Beyond the Growth Versus Austerity Debate: Three Smart Things To Do Together
By José Viñals, Financial Counsellor and Director of the Monetary and Capital Markets Department
International Monetary Fund
The Eurofi Financial Forum
Brussels, September 27, 2012
As prepared for delivery
Good evening, ladies and gentlemen.
It is a great honor for me to be here in front of such a distinguished audience of stakeholders in Europe’s financial system.
I would like to very warmly thank Jacques de Larosière for giving me the opportunity to speak on an issue that is very dear to us at the IMF—the goal of restoring stability and growth and securing a prosperous future for the world.
The crisis, now five years long, continues to surprise most of us through its wide reach and mounting human cost. This is especially true for parts of Europe. Far too many people have lost their jobs, and there is a new generation that has not even had the chance to get a job. And too many people—even with jobs— are struggling to make ends meet. Overall unemployment in the euro area has continued to rise, now standing at 11.3 percent on average. In Greece and Spain, one out of four are unemployed.
This is devastating and must not be allowed to go on any longer.
So where do we turn? How do we overcome the crisis? This has been the subject of much spirited debate. Is austerity hurting growth, and if so by how much? Are structural reforms effective when demand is so weak? Is regulation making the financial system safer but at the price of damaging growth?
Much of this debate has, regrettably, been about false dichotomies. The reality is that the European economy is struggling to get out of two interlocking vicious cycles: an economic one and a political one.
The vicious economic cycle is driven by three mutually dependent forces: weak sovereigns, weak banks, and poor economic growth. When banks ran into trouble, growth weakened and the sovereign stepped in. Conversely, when the sovereign ran into trouble, banks suffered, again with adverse consequences for growth. Weak growth, in turn, reduced the strength of both sovereigns and banks, giving rise to a vicious cycle. The impact of these adverse spirals on public debt was quite large.
The most striking example is Ireland, where before the crisis public debt was 25 percent of GDP; in early 2012, it was almost 110 percent. Along the way, Ireland lost market access.
The fiscal adjustment that is now needed to correct the sovereign balance sheet in several euro area countries is therefore not about austerity versus growth but about restoring the safety of the sovereign, which in turn will strengthen the banking system and allow both to support growth.
In the euro area, an overarching political cycle has caused difficulties in managing the economic crisis. In a currency union, it is obvious that in addition to national discipline, conditional mutual support among members is necessary to maintain its viability.
But over the past couple of years we have seen a cycle played out a number of times: escalating market tensions, followed by euro-area level policy reactions and market relief, in turn followed by either complacency setting in among policymakers or political fragmentation arising along national lines, with even larger market tensions reappearing as a result.
These vicious political and economic cycles need to be broken and cooperation needs to be strengthened. As the Roman politician Cicero once said: “We may have come in different ships, but we are all in the same boat now.” This boat is being built. It needs to be ready to set sail very soon.
Confidence has recently improved with the announcements of new ECB policies and the prospect of a banking union. This is encouraging. But fragilities remain and it is too soon to declare victory on the euro area crisis.
Rather, the space provided by the ECB now needs to be fully used by political leaders to effectively tackle the roots of the crisis, once and for all, at both the national and European levels so as to secure a bright future for the euro area.
What Europe needs is stabilization, integration, and growth. Stabilization will return sovereigns and banks to safety; integration will strengthen the currency union and anchor crisis management; and growth will put people back into jobs.
Pushing Europe’s emerging consensus
To make progress toward sustained growth amidst all these constraints we will need to be “smart,” and we will need to work on several fronts to be smart together:
Fiscal adjustment needs to be smart: Countries have a legacy of very high public debt partly due to the crisis and, in a number of countries that we all know well, sovereign debt has lost its traditional risk-free character. Consequently, fiscal stimulus is clearly not an option and fiscal consolidation is essential.
But fiscal consolidation is a marathon and not a sprint. The right pace is essential. Neither too fast—to avoid hurting growth—nor too slow—to avoid disappointing markets. If growth is worse than expected, the focus should be on fiscal measures rather than fiscal targets to avoid being unduly procyclical.
Structural policies need to be smart: While demand is key for today, supply is essential for tomorrow. Broad reforms in labor and product markets will provide investment opportunities for the money that is currently idling on the sidelines. This is politically tough but according to internal studies by the IMF, in-depth product, labor market and pension reform could lift growth in the euro area by 4.5% over five years.
Europe has repeatedly disappointed in the past by setting ambitious targets expanding structural reform and failing to deliver (remember the Lisbon Agenda?). The stakes are now too high to fail again, particularly in Southern Europe, where competitiveness problems are most important.
Financial sector reforms also need to be smart. The reforms first need to clean up excesses wherever they still exist, and gradually and consistently build buffers with higher quality capital and truly liquid assets. And we need to restart securitization but on safer grounds than before the crisis.
We must think of what financial system we need and want. A system that is lean and fit, fair and accessible; a system that oils the engine of growth rather than disrupting it.
Let me turn now towards the global financial system and how it can help growth.
The financial sector has been in the eye of the storm. It has often been blamed for having caused and amplified the crisis, though as we know other factors have played a role too. Recent scandals such as LIBOR do not help to restore trust in the sector.
Many people wonder whether the considerable reform efforts that are being undertaken will be pursued to their successful conclusion. They also wonder when the financial system again will forcefully help finance sustainable growth.
There are many underlying causes of the crisis. One critical issue was a regulatory system that did not keep up with financial innovation, combined with insufficient enforcement by supervisors of the regulations that were on the books. Policymakers have taken various lessons to heart and have put in place a vision, a new financial regulatory framework, to help mitigate these financial stability risks.
Has the quest for a safer, more stable financial system come to an end? My answer would need to be “probably not”—at least not yet.
Banks are looking healthier today compared with a few years ago but, as the IMF has stated this week based on its most recent analysis, considerable more work is needed to move to a truly safer global financial system.
On the regulatory front, we have positive developments: there is agreement on new capital frameworks. Some institutions have already moved toward the new requirements.
But we need rigorous and internationally consistent implementation of the new regulatory framework. We also need to better understand the shadow banking system, ensure counterparty risk reduction in derivatives markets, and adopt effective national and cross-border resolution regimes.
On the supervisory front, enforcement needs to be strengthened. The initiative to set up a euro area banking union is designed to remedy a number of weaknesses in this area.
Incentives need to be better aligned. Management of financial institutions plays a key role in allocating the regulatory cost to different stakeholders. As financial institutions become safer in the wake of new financial regulations, shareholders and bondholders will likely accept lower returns on their investments. Management may align staff compensation with the new lower risk profile. At a broader level, shifting the burden from taxpayers to other stakeholders seems appropriate.
So, while a safer global financial system is being established, what needs to be done to ensure that the financial system contributes to growth in Europe?
First, repair. Policymakers need to focus on the problem areas and do so as fast as possible.
They need to speedily complete the cleaning-up of banks and prevent the emergence of so-called Zombie banks, which are very detrimental for growth. Moreover, those banks that are too dependent on wholesale funding are particularly vulnerable to a change in the sentiment among their liability holders; even banks with ample deposits are not completely safe.
Second, banks need to continue to build up capital and liquidity buffers, steadily and consistently, in line with the new Basel III requirements.
Examining the effects of regulation, the IMF finds that reasonably higher capital and liquidity buffers in the banking system not only contribute to lower financial stress but also—and contrary to what some believe—to higher and more stable growth. This is particularly the case for economies where these buffers are made up of high quality capital and more liquid assets.
Third, we need to fully understand the implications of globalized financial systems.
The crisis has been a global one and the solutions are also global. The response to contagion is, therefore, not fragmentation but better institutional integration and cooperation. We need to move back to risk-sharing so that we end up with good globalization.
This point is nowhere more evident than in the euro area. As the sovereign debt crisis has accelerated there has been a trend towards financial home-bias and fragmentation along national lines. But, inside a monetary union, this is an untenable situation.
That is why I strongly welcome the intention to establish a banking union. The Fund has long advocated the need for a strong and effective union. It needs to be put in place as soon as possible and done right so that it reverses fragmentation, ends financial repression, and reopens the door for efficient cross-border allocation of resources within the common currency area.
Let me conclude. “Austerity or growth” and “stability or growth” are not the real choices in front of us.
The real choice is between making tough political decisions that address once and for all the roots of the crisis, and postponing—once more—taking the necessary measures with the false hope that time is on our side.
What we need to choose is a combination of smart demand management, structural change, and regulatory reform that fosters confidence and restores stability and growth simultaneously. We need to reboot the financial system and put it on a safer path so that it can channel resources in support of stronger and more stable growth.
Leadership is often defined as turning intention into reality. Let’s hope that it will be decisively exercised.
This time it must be different.