Confronting the Future with Wisdom and Courage

Speech by Rodrigo de Rato
Managing Director of the International Monetary Fund
At the European Ideas Network and International Republican Institute Seminar on "The Future of the World Economy"
Washington, DC, July 19, 2007

As Prepared for Delivery

1. Thank you very much for inviting me to be with you today. I would also like to thank Ana Palacio for her generous introduction, and also James Elles, Chairman of the European Ideas Network and Lorne Craner, President of the International Republican Institute.

2. There is a famous prayer, called the Serenity prayer, which was originally composed by the German theologian Reinhold Niebuhr. The prayer says, "God, give us grace to accept with serenity the things that cannot be changed, courage to change the things that should be changed, and the wisdom to distinguish the one from the other." It has been a guide and comfort to soldiers and to alcoholics. It can also be a useful guide for policy makers when thinking about the future, and especially about the future of the world economy.

3. There are some things we cannot change—the laws of science and of economics, the behavior of others, and sometimes our own desires and concerns. But there are many things that we can change, if we have the courage. And we need to have the wisdom to know what we can change, and how we should try to achieve change. We need this wisdom and courage because what the world economy will look like in the distant future depends greatly on what we do in the near future and on what we do now. There are many policy issues to which this applies. Today, I will focus on a few that are particularly relevant to policy makers in Europe and the United States: in particular, demographic change and the effects of globalization.

4. Looking first at demographic change, in many countries life expectancy is increasing and birth rates are falling. These are generally welcome developments. People are living longer and healthier lives, and they are exercising their freedom to have or not to have children. But the economic effects of these developments could be damaging.

• Older populations are likely to produce less, because the active labor force is a smaller part of the populations. For example, in the euro area, there are at present about four people in the age range 15-65 for every one over 65. But by 2050, that ratio is projected to be closer to two to one.

• Demands on health care systems will also tend to be greater, because more people will be older, and the average cost of healthcare tends to rise as people age. OECD and European Union studies suggest that demographic changes will lead to increased medical care spending of 2-3 percent of GDP between 2000 and 2050.

• Strains on pension systems will also increase. A number of defined benefit public pension schemes are already facing financial problems. Shifting towards defined contribution systems, as several countries and many private employers have been doing, reduces the financial risk to the pension plan, but increases the risk to pensioners that their pension will be insufficient.

5. Demographic change is a good example of a change that governments can do little to prevent: nor should they. However, there are actions that governments can and should take to anticipate and manage the economic effects of demographic changes.

• Governments can make structural reforms to improve productivity, so that a relatively smaller active labor force will be able to produce more. Product market reforms such as reduction in tariff and legal barriers, opening up of markets to competition, and measures to create a more business-friendly environment can all increase productivity. So can financial sector reform, and especially financial sector integration, an area in which Europe has lagged the United States in recent years. Governments in countries with aging populations can also help reduce labor market shortages by encouraging immigration and putting in place policies to integrate immigrants into their societies.

• Reform of health care systems can also help to offset the increased costs arising from demographic changes. Many health care systems in industrial countries have aspects of inefficiency. For example, the per capita administrative costs of health care in the United States exceed the per capita total costs of health care in Singapore, a country with comparable health outcomes. There is clear evidence of market failures in these high costs, and substantial scope for reform. More generally, older populations need not result in significantly higher health care costs if people also stay healthier for longer. This suggests that emphasis should also be placed on preventive medicine and improving health behavior by individuals.

• Even with reform, there is likely to be a need for greater public provision for health care. This could be financed, for example, by reducing tax breaks in areas where they have outlived their usefulness. For example, it should be possible to reduce subsidies and tax deductions for mortgage payments since housing finance is now well served by an efficient market.

• Pension reform is already on the agenda of many countries. Retirement ages are being raised in France, Italy, and Japan, and the normal retirement age for social security in the United States has been rising gradually from 65 to 67 since the implementation of the recommendations of the 1983 Greenspan Commission. Raising retirement ages seems to make sense, given rising life expectancy. But governments would do well to accompany such measures with labor market reform, to improve job opportunities both for older workers and for younger ones, for whom unemployment rates are still high in much of Europe.

• Another approach to pension reform is to reduce benefits, but there are limits to how far this can go while still providing pensioners with a decent living. Indeed, in many countries, governments need to recognize that even with pension reform, costs will be higher, and fiscal adjustment in other areas is needed to offset these costs. This is true in most countries in the European Union, and in the United States. The expected fall in saving rates in countries with aging populations adds to the need to reinforce public savings in those countries.

6. Let me now turn to the second main issue that I would like to cover today, the effects of globalization. Globalization has improved the lives of billions of people, by expanding trade, increasing incomes, and broadening economic opportunities. And financial globalization, a more recent phenomenon, is also beginning to have a dramatic impact, broadening the pool of savings available for investment and giving savers more freedom and more opportunities to deploy their savings in a profitable and diversified way. It is no coincidence that the world is currently experiencing the longest period of strong growth since the 1970s.

7. But there is also opposition to globalization. I am particularly concerned about the risks of a rise in protectionist sentiment, especially following the lack of progress in the Doha Round negotiations. I believe that politicians in all of the countries concerned are both throwing away a major opportunity and playing with fire. The benefits from trade liberalization are immense. For example, studies indicate that trade liberalization, including trade deals under the GATT and the WTO, have lifted annual incomes in the United States by as much as US$750 billion. Indirect gains arising from investment and similar reforms have been of a similar magnitude. There is also a risk that if the world does not quickly move forward on trade, it risks moving backward, to the narrow nationalism that characterized the Depression era. We have seen where that leads, and we know it does not work. So a rapid resumption of multilateral trade negotiations is very important.

8. It is also necessary to be candid about the risks and costs associated with globalization, and address these. For example, there are many more winners than losers from trade liberalization: that is the very nature of the comparative advantage which underlies trade between people and between nations. But we should not ignore the losers. Both our sense of humanity and our common sense suggest that we should help those who lose out from trade liberalization find new opportunities and new jobs. Further trade liberalization could be accompanied by measures to help those adversely affected, while strengthening the economy's adaptability. For example, trade adjustment assistance can both protect workers and help them to move to growing industries.

9. We should also bear in mind the distributional consequences of globalization. The Fund has advised emerging market economies and developing countries to complement liberalization of trade and markets with measures to improve income distribution. Our advice includes putting in place adequate social safety nets, and additional and more efficient spending on education, which improves equality of opportunity and makes workforces more flexible. It also includes replacing subsidies, which often mostly benefit better-off citizens, with spending targeted toward those who need it most. Industrial countries too should look critically at their tax systems and public spending with these considerations in mind. There are good reasons why people who are already better educated and have more capital benefit most from globalization. But political support for globalization will only be sustained if governments adopt policies which spread its benefits broadly.

10. Financial globalization also brings with it risks as well as opportunities. The Fund has emphasized the need for emerging markets and developing countries to build up sound financial systems capable of handling capital flows without strain, and to pursue sound macroeconomic policies that will avoid financial disruptions. Financial globalization also carries risks for advanced economies. It is important that supervision and regulation of the financial sector keep up with financial innovation, especially as the financial risks associated with saving through pensions shifts away from institutions and toward individuals.

11. Aging populations are a change that we can see coming a long way off, and our understanding of the changes produced by globalization is improving with time. But the economic effects of other potential changes are less certain. We know that climate change is taking place, but we are only gradually increasing our understanding of its extent and its consequences. We know that there is a risk of pandemics, but we do not know the scale of human loss and economic disruption a pandemic would cause. Confronted with these kind of uncertainties, we need good systems of risk appraisal and risk management. And since many risks have causes and consequences which cross borders, we need good international coordination and strong international public institutions.

12. The International Monetary Fund is acting to improve our preparedness in many ways. We are doubling the frequency of our regular projections of economic indicators. Indeed, Simon Johnson, Director of the Fund's Research Department, announced today that the first of the new economic updates will be issued next week. We have stepped up our analysis of the vulnerability of countries to economic shocks and we are deepening our expertise on the relationship between economic and financial market developments. We are researching the macroeconomic effects of climate change and we have already acted as a clearing house for exchange of information on how to contain economic damage from possible pandemics like avian flu.

13. We are also engaged in deep institutional reform. We have pioneered a new mechanism for cooperation on common problems—Multilateral Consultations between major countries to discuss shared analyses and approaches to these problems. Just last month we updated the legal framework for our monitoring of individual economies. And we are in the middle of a program of reform of voice and representation of our members, to give more weight to economies that have grown in importance, including major emerging economies, while also protecting the voice of low-income countries. These reforms are essential to ensure that the Fund remains both useful and legitimate in the eyes of all of our members.

14. Both the Fund and its members will need wisdom in deciding how to change, and courage to implement the needed changes. The stakes are high. We know some of the problems we will face in the future. Other problems, as yet unknown, will certainly emerge. We must be prepared, just as our member countries, including the countries of Europe and the United States, must be prepared to deal with the problems that they will face, with wisdom and with courage.

15. Thank you very much.



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