Ladies and Gentlemen:
The global economy is still struggling to recover from the worst downturn since the Great Depression. Numerous countries had recovered remarkably rapidly from the initial downturn after the onset of the financial crisis three years ago. Courageous, globally coordinated countercyclical policies succeeded in rescuing economies from the brink of collapse. However, this initial rebound proved to be temporary, especially in many developed countries whose very slow recent growth path has been bordering on recession. Much of these countries´ initial recovery was based on temporary factors, such as inventory cycles and fiscal stimulus and rescue programmes. Since mid-2010, these stimulus packages have either expired or been replaced by a desire to return to business-as-usual, i.e. economic policies that no longer aim at stimulating growth but, instead, focus on controlling inflation and reducing fiscal deficits and public debt. This reorientation has brought the fundamental weakness of the recovery in developed countries to the fore and poses a serious risk of renewed global economic slowdown.
The global economy has entered this renewed phase of fragility because the hoped-for process of self-sustaining growth through private spending and employment creation is still not assured, especially in developed countries. Many of these countries have shifted their fiscal policy stance from stimulus to retrenchment with the faint hope that the private sector would take up demand stimulus. This hope has so far been elusive. Private demand alone is not sufficiently strong to maintain the momentum of recovery, as unemployment remains high and wages are stagnating. Consumers have still not completed their deleveraging process as household indebtedness continues to be high, and banks have still not completed their recapitalization process but remain reluctant to provide new financing. This situation has led to an erosion of both consumer confidence and expectations in the manufacturing producing sector. The withdrawal of public stimulus packages and the diminished expectations in the private sector have combined to make the slow recovery in developed countries to be not only jobless but also without any real wage growth. The shift towards fiscal and monetary policy tightening represents a major risk of a prolonged period of mediocre growth in developed countries - if not of an outright contraction.
Growth rates in developing countries have remained strong, with the exception of North Africa. Rapid recovery from the crisis and the subsequent sustained growth have been the result of various factors, including countercyclical measures, the recovery of commodity prices since mid-2009 and, perhaps most important of all, an expansion of real wages. Indeed, in marked contrast to developed countries where recovery has been associated with wage stagnation, developing countries have not resorted to cuts in real wages - rather, domestic income and demand have remained on a growth trajectory. Moreover, since the financial systems in developing countries were largely unaffected by the most recent crisis, their domestic demand is further supported by the availability of domestic credit.
Despite these achievements, it would be a mistake, however, to claim that the large emerging economies can lead the global recovery. This is unrealistic because of their insufficient weight, relatively low absorptive capacity, and inability to issue international currencies. Most emerging economies face own demanding adjustment needs over the coming years, which will demand significant domestic resources. Moreover, developing countries still face significant external risks because of economic weakness in the developed economies and a lack of significant reforms in international financial markets. As a result, these countries remain vulnerable to trade and financial shocks that would strongly affect the volume of their exports and the prices of primary commodities, as in 2008. Without far-sighted and effective measures in the developed countries and at the international level, new imbalances in these countries will build up, with the threat of repeated crises and a reversal of recent gains.
International trade in goods and services rebounded sharply in 2010, after having registered its steepest fall since the Second World War. Recovery in trade has been faster in developing than in developed countries, mirroring the two-speed recovery of GDP growth rates.
Commodity prices have been recovering since the second quarter of 2009. They surged from mid-2010 to early 2011, but experienced a reversal in the second quarter of 2011. Price increases have partly followed demand recovery and supply shocks, as well as a boost in financial investment in commodities. More recently, drops in commodity prices have largely reflected negative changes in the sentiment of financial investors.
The implementation of measures to reduce domestic demand in response to high commodity prices has proven to be inappropriate, harming growth without significantly lowering inflation. The recourse to incomes policy in which wages would progress in line with productivity would be a more appropriate way to control inflationary pressures and to support domestic demand growth at the same time.
The persistence of global imbalances remains a risk to sustained economic recovery. The evolution of current-account positions has been affected by the timing and characteristics of countries´ recovery from the crisis. A decomposition of growth into domestic demand and net exports shows that growth in Brazil, China, India and the Russian Federation has been largely driven by an increase in domestic demand. This suggests that some large surplus developing and emerging economies, such as China and the Russian Federation are honouring their commitment to help reduce global imbalances. By contrast, net exports have been the major engine of growth in the main developed countries with a current-account surplus, such as Germany and Japan.
Much is at stake in finding a globally coordinated answer to the issue of global imbalances. However, the G-20 process which has aimed at coordinated economic policies with a view to reducing excessive imbalances has not led to any tangible result. One reason for this has been conflicting policy views. Disagreements pertain to how global imbalances contributed to the global crisis, which policy adjustments may be best suited for reducing excessive imbalances, and which countries should undertake most of those adjustments. It is important to note in this context that the sustainability of current-account imbalances is determined less by their size than by how they are financed. Moreover, the G-20 identified a move towards ensuring that exchange rates are determined by market fundamentals as a key step towards reducing global imbalances. However, market forces have generated exchange rate movements that are clearly disconnected from macroeconomic fundamentals and that in surplus countries have led to appreciation, rather than depreciation which would have driven their external accounts towards balance. This calls for a multilateral system of managed floating which aims for exchange rates that are consistent with stable and sustainable current-account positions.
Need for further demand stimulus
The G-20 process has also fallen short of maintaining coordinated demand stimulus until the recovery of private domestic demand is sufficiently strong. With private sector demand remaining feeble, it is of great concern that the coordinated fiscal policies that pulled the global economy back from the brink of collapse are now being prematurely abandoned. The lessons from the Great Depression are clear: then, as now, there was a ´tug of war´ between policy-makers clinging to orthodox textbook models and favouring early fiscal retrenchment, and more pragmatic ones who (correctly) judged that the timing of fiscal consolidation is an empirical matter, and that hasty policy shifts can trigger a deep and long-lasting economic contraction with unpredictable consequences for civilized life.
Withdrawal of fiscal demand stimuli at a time when the state of the economy remains depressed, tax revenues fall and public expenditure rise through automatic stabilizers points to the need to reappraise government debt in a wider context including the purpose of the debt, the multipliers it can create, and the cost of financing it.
One key area of such a reappraisal is the recognition that fiscal space is a largely endogenous variable. From a dynamic macroeconomic perspective, an appropriate expansionary fiscal policy can boost demand when private demand has been paralysed due to uncertainty about future income prospects and an unwillingness or inability on the part of private consumers and investors to incur debt. It is possible to extent the economic impact of fiscal policies further by changing the composition of public expenditure or structuring public revenues in a way that maximizes their multiplier effects. Increases in spending on infrastructure, social transfers, or targeted subsidies for private investors tend to be more effective in stimulating the economy than tax cuts for higher-income groups.
Another area is the need to emphasis incomes policy. Given the importance of consumption for boosting global demand, incomes policies in the biggest economies could contribute significantly to a balanced expansion, especially when the global recovery is still fragile. An essential element of such a policy is the adjustment of real wages in line with productivity, so that domestic consumption can rise in line with supply. This would also help prevent an increase in unit labour costs, and thus keep the main domestic source of inflation under control. Monetary policy could then reduce its focus on price stability and pay greater attention to securing low-cost finance for investment in real productive capacity, which in turn would create new employment opportunities. Wages rising at a rate that corresponds approximately to the rate of productivity growth, augmented by a target rate of inflation, is the best anchor for inflation expectations.
From the perspective of a single country, strengthening the international competitiveness of producers may seem to justify relative wage compression. However, the simultaneous pursuit of export-led growth strategies by many countries has systemic implications: a race to the bottom with regard to wages will produce no winners and will only cause deflationary pressures. With widespread weakness in consumer demand, fixed investment will not increase either, despite lower labour costs. Global deflationary tendencies and the drag on global demand resulting from wage compression in many developed countries would need to be countered by some form of policy engineered higher spending somewhere in the world economy. In the pre-crisis era, widespread resort to export-led growth strategies was made possible mainly by fast-growing imports in the United States, leading to increasing external deficits and financial fragility in that economy. Subsequent crises, with private sector deleveraging and increasing public debt, clearly showed the deficiencies of this approach.
Major items on the post-crisis reform agenda still need to be tackled
The reform agenda in the wake of the global financial crisis is far from being completed. It has advanced slowly, and much of the enthusiasm for reform has waned. But policymakers cannot afford to waste the opportunity for a more fundamental reorientation of policies and institutions.
Reform must start from the recognition that deregulation favoured the emergence of a large, unregulated and undercapitalized shadow banking system, while traditional banking shifted from reliance on deposits to financing from capital markets, and from lending to trading. The loss of diversity of the financial system and uniformity of agents´ behaviour fuelled destabilizing speculation, accentuated pro-cyclical trends and eventually led to economic crises. The re-regulation of the financial system is necessary to prevent the repetition of these crises. However, the attempts made so far have been slow and inadequate to cover the shadow banking system and to cope with a highly concentrated financial sector that is dominated by a small number of gigantic institutions.
Regulation must be tighter with the "too-big-to-fail" institutions and incorporate a macro-prudential dimension, including anti-cyclical capital requirements and the recourse to capital controls for coping with volatile capital flows. However, even if the financial sector were to be better regulated, it would not automatically drive growth and employment or make credit accessible to small and medium-sized firms or the population at large. In addition to a better regulation, the financial sector needs to be restructured in order to reduce the risk of systemic crises and to improve economic and social utility. Financial restructuring should aim at more diverse national financial systems, with a bigger role for public and cooperative institutions, a sizing down of giant institutions and a clear separation between the activities of investment and commercial banking.
Strict regulation of the financial sector, orienting it more towards investment in fixed capital, is key to greater stability of the global economy and to its return to a sustainable growth path.