How Europe can Help the Global Economy while Helping ItselfSpeech by Rodrigo de Rato,
Managing Director of the International Monetary Fund
At the Foro de Cádiz
November 21, 2006
As Prepared for Delivery
1. Thank you very much. It is a pleasure to be with you here in Cádiz. I strongly support the Foro de Cádiz's work in promoting discussion of policy issues, and I am pleased to be able to contribute to your discussions.
2. I'd like to talk to you today about some issues confronting the global economy and especially about some of the steps that European countries and the European Union can take to increase prosperity and reduce risks in the world and in Europe itself. I'll also talk a little about some of the changes we are making at the organization I head, the International Monetary Fund. We have begun a series of reforms at the Fund, to help all of our members confront global economic issues and the challenges of financial globalization.
3. Both the global and European economies are currently in a strong position. As Managing Director of the International Monetary Fund, one of my jobs is to keep policy makers alert to risks and vulnerabilities in the global outlook. Some of the downside risks have increased recently, and I will talk about these in a few minutes. But these risks should be seen against the backdrop of a global economy that is unusually strong. Global economic growth is likely to be around five percent in both 2006 and 2007. Growth is also becoming better balanced regionally. In the recent past, global growth has largely been driven by demand in the United States. This is changing. China and India have become important engines of growth for the world economy. We are also seeing a long-awaited pickup in investment and in employment in Europe. The Fund projects that growth in the euro area in 2006 will be about 2 ½ percent, led by increases in exports and in investment, especially investment in metals and machinery, as well as increased construction.
4. Past episodes of growth have often been followed by inflation. This is less likely now because of the credibility which independent central banks, including the European Central Bank, have built up by keeping inflation down and inflationary expectations under control. This credibility is an asset that pays substantial dividends. It keeps long-term interest rates lower than in the past, because investors do not fear that their capital will be eroded by high inflation. This encourages investment. It also benefits long-term borrowers, including homeowners who can borrow at lower rates, and it is good for the economy. But, as someone said about liberty, the price of credibility is eternal vigilance. Central banks must maintain their hard-won gains over inflation. The long-term benefits of doing so are certainly worth the short-term costs.
5. A period of strong growth—such as the world has experienced for the last four years and Europe is beginning to share—gives policy makers an opportunity to make changes which will sustain economic growth in the long run. Let me single out two areas where I think European countries could most usefully increase their efforts: consolidation in fiscal policy, and structural reforms.
6. High structural fiscal deficits and government debt are still problems in many countries, including in Europe. It is both easier and economically sensible to reduce these deficits when the economy is strong than when it is weak. It is important to distinguish here between headline and structural deficits. In good times, the strength of the economy helps to reduce headline deficits, because revenue is higher during economic booms. But it is also important to improve the structural fiscal position—to prepare economies for times when revenue will weaken, and when pressures on spending will rise. I am concerned that governments around the world are not taking sufficient steps to do this. In many advanced countries, more ambitious action is needed to tackle structural deficits. The Fund has recommended that those European countries which have not yet achieved their medium-term objectives for their budgets aim at an improvement in the fiscal position of half a percent of GDP in each year. But some governments have not been so ambitious. Indeed, on average, structural fiscal targets in euro area countries have become less ambitious over the last five years. And even in countries that have set more ambitious fiscal targets, the policies to achieve the adjustment planned have mostly not been specified yet.
7. This issue is urgent because in most advanced countries populations are aging, and the demands on government are likely to increase over time. Our most recent estimates are that population aging will add about 3 ¾ percent of GDP to public expenditure in euro area countries through 2025, and the effects could well be higher than this. Governments would do well to prepare for this now, when times are good, rather than waiting until the pressures from aging populations are already impacting budgets and raising social tensions.
8. Let me turn now to structural reform. The words may have an ominous sound to some, but structural reforms can improve both national prospects and people's lives. Indeed, we estimate that the structural reforms that make up the Lisbon package could raise potential growth by ½ to ¾ percentage points each year. I will mention today two areas that the Fund believes are particularly important.
9. First, deregulation. There is very strong evidence that countries that adopt a package of labor market and product market liberalization can achieve good outcomes in both employment and economic growth. There are many approaches that can be taken to labor market reform. Recently the Fund published a study of four of the most successful reformers over the last two decades: Denmark, Ireland, the Netherlands, and the United Kingdom. For example, Denmark made important reforms to the structure of benefits, maintaining generous benefits but reducing their duration, and imposing tougher conditions and activation requirements. Ireland and the Netherlands sought agreements with social partners, trading wage moderation for labor tax cuts. The United Kingdom reduced the legal powers of trade unions. Denmark and the Netherlands boosted active labor market policies—especially measures to promote job retraining, and also loosened restrictions on employment protection legislation. All kinds of labor market reform are likely to be most effective if they are accompanied by product market reform, and especially liberalization of regulations in services sectors. This enables more flexibility in labor markets to be translated into increases in incomes, rather than increases in rents accruing to businesses in protected sectors.
10. The second important set of measures is in the area of financial sector reform. I see three priorities here: improving competition in the banking sector, integrating clearing and settlement systems, and addressing issues relating to supervision and regulatory regimes and approaches to crisis management that differ between countries. Taking each in turn:
European Union Commissioner McCreevy has launched a proposal to harmonize and streamline the mergers and acquisitions process across the EU, which we in the Fund strongly support. One of the main differences between productivity growth in the United States and Europe over the last decade has been different rates of productivity growth in financial sectors. Measures to streamline mergers can make an important contribution to improved competition and productivity, which will benefit customers as well as bank owners.
The European Commission announced earlier this year that it will seek integration of clearing and settlement systems through a voluntary code of conduct, and the European Central Bank is taking steps to facilitate this. We believe that progress on this issue is critical in helping to integrate Europe's financial markets.
Turning to supervision and regulation, the guiding principle should be that Europe should move toward a single set of best regulatory and supervisory policies and practices rather than a compilation of national policies and practices. This is critical in ensuring a level playing field for competition. In this regard, national authorities are likely to face new challenges over the coming years. The increasingly dominant role of conglomerates in domestic markets, their increasingly international character, and the ongoing integration of European financial markets all suggest a need for more coordination among authorities. This should include cooperation in the areas of day-to-day cross-border supervision, deposit insurance, and especially crisis management. I believe that this cannot be achieved without some centralization of authority at the European level. A good first step would be to set up a central crisis management unit at the European Union level, which could assist or take over from national supervisors in times of crisis.
11. So far in these remarks I have focused largely on policies in Europe. The reason is that all of the measures I have talked about are in the interests of European countries and citizens. They are worth doing for their own sake. But they can also make an important contribution to resolving tensions and potential problems in the global economy.
12. The Fund has for some time been raising concerns about the consequences for the global economy if current accounts imbalances between the United States and the rest of the world were to unwind in a sudden and disruptive way. This could happen through a sharp fall in U.S. consumption, which has been the main stimulant to global growth for the past few years. Or it could happen if investors suddenly become unwilling to hold U.S. financial assets at prevailing exchange rates and interest rates. This could cause global financial market disruptions as well as an economic downturn.
13. The risk that is on most people's minds at the moment is a slowdown in the United States. So far the effects have been limited to a decline in residential investment, with consumption growth holding up and business investment solid. But the correction in the housing market could have some effect on household consumption. An important factor in consumption growth in recent years has been the increased ease with which homeowners in the United States have been able to use asset price gains to finance higher consumption. Moderation in U.S. consumption growth is not in itself a bad thing: it would help to bring down the external current account deficit. This is important because if the United States were to continue to run current account deficits at the present level it would mean ever-growing external indebtedness. This would raise the risks of a disorderly unwinding of global current account imbalances by a sharp depreciation of the U.S. dollar and, in response, an increase in dollar interest rates. But an abrupt slowing of U.S. consumption growth—if not offset by stronger demand growth elsewhere—would have spillover effects elsewhere that would be a cause for concern. This makes some of the structural reforms that are under consideration for Europe even more important. By taking measures which will stimulate growth, European countries can both offset the effects of a withdrawal of demand by the United States on their own economies, and offer the world an alternative source of demand growth.
14. I should stress that the Fund is actively involved with all of its members to reduce risks related to an abrupt unwinding of global imbalances. In some countries we urge governments to take steps to reduce vulnerabilities to such an event. In others, those countries which can help defuse the imbalances, we advise that they take action to do so. This includes fiscal adjustment and measures to stimulate private saving in the United States, further exchange rate appreciation and measures to stimulate domestic demand in some countries in emerging Asia, and structural reforms to stimulate demand and improve productivity in the non-tradeables sector in Japan as well as in Europe, as I have already discussed.
15. One way in which the Fund is trying to help is through a new tool: Multilateral Consultations. Earlier this year, the Fund began its first Multilateral Consultation—a discussion with several members and groups of members at once—to share analysis of the nature and consequences of global imbalances and to help build a common understanding on policies designed to make needed changes. It will take time to complete the consultation, and for agreed actions taken to produce effects on global imbalances. But if we can make progress on this issue, we can remove a significant risk to global economic prospects.
16. Before concluding, let me say a few words about other steps that the Fund is taking to reform itself, and help our members meet the challenges they are facing. Multilateral Consultations are just one aspect of a broader reform of our surveillance—that is, the analysis, advice, and supervision that the Fund makes of the national economies of our members, and also of the global economy. We are making other changes to strengthen our surveillance too. For example, we are working to improve the quality of our analysis, including of exchange rates. One aspect of this is that we are in the process of extending to the currencies of the major emerging economies the analysis that the Fund currently does on industrial countries' economies. The aim is to assess, within a consistent cross-country framework, whether exchange rates are broadly in line with fundamentals. This is something that needs to be handled with caution, given methodological difficulties and sensitivities, but it is an important step, which will strengthen the analysis of competitiveness that we regularly undertake in our work on individual countries.
17. We are also intensifying our efforts to integrate our financial sector work, including on capital and financial markets, in our regular surveillance activities. The increased importance of financial markets for growth and development for all countries is a major feature of the new world of globalization. It is of particular importance for emerging market countries, which have a lot to gain from financial integration but may also become more vulnerable in integrated global markets. To reflect this, in our surveillance of the global economy, we have already begun to devote more attention to the linkages between the financial sector and real economy. Meanwhile, in our surveillance of individual countries' economies, we are enhancing the analysis of financial sector vulnerabilities and ensuring that this is reflected in our macroeconomic analysis and policy advice. In the past, nasty surprises in the financial sector have had even nastier effects on the real economy. To better anticipate financial sector shocks, we are devoting increased resources to financial sector surveillance.
18. And the reforms of surveillance are themselves part of a broader package of reform, a Medium-Term Strategy for the Fund which I proposed last year, and which we are now implementing. You may be aware that our members agreed in Singapore in September on a major package of reforms of the Fund's governance structure to reflect changes in the global economy, and especially the rising importance of emerging market countries. The Fund's membership took the first steps in this process in Singapore by increasing the quotas of four emerging market countries: China, Korea, Mexico, and Turkey. In addition, over the next two years, the Fund will seek consensus on a new formula for quotas—which largely determine voting shares—that better reflects the weight of countries in the global economy. The Fund's governors also agreed that this process should not weaken the voice of low-income countries.
19. In addition, we are improving other services we provide to other members. We are considering whether our existing lending tools are sufficient to offer necessary support to emerging markets, to prevent and, if necessary, respond to new financial crises. We are also sharpening the focus of our work on low-income countries, to help them become fully integrated into the global economy, and to meet the United Nations Millennium Development Goals, including reducing poverty through sustained economic growth. The Fund has already helped countries in the past year by implementing the Multilateral Debt Relief Initiative, which wiped out debt owed to it by 22 poor countries. A priority for the coming years will be to help low-income countries get the support they need while also avoiding a new buildup of unsustainable debt.
20. This is a time of great opportunity for all nations. The important thing now is to take advantage of good global economic and financial market conditions. Governments need to take measures now that will keep growth high in the future. Europe has a particular opportunity to help itself: by maintaining prudent monetary policies and promoting ambitious fiscal and structural policies. In doing so, it can also help its global partners. I hope that policy makers will seize this opportunity.
Thank you very much.