trading in drugs and weapons, as a form of economic survival. As some of these situations go critical, there will rightly be pressure for the international community to act in defence of the defenceless and to try to contain the consequences of failure” (Kearns).
63. The international community confronts financial, economic and political challenges on multiple fronts. Strategies and resources are needed to deal with the global financial crisis, a global food crisis, an almost permanent energy crisis, a global warming crisis, and a series of security crises. Simply creating an order of priorities in the current environment is no easy task, and coming up with the resources, imagination and will to deal with all of them may prove well nigh impossible.
64. In broad terms, governments must mitigate the financial crisis today, but do so in a manner that is mindful of risks to future economic health, environmental and energy security, and social well-being. They also must address the sources of the several related phenomena: the financial/banking crisis, the deep recession that grew out of it, the grave deficiencies in global financial architecture and regulation and the security risks posed by collapsing economies in the developing world. Massive intervention in the economy appears to have prevented the world economy from falling into a catastrophic depression, but today there are still threatening clouds on the horizon. Fiscal imbalances are one of these, and governments are going to need credible strategies to deal with budget shortfalls.
65. Regulatory reform, the vague outlines of which have been agreed in Pittsburgh must now be developed and implemented. The moral hazard problem must also be addressed as must conflict of interests like those that have beset the ratings agencies. Many of today’s banks still seem too big to fail and the bail out legacy will somehow have to be countered (OECD Briefing 2009). In the same way, the compensation system in many financial companies needs to be altered to discourage excessive risk taking and to ensure that failure is not rewarded with millions in bonus payments – particularly when the taxpayer is underwriting this largesse. Even during the miserable year of 2008, bankers on Wall Street enjoyed the sixth largest bonus payout on record, suggesting that may of these institutions have become more akin to mutual enrichment societies for insiders than efficient allocators of capital. They must be steered in the latter direction.
66. What began as a financial crisis and then became a general economic crisis today is also an unemployment and social crisis. Governments have made enormous efforts to mitigate the effects on job markets, but the rate of joblessness is soaring. Past experience suggest that it can take years to reintegrate the unemployed back into labour markets. Governments can help here by developing programs to keep people working, to ensure that the unemployed do not fall into abject poverty, and to retrain the unemployed so that they are better prepared to rejoin the labour market when conditions improve. Young people and immigrants are particularly vulnerable and many countries risks losing a generation of workers if the unemployed are not actively engaged in strategies to engage them in economic activity (OCED 1 October).
67. On the macro-economic front, the United States is going to need to resolve its daunting problem of chronic budget and current account deficits, and the rest of the world will need to reduce its dependence on the American consumer and, in the case of China, begin to spend some of its savings domestically. Constantly running deficits even in boom times clearly leaves countries far more fiscally vulnerable during a downturn and tends to exaggerate the swing of economic cycles. This will be a difficult transition and could well shape its global security posture.
68. Governments need medium-term fiscal strategies and a corresponding capacity to judge at what point emergency fiscal and monetary policies and the debt that they generate have become greater threats rather than solutions to long-term economic growth. This is no easy task given the unchartered territory in which the world’s leaders find themselves and the myriad burdens on national budgets arising not only from emergency spending programs, but also from rising social security, health care, military and security outlays etc. Most experts agree, however, that the moment is not yet propitious to ease off on public spending. Indeed, if there is a recovery underway, it remains a very fragile one. In the long term, counter-cyclical fiscal polices should encourage savings in boom times so that resources can be deployed for social outlays and stimulus on the down swing. The beauty of these approaches is that they can also help moderate rather than exacerbate the business cycle and thereby create a more stable investment climate.
69. Governments will have to forge coherent strategies for a developing world increasingly buffeted by this crisis. Both the IMF and the World Bank need more resources to help these countries through what for them has been a devastating setback to their development prospects. Fragile states pose an even more worrisome set of problems and it is vital that they continue to receive aid and support from the West. Failure here would not only represent a moral catastrophe, but would also pose a serious security conundrum. Meanwhile, genuinely revamping the international financial and developmental architecture will require governments to plunge into a profound intellectual and indeed moral discussion about the purpose or ends of globalization and the proper relationship of state and citizen to it.
70. Trade will remain a vital catalyst of growth and holds out an effective means to achieve rapid recovery. The paradox is that protectionist instincts are always strongest when economic times are hardest. Indeed, it is politically easy to blame foreign competitors for domestic woes, while rising unemployment places a political premium on legislation that preserves jobs by any means – even those that in the long-run may cost jobs. Democratic politics, like banking remuneration practices, can sometimes reward those who focus on the short term with no regard for the long-term. Protectionist policies are a case in point; they seem to hold out the prospect of preserving domestic jobs, and the beneficiaries are often well organized and politically powerful groups. The losers, however, are generally far more numerous, but invariably they are also more diffuse and politically less well organized. This sends a perverse signal to the political class that can nonetheless be politically difficult to resist. Political leaders recognizing the value of trade must be vigilant in defending this key tenet of a liberal order.
71. Along these lines, Western countries must be prepared to make concessions to advance the Doha Round. There are very good economic and strategic reasons to further open agricultural trade, and it is in the interest of Europe and the United States to do. Insofar as this might help advance the Doha Round, the benefits of the policy would be generalized. This makes all the more sense in light of the ongoing food crisis. North America and Europe must take the lead in ensuring that the current crisis is not exacerbated by a wave of protectionism. It was the onset of “beggar thy neighbour” protectionist policies in the 1930s that helped turn a financial crisis into a sustained global depression with terrible political ramifications. This must be avoided at all costs. Open trade will help the world transcend this crisis. Protectionism will deepen it. Unfortunately many governments are moving in the wrong direction, and the crisis appears to have buried the trade agenda at the bottom of the priority list. It should rather be made a central plank of the recovery strategy.
72. Finally, governments must do all of this in a manner that inspires rather than undermines economic confidence. This crisis thus offers opportunities as well as risks. Visionary leaders could seize the moment to strengthen vital international organizations, address energy security and environmental/climatic concerns, and endow globalization with a more equitable character. Accordingly, governments will need to ensure that they are strengthening rather than weakening the foundations for future prosperity and doing so in a multilateral and, when feasible, co-ordinated fashion. Failure here could trigger a crisis of governability akin to that which unfolded in the 1970s.
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