While the global economy is clearly on the mend and recent data is encouraging, concerns remain over the possible deterioration of the European debt crisis, the potential effects of U.S. counter-cyclical measures (especially QE2), continuing currency tensions, and the fragility of the banking sector in some advanced countries. While the Great Recession is subsiding, in part thanks to the immediate crisis-fighting measures, policy makers are failing to address the structural reforms and regulatory changes necessary to ensure that a repeat of the crisis is avoided, and international policy coordination is proving inadequate to the task.
Carnegie assembled a distinguished panel of experts to discuss these issues, including Hans Timmer of the World Bank, Jörg Decressin of the International Monetary Fund, Philip Suttle of the Institute of International Finance, Desmond Lachman of the American Enterprise Institute, and Uri Dadush of the Carnegie Endowment. Carnegie’s Moíses Naím moderated the event.
Crisis in Europe
While several panelists agreed that some form of debt restructuring is likely in several of the periphery countries, the panelists disagreed about the impact on Europe’s banks and the euro.
- Debt Restructuring: Without the ability to resort to devaluation, it will be difficult to reignite growth while engaging in large scale fiscal consolidation. Debt burdens will continue to rise, and in several euro zone countries a debt write-down is very likely, Lachman said. Dadush agreed that some form of restructuring is virtually inevitable for Greece and perhaps Ireland as well.
- Europe’s Banks: German, French, and British banks hold most of the periphery country debt, and Lachman predicted a European banking crisis by the end of 2011 triggered by sovereign debt defaults. Dadush suggested a “soft” restructuring—with long-term rescheduling, lower interest rates, and potentially a partial guarantee by an expanded European Financial Stability Facility (EFSF)—could avoid this outcome.
- The Euro’s Demise? Lachman said the euro will likely unravel, while Dadush argued that Europeans can—and should—contain the crisis by raising the EFSF’s size and increasing liquidity injections, allowing time for countries in the periphery to undertake fiscal and structural adjustments. Suttle and Timmer agreed the euro zone can survive, but only if countries take decisive action, such as increasing fiscal integration and improving competitiveness.
- Germany: Dadush noted that Germans are very ambivalent about the steps needed to curb the crisis, and felt the crisis may need to get worse before policy makers reach a consensus that more far-reaching steps are needed. Decressin stressed that, though the situation will remain uncertain as interest spreads widen in a “new normal,” markets underestimate Germany’s commitment to the European project.
- E-bonds: Dadush described the recently proposed “e-bonds”—euro zone bonds—as one “nuclear option” that countries may pursue if the crisis deepens, but noted that introducing them now would take the pressure off reforms in the periphery countries. Some form of a sovereign debt restructuring mechanism is needed to contain the costs of the rescue and mitigate moral hazard. Timmer added that overcoming German opposition to such bonds would be difficult, not only because they would require Germany to expand its support to Europe’s troubled countries, but also because they would increase German borrowing costs.
Speakers offered varying assessments of the recent quantitative easing (QE2) and proposed tax cut extensions in the United States, but they generally agreed that Washington needs to take steps to stimulate demand.
- U.S. Outlook: Lachman provided the most pessimistic view of the U.S. economy, suggesting the fragile recovery has little chance of growing stronger due to a weak housing sector and high unemployment. Decressin, on the other hand, suggested that improvements in recent months will likely lead the United States to outperform the IMF’s most recent growth forecast.
- Tax Cut Extension: Decressin, Suttle, Lachman, and Dadush agreed that allowing the tax cuts to expire would have hurt growth, but Timmer said the cuts are not targeted enough to be efficient. Suttle noted that such short-term stimulus must be accompanied by clear signals of medium-term fiscal reform, such as that proposed by the president’s commission on reducing the budget deficit.
- QE2: Suttle supported the Fed’s QE2 move, pointing to the recent stock market surge as proof of the policy’s success. Lachman and Dadush, on the other hand, questioned its effectiveness, noting that long-term U.S. interest rates have actually risen. Beyond the policy’s impact on the United States, Timmer and Dadush worried that the liquidity injection could hurt emerging markets, which now face appreciation pressures and potentially volatile capital inflows.
Decressin argued that currency appreciation in emerging markets is consistent with their strong, resilient growth and the more sluggish progress in advanced countries, but noted important imbalances.
- Regional Appreciation: Decressin suggested that more appreciation should be occurring in Asia and less in Latin America.
- Renminbi Appreciation: Lachman indicated that China risks a trade war by not appreciating at a time of high U.S. and European unemployment. Appreciation would be in China’s interest, Dadush said, but it would likely hurt countries that have large trade imbalances with China, such as the United States, because of higher import prices.
- Domestic Demand: While Suttle agreed that China should allow its currency to appreciate, he felt that China’s domestic demand growth had already boosted the global recovery significantly. Timmer and Dadush agreed that the international focus should be less on currency and more on maintaining high growth in China.
Fiscal and Banking Reforms
Panelists also discussed fiscal and banking reforms in advanced countries and their effects on emerging markets.
- Reform in Advanced Countries: On the fiscal front, policy makers should stimulate the economy now while introducing reforms that will lower spending in the future, such as raising the retirement age, Decressin suggested. In banking, they should enact long-term reforms, such as raising capital ratios and switching from wholesale to retail funding, while filling in short-term gaps in capital. However, Suttle argued that such reforms would dramatically burden the banking recovery. While they would have been helpful prior to the crisis, he said, they will only intensify the near-term adjustments now, even if the regulation is not implemented for several years.
- Emerging Markets: Suttle also argued that banks in advanced countries are already changing to reflect the lessons of the crisis. Banks recognize the risks associated with maturity transformation—turning short-term debt into long-term loans—which Suttle flagged as the biggest issue leading to the financial crisis. But reformers are ignoring the risks in emerging market institutions, which are now lending hectically and aggressively. As a result, Suttle predicted the next financial crisis may well come from emerging markets, while Timmer noted that advanced countries delaying action creates instability for developing countries.