The Global Economic Situation and Its Impact on the Transatlantic RelationshipJohn Lipsky - First Deputy Managing Director, International Monetary Fund
5th U.S. – France Bilateral Dialogue
Washington, D.C., May 2, 2011
As prepared for delivery
I am honored to have the opportunity to address this opening dinner of the 5th U.S. – France Bilateral Dialogue. I also wish to thank Ambassador and Mme. Delattre for graciously hosting this event at their beautiful and elegant residence.
I was pleased to be asked by the organizers to focus my remarks on how global economic developments are impacting transatlantic relations, as I find this issue to be both important and timely. As I will explain, I also find the answer to be uncertain, as I anticipate that the course of this key partnership will depend to a large extent on the resolution of key challenges being faced at this time in three arenas -- that is, in Europe, the United States and the global economy.
Thus, a central and recurring theme of my remarks will be that of turning points, as it appears that turning points are at hand regarding critical economic policy issues on both sides of the Atlantic. In particular, the European Union today is confronting a need to implement effectively crucial initiatives that already have been undertaken -- but that remain incomplete -- to address serious economic, financial and architectural strains currently afflicting the euro area, in part by strengthening European fiscal institutions. When complete, these actions will reset to an important degree the balance between fiscal policymaking at the national and the EU and/or euro area level.
In the United States, unprecedented anti-crisis policy efforts inflated the federal deficit, while raising public debt to record heights. As a result, the already inevitable realization that serious decisions about both federal spending and revenues will be required in order to reestablish the long-term sustainability of the United States government's fiscal position has been drawn forward into the current public debate. At the same time, a turning point is evident at a global level with regard to economic governance, as historic shifts in relative economic weight are being reflected in the evolving framework for economic policy cooperation. The direction ultimately taken from each of these three turning points will have important implications for the transatlantic relationship. I will explain why – despite the potential difficulties --I see many reasons for optimism about the relationship's future.
Europe’s near-term challenges are the most pressing. Of course, from the point of view of the euro area economy as a whole, the recovery has been solid: Growth last year reached 1.7%, and the IMF's World Economic Outlook base case forecast anticipates growth rates of 1.6% and 1.8% for this year and next. Moreover, overall euro area budget deficits and overall debt levels are not notably high.
At the same time, large divergences exist across countries, and there are serious downside risks in some cases that could have broader implications. Successfully addressing the severe vulnerabilities that have emerged in several peripheral euro area economies will be essential if the financial market and other pressures that have been building on these economies – and the contagion risks that they have created for larger euro area economies and their banking systems -- are to be overcome. This will require such measures as cutting these countries' budget deficits and strengthening their public sector balance sheets, repairing and reforming their financial sectors, and introducing structural reforms to boost their prospects for faster economic and employment growth.
The emergence of each of these challenges in the post-crisis environment underscored essential weaknesses in Europe’s institutional architecture. First, the fiscal problems in some of the peripheral euro area economies demonstrated that the Stability and Growth Pact had not been effective. Second, the lack of operational mechanisms to deal with cross-border financial sector difficulties demonstrated the relative absence of adequate area-wide institutions to support the single financial market. Third, the lack of structural reforms in some economies produced wide variations in competitiveness within the euro area, contrary to the expectations of the framers of the Maastricht Treaty and of the authors of the Lisbon Reform Agenda. And finally, no euro area-wide crisis mechanism existed to provide financial support to member countries facing serious strains.
As financial market pressures mounted in the wake of the crisis in several euro area countries, corrective actions were undertaken at the national level. Progressively it became evident that, at least in some cases, national efforts alone would not be sufficient. The response to this realization has involved a remarkable burst of institutional reform in the euro area, even though the process hasn't always been smooth.
In particular, the European Central Bank acted decisively to ensure the liquidity of euro area banks and the ability of euro area sovereigns to market their debt. The pre-existing European Financial Stability Mechanism (EFSM) was made available to euro area members. In addition, European leaders last year established the European Financial Stability Facility (EFSF) -- to be converted into a new Stabilization Mechanism (ESM) in 2013— in order to provide euro area members with financial support in times of stress. Both the EFSM and the EFSF are partnering with the International Monetary Fund in helping member countries to design stabilization and reform programs, and in providing them with financial support.
In the financial sphere, the Committee of European Banking Supervisors (CEBS) last year conducted the first-ever euro area-wide bank stress tests. Subsequently, further steps have been taken to underpin the European single financial market, including the establishment of the European Banking Authority (EBA), and the European Systemic Risk Board (ESRB). The latter is responsible for macro-prudential oversight of the EU’s financial system. These new institutions are intended to reduce the probability of new crises. Other steps intended to strengthen European institutions include proposals to bolster the Stability and Growth Pact (SGP) in the interest of more credible fiscal discipline, together with other measures to promote productivity-boosting structural reforms.
These developments clearly constitute very important changes in European policymaking. However, they remain incomplete, and their effectiveness remains unproven. For example, there are significant restrictions on the flexibility of the EFSF. Moreover, the EBA and ESRB are cooperative institutions, and there is no recapitalization funding available to back up the euro area bank stress tests, nor is there a European or euro area bank resolution mechanism.
It goes without saying that the ability of these new euro area initiatives to reliably produce fiscal discipline and structural reform remains uncertain. Moreover, current financial market prices demonstrate that even the substantial efforts undertaken so far to quell the crisis in the euro peripherals are not yet seen as credible by investors.
Taken together, these developments define a turning point for the European Union and for the euro area in particular. Unprecedented steps have been taken to overcome the crises in the peripherals, yet it is clear that new efforts are going to be needed. However, it is far from certain that the necessary political support exists for such new initiatives at the European level. Nonetheless, the record to date indicates that although the process often is cumbersome and even clumsy, EU members eventually end up adopting the measures that are needed to protect and preserve the single market and the single currency.
I assume that when we look back at this period from the perspective of a few years hence, it will appear to have been decisive -- one way or another -- for the efforts to create effective European fiscal, financial and structural institutions equal to the demands implicit in a true single market. The economic arguments for such changes are powerful. Nonetheless, we simply will have to wait and see whether they will translate into effective policy action. We will not have to wait very long, however, as market pressures are intense and still building.
With virtual certainty, the outlook for stronger European institutions will directly influence transatlantic relations. After all, renewed progress toward a single European market, underpinned by solid institutions and sustainable policies will make Europe a more effective and attractive partner for the United States. I would remind Euro-skeptics that only six months ago or so, the overwhelming market consensus held that any move by Portugal to negotiate an economic program with the "troika" of the EC/ECB/IMF immediately would be transmitted to Spain and beyond. In the event, what was held to be certain mere months ago simply hasn't occurred.
Turning next to the United States, the world's largest economy faces challenges to its economic and financial leadership from two principal sources. First, it is very plausible -- and widely recognized to be so -- that this country will cease to be the world's largest economy (in real GDP terms) within a decade, or even sooner. At the same time -- and perhaps more to the point -- the spreading recognition that the United States faces a very large medium-term fiscal adjustment challenge is coupled with widespread skepticism that this challenge will be addressed successfully.
The task of reforming U.S. public finances is the most daunting economic policy challenge currently facing U.S. authorities — although there are many others, including bringing down high unemployment, and advancing the ongoing effort to repair and reform the financial sector. In the absence of corrective measures, and taking into account the underlying fiscal pressures that predated the crisis, federal debt could reach about 95 percent of GDP by the end of this decade, a level last reached immediately following World War II. Moreover, it will keep on rising in the absence of policy adjustments, reflecting mainly pressures from population aging and expected health care cost inflation.
Just halting the deterioration in the U.S. federal government's debt position will require a substantial, sustained and presumably painful improvement in the primary budget balance. Nonetheless, the actions needed to achieve long-run fiscal sustainability are clear. Broad-based measures will be required, including curbing the growth in discretionary spending and, most importantly, reforming entitlement spending. As is well-understood, the latter implies important changes to Medicare and Medicaid, the basic forms of the federal government’s health care spending. Also important to this adjustment effort will be fundamental tax reform, most likely combined with raising fiscal revenue relative to GDP.
Despite the skepticism that the needed discipline will be adopted and implemented, U.S. political discourse regarding budget policy has shifted sharply in recent months, with budget consolidation plans suddenly proliferating, not all that long after a new 2011 stimulus initiative was announced. At least the implications of not taking effective action seem increasingly clear and widely acknowledged. According to IMF analysis, the absence of serious reform could cause U.S. interest rates to rise by as much as 100 basis points above the level that otherwise would be indicated by other fundamental factors, dampening growth prospects. The recent market reaction to the downgrading by Standard & Poor's of their U.S. credit outlook, while very short-lived, hinted at the possible financial market turmoil that could occur if the country fails to enact credible fiscal consolidation.
Such a scenario also would create costs for other countries. Global interest rates likely would increase, raising the cost of capital for investors everywhere. Inaction also could lead to significant adjustments in the global foreign exchange markets. A significant U.S. dollar weakening could produce unwelcome competitive implications for U.S. trading partners. Thus, Europe could sustain a triple blow—from lower demand in its key trading partners, higher global interest rates, and an appreciated euro that could intensify strains between the core of the euro area and its periphery. Thus, putting U.S. government finances back on a sustainable path is more than of national importance.
It should be noted that U.S. monetary policy also has been subject to unprecedented challenges of an economic downturn coupled with a financial crisis. In response, the Fed combined maintaining the Federal Funds rate at zero for an extended period with direct purchases of Treasury securities (QE1 and QE2). As a result, the Fed's balance sheet ballooned, eliciting criticisms that Fed policy has become excessively expansionary. For their part, Fed officials are confident that they possess the policy tools needed to insure that they will be able to withdraw monetary stimulus effectively when it is appropriate.
No doubt, the future of the transatlantic relationship will be influenced by whether the United States is successful in addressing its fiscal challenges, and by the overall resilience of the U.S. economy. Analogous to the European case, if the United States successfully overcomes its challenges, the stronger a partner it will be to its traditional transatlantic allies.
Even assuming that the U.S. is successful in restoring fiscal sustainability, the likelihood remains that the United States' relative share of global GDP will tend to decline in the coming years. Does this factor imply that that the US will become less interesting as a relationship partner for its traditional European allies? Or perhaps it could be the opposite – that a relatively diminished United States would be a more comfortable and less demanding partner?
This brings me to the topic of global governance, a important area where the recent crisis has motivated potentially-significant changes. Of course, the transformation of the global economy has been remarkable by any standard. Emerging and developing nations as a group have enjoyed tremendous gains, and countries that previously lagged behind technologically today are among the most innovative—thanks in large part to the opening of markets, and the transmission of ideas and the availability of finance. Based on growth rates and demographic trends, the shift in global economic weight—from the advanced economies to the developing and emerging economies—is set to continue.
The emergence of the G-20 as a leading forum for dialogue on financial and economic policy is an important expression of the perceived need for a shift in global governance. During the crisis, the G-20 provided a valuable and effective forum for policy cooperation among the world’s largest economies, supplanting in many ways the G7 and G8. The unprecedented anti-crisis effort organized through the G-20 in early 2009 demonstrated graphically the concrete benefits of global policy cooperation—without it, the crisis almost certainly would have been far deeper.
As the global economy recovers from the crisis, the G-20 is implementing its Framework for Strong, Sustainable and Balanced Growth through a Mutual Assessment Process—or MAP. The MAP represents an ongoing process of policy cooperation based on a serious analytical foundation. In essence, the MAP reflects a concrete recognition that policies developed and implemented in a coherent process can produce a superior outcome for all participants relative to a situation in which policies set independently.
And while the MAP was greeted initially by a considerable degree of skepticism, the progress to date appears to have exceeded consensus expectations by some degree. For example, G-20 Finance Ministers at their April meeting agreed to a detailed assessment of seven major economies whose imbalances—in areas such as private and public saving, and international trade — could represent a potential systemic risk to the global economy. An Action Plan will be prepared for the Leader’s examination and approval at the Cannes Leader’s Summit in November.
The MAP therefore represents the third turning point I will address. If the MAP is viewed as a success -- not only because it will have been taken seriously by the key participants, but also because the process will have produced a positive outcome -- then it likely will have a lasting influence on global relations, as well as on transatlantic relations. First of all, since the MAP is the only item on the G-20 Leaders’ Agenda that is “of the G-20, by the G-20 and for the G-20”, -- and because it deals with the economic and financial sector issues that lie at the heart of the G-20’s proclaimed competence -- the G-20’s relevance and importance will depend notably upon the MAP’s perceived success.
This leaves the obvious question whether the "leveling of the playing field" in setting broad economic policy priorities that a successful MAP implies would tend to make the transatlantic relationship more important to its members and others, or the opposite? My conclusion is that the emergence of an effective, more principles-based, analytical and cooperative approach to setting macroeconomic policies in the largest economies would suit both sides of the transatlantic relationship very well. I also expect that such a situation would tend to strengthen the sense of partnership, reflecting the broadly shared objectives and long-standing avenues of cooperation. Of course, others may hold different views regarding this key subject.
I would be remiss if I didn’t avail myself of the opportunity to mention that the IMF itself is adapting to the new global economic realities. Historic governance reforms at the Fund are delivering a greater voice for the dynamic emerging market economies. Once the latest round of already agreed reforms are in place, China, India, Brazil and Russia will be among the Fund's top ten shareholders (along with the United States, Japan, and the four largest European economies). At the same time, the voice of our poorest members has been protected. As result, it is our expectation that any issues regarding the IMF’s “legitimacy” will have been laid to rest.
Eventually, the role and responsibilities of the G-20 will need to become more clearly defined with regard to universal membership institutions like the IMF. For now, however, these institutions are best viewed as mutually supportive – and with broadly consistent goals.
Returning to my starting point, the outlook for European institutions and governance, for U.S. economic prospects and long-term policy discipline, and for global economic policy governance all currently are at turning points. Each will influence directly the prospects for the transatlantic relationship. And in each case, the outcome is far from certain. Nonetheless, I have tried to lay out in a simple fashion the reasons why I think that the most likely outcome – and the most favorable one – will tend to strengthen the transatlantic alliance, even in the context of ongoing and ultimately successful globalization.
The coming months and years are going to be especially fascinating. I only wish I could peek briefly into the future and find out with certainty whether we’re on the right track.
Thank you for your attention, and good luck for your discussions and deliberations.