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Policies in the eurozone
I will start with Europe, which is at the centre of concerns—not only because of the historical project it represents but, more pointedly, because of the extensive trade and financial linkages that bind everyone else to it.
In coming to grips with Europe’s crisis, I want to acknowledge up front just how far the eurozone has come in addressing the new realities it faces.
Eurozone countries have established their cross-border safety net with the European Financial Stability Facility (the EFSF) and outlined a permanent version of it with the European Stability Mechanism (the ESM)—only two years ago, this was heresy. They have taken a harmonised approach to recapitalising banks, and set up a systemic risk board. Governance reforms to enforce stronger and more effective fiscal discipline are in train and individual countries are taking tough decisions to rein in fiscal deficits. In addition, the European Central Bank has unleashed impressive resources to make long-term liquidity available to banks.
These major steps must be recognised. Yet I would not be the first to argue that these moves form pieces, but pieces only, of a comprehensive solution. Many within Europe are themselves making this point with increasing forcefulness.
Let me therefore offer my perspective on what remains to be done. There are three imperatives—stronger growth, larger firewalls, and deeper integration.
First, stronger growth. This has a number of dimensions.
With the euro area economy slowing sharply, inflation is already declining and we see a sizeable risk that it will fall well below target next year, raising debt burdens and further hurting growth. Additional and timely monetary easing will be important to reduce such risks.
Stronger growth also means preventing banks from going into reverse gear, contracting credit in the face of market pressure. Solutions should focus on raising capital levels—rather than cutting back lending—as the way to boost capital ratios. Maintaining orderly funding conditions is also imperative.
On fiscal policy, resorting to across-the-board, across-the continent, budgetary cuts will only add to recessionary pressures. Yes, several countries have no choice but to tighten public finances, sharply and quickly. But this is not true everywhere. There is a large core where fiscal adjustment can be more gradual. Automatic stabilisers, which let tax revenues fall and spending rise as the economy weakens, should certainly be allowed to operate. And those with fiscal space should support the common effort by reconsidering the pace of adjustment planned for this year.
Some countries still have much to do to boost their competitiveness and growth potential. For this, structural reforms are critical, however medium- or long-term their impact might be. As experience tells us, fiscal sustainability depends, ultimately, on generating long-term growth.
Second, we need a larger firewall. Without it, countries like Italy and Spain, that are fundamentally able to repay their debts, could potentially be forced into a solvency crisis by abnormal financing costs. This would have disastrous implications for systemic stability. Adding substantial real resources to what is currently available by folding the EFSF into the ESM, increasing the size of the ESM, and identifying a clear and credible timetable for making it operational would help greatly. Action by the ECB to provide the necessary liquidity support to stabilise bank funding and sovereign debt markets would also be essential.
We must also break the vicious cycle of banks hurting sovereigns and sovereigns hurting banks. This works both ways. Making banks stronger, including by restoring adequate capital levels, stops banks from hurting sovereigns through higher debt or contingent liabilities. And restoring confidence in sovereign debt helps banks, which are important holders of such debt and typically benefit from explicit or implicit guarantees from sovereigns.
This brings me to my third point—deeper integration. In a sense, the crisis is a crisis of incomplete integration. At the euro area level, the fundamentals look good—the current account is balanced and inflation and the fiscal deficit are both low. But the euro area does not handle internal imbalances well. In addition, a single financial market cannot rely on legal and institutional frameworks that operate on an asymmetric national basis.
To break the feedback loop between sovereigns and banks, we need more risk-sharing across borders in the banking system. In the near term, a pan-euro area facility that has the capacity to take direct stakes in banks will help break this link. Looking further ahead, monetary union needs to be supported by financial integration in the form of unified supervision, a single bank resolution authority with a common backstop, and a single deposit insurance fund.
The euro area also needs greater fiscal integration—it is not tenable for 17 completely independent fiscal policies to sit alongside one monetary policy. To complement its “fiscal compact”, the area needs some form of fiscal risk-sharing, which would allow for common support before economic dislocation in one country develops into a costly fiscal and financial crisis for the entire euro area.
A number of financing options are available to support such risk sharing, including the creation of euro area bonds or bills or, as proposed by the German Council of Economic Advisors, a debt redemption fund. Political agreement on a joint bond to underpin risk sharing would help convince markets of the future viability of European economic and monetary union.
Policies in the rest of the world
Let me now turn to my second broad area—policies in the rest of the world. I have dwelt on Europe only because it is at the epicentre of the current crisis and thus key to the global outlook. But other economies have at least as important a role in getting to a better outcome.
The United States, as the world’s largest economy and the centre of the global financial system, has a special responsibility. Yes, it is recovering, but at a timid pace, and unemployment—while declining—remains unacceptably high.
The key policy priorities must be to relieve the burden of household debt and to deal decisively with the issue of public debt.
On housing, we have been calling for ways to make mortgage debt sustainable, including programmes to facilitate write-downs. I understand the legal and political complexities but the current strategy is not working satisfactorily, and we need a rethink.
On public debt, American policymakers need to find a way past the partisan impasse, grasping all reasonable means of bringing down tomorrow’s deficits—including by reforming entitlements and raising revenue—without bringing down today’s economy.
This brings me to another worrisome tendency in many quarters—to view fiscal policy as a morality play between profligacy and responsibility. Political and market commentary is too often cast in these terms. Yet markets themselves have been schizophrenic about fiscal tightening, at times rewarding it with lower interest rates, and at other times recoiling at the implied growth slowdown and pushing up interest rates.
What about other countries and regions?
In Japan, there is no way to avoid a credible consolidation plan that brings down public debt in the years ahead. Japan also needs reforms to raise long-term growth.
Countries with current account surpluses, whether advanced or emerging, also have a role to play—primarily by shifting to domestic demand to support global growth. After all, global deficits will shrink only if surpluses shrink too. Here, China can help itself and the global economy by continuing to shift growth away from exports and investment, toward consumption. To get there, I’m thinking of such measures as fiscal support to household consumption and expanding social safety nets, and liberalising the financial system. These are all reforms that the Chinese government itself has embraced.
One more point: We must not let financial regulation slip off the policy agenda. We simply cannot carry on with the financial sector that gave us the global financial crisis.
The role of the IMF
Let me now turn to the role of the IMF, my third and final issue. Clearly, a cooperative path means that all countries must work together with a common diagnosis toward a common solution.
A key role of the IMF is to lay out the inter-dependencies between countries and push for a cooperative outcome. But the IMF can provide much more than analysis, advice and exhortation. It can also provide financing when needed. I am convinced that we must step up the Fund’s lending capacity. The goal here is to supplement the resources Europe will be putting on the table, but also to meet the needs of “innocent bystanders” infected by contagion, anywhere in the world. A global world needs global firewalls.
In the coming years, we estimate a global potential financing need of $1 trillion. To play its part, the IMF would aim to raise up to $500 billion in additional lending resources. Right now, we are exploring options and consulting the membership. In addition to resources, the IMF can also provide a “commitment mechanism” to lock in good policies when funding is not needed. Italy’s request for IMF monitoring of its policies is a good example of this.
Finally, because there has been so much loose talk about special “European bailouts”, let me reiterate a few points. Our financing is for all members, euro area or otherwise. We only lend to individual countries that request support and make strong policy commitments. That said, any support we provide to euro area countries must be anchored in a clear policy framework for the entire euro area. To safeguard our members’ resources, we have a responsibility to lend into sustainable debt positions. Our role is to catalyse, not indefinitely replace, private financing.