ATHENS – The International Monetary Fund¢s belated admission that it significantly underestimated the damage that austerity would do to European Union growth rates highlights the self-defeating character of “orthodox” recipes to address the causes of the debt crisis that followed the financial crash of 2008-2009.
Conventional theory suggests that a single country (or group of countries) consolidating its finances can expect lower interest rates, a weaker currency, and an improved trade position. But, because this cannot happen for all major economies simultaneously – one country¢s (or group of countries¢) austerity implies less demand for other countries¢ products – such policies eventually lead to beggar-thy-neighbor situations. Indeed, it was this dynamic – against which John Maynard Keynes fought – that made the Great Depression of the 1930¢s so grim.
Today¢s problems are compounded by a lack of sufficient private demand – particularly household consumption – in the advanced economies to compensate for demand losses stemming from austerity. During the last two decades, consumption drove these countries¢ economic growth, reaching historically high GDP shares.
Moreover, major advanced economies, such as the United States, Germany, and Japan, face longer-term fiscal problems in the form of aging populations or oversize welfare states, limiting their capacity to contribute to demand management. Recent moves to ease monetary policy have been a step in the right direction; but, so far, they have not proved to be a game changer.
For domestic demand to act as an engine of growth, policies should shift resources from investment to consumption. While the magnitudes involved are huge, they must be attained if an extended period of low growth, high unemployment, and declining living standards among the world¢s poorest is to be avoided.
International economic policy coordination should be significantly strengthened in order to deal effectively with changes on such a scale. Start with Europe. It is by now patently obvious that austerity and domestic reforms are not enough to pull the eurozone¢s periphery out of deep recession. Growing awareness of the failure of current policies is causing social discontent, civil disorder, and political instability, with the recently concluded Italian elections and the growing popular resistance to Greek reform efforts serving as a bellwether.
Returning the eurozone¢s peripheral economies to the path of growth requires more than structural reforms and fiscal consolidation. It also requires a substantial reform of the monetary union¢s system of economic governance, aimed at restoring financial stability and lowering borrowing costs, together with a boost in external demand in order to compensate for the effects of austerity.
Reforming governance implies significant progress toward economic unification: centralizing European debt through Eurobonds, mobilizing sufficient rescue funds, allowing the European Central Bank to intervene in the primary bond markets, and establishing both a fiscal and a banking union.
This is a tall order, in view of the reluctance of most EU member states to cede competences to European institutions. But Europe should move more decisively in this direction. Otherwise, speculation on member states¢ national debt will persist, keeping borrowing costs at levels that are inconsistent with the conditions required to sustain economic recovery.
Concerning external demand, intra-European help in the form of reflationary policies in stronger economies is unlikely to prove sufficient, owing primarily to the fiscal and political conditions prevailing in Germany. Implementing a Marshall Plan-type initiative by mobilizing EU budget resources and additional lending by the European Investment Bank to finance investments in weaker countries could be an alternative, but it lacks political support.
On a global scale, neither the US nor Japan is in a position to provide significant external stimulus. Only the emerging and developing economies of Asia could effectively contribute to lifting global demand through a coordinated effort aimed at boosting domestic consumption, which, in turn, would stimulate additional investment. Recent IMF experience suggests that, through appropriate coordination, private funds could be mobilized for big private-public partnership projects linking demand expansion with infrastructure investment.
In other words, a global “New Deal” – combining policies designed to achieve an orderly realignment of consumption and investment worldwide – seems to be required. The advanced economies should promote productivity-enhancing structural reforms with renewed vigor. The eurozone should solidify its currency union. And the emerging and developing economies should support domestic sources of growth.
For such a deal to become possible, certain preconditions must be met. First, international policy coordination by the G-20 must be tightened by creating a permanent secretariat to make policy proposals and recommendations concerning macroeconomic and financial developments. The secretariat should actively cooperate with the IMF to benefit from its analysis, notably regarding exchange rates.
Second, global financial reform must proceed at a faster pace. The financial sector requires tougher regulation, strengthened supervision, and internationally consistent resolution mechanisms to address the problems posed by very large, global institutions that are considered too big (or too complex) to fail. Such reform is essential if the international financial system is to mediate the sizeable resource transfers that will underpin the required changes in the structure of global demand.
Finally, a new trade pact – possibly, but not necessarily, within the Doha Round – is needed to ensure the major trading powers¢ access to foreign markets. This is critically important for inspiring confidence in Asian countries, which might be persuaded to favor domestic, as opposed to external, sources of demand. Moreover, trade liberalization will also increase consumer confidence worldwide.
The time is right for a new global settlement that targets growth, addresses crisis conditions in certain parts of the world, and rebalances the global economy to set it back on a path of strong and steady growth.
