Beyond the Growth Versus Austerity Debate: Three Smart Things To Do Together

IMF News, September 27, 2012

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Authors: José Viñals
Published: September 27, 2012

Overview

Speech by José Viñals, Financial Counsellor and Director of the Monetary and Capital Markets Department, International Monetary Fund.
Delivered at The Eurofi Financial Forum, Brussels, September 27, 2012.
Central thesis: the debate framed as “austerity versus growth” is a false dichotomy; Europe must pursue stabilization, integration, and growth together through coordinated, smart policies.

Diagnosis: two interlocking vicious cycles

Economic vicious cycle:
- Driven by three mutually dependent forces: weak sovereigns, weak banks, and poor economic growth.
- Interaction: bank weakness → weaker growth → sovereign support → sovereign weakness → bank strain → weaker growth.
- Example: Ireland public debt was 25 percent of GDP before the crisis; in early 2012, it was almost 110 percent.
Political vicious cycle:
- Escalating market tensions → euro-area level policy reactions → market relief → complacency or political fragmentation → renewed larger market tensions.
Current conditions highlighted:
- Euro area overall unemployment standing at 11.3 percent on average.
- In Greece and Spain, one out of four are unemployed.

Fiscal policy: “Fiscal adjustment needs to be smart”

Core points:
- Many countries have legacy high public debt; sovereign debt has lost its traditional risk-free character in some cases.
- Fiscal stimulus is not an option; fiscal consolidation is essential to restore sovereign safety and support banks and growth.
- Fiscal consolidation should be paced appropriately: neither too fast nor too slow.
- If growth is worse than expected, prioritize fiscal measures over fiscal targets to avoid undue procyclicality.

Structural policies: “Structural policies need to be smart”

Priority areas:
- Broad reforms in labor and product markets to unlock investment and improve supply capacity.
- Delivering on ambitious structural reform agendas is politically difficult but essential, especially in Southern Europe where competitiveness problems are acute.
Quantified IMF estimate:
- Internal IMF studies indicate in-depth product, labor market and pension reform could lift growth in the euro area by 4.5% over five years.
Financial sector reforms:
- Clean up remaining excesses; build higher quality capital and truly liquid assets.
- Restart securitization on safer grounds than pre-crisis.
- Design a financial system that is lean, fit, fair, accessible, and supportive of growth.

Financial regulation, supervision, and incentives

Regulatory advances and remaining needs:
- Agreement on new capital frameworks and movement by some institutions toward new requirements.
- Need for rigorous and internationally consistent implementation of the new regulatory framework.
- Better understanding of the shadow banking system; counterparty risk reduction in derivatives markets; effective national and cross-border resolution regimes required.
Supervisory enforcement:
- Enforcement needs strengthening; banking union initiative designed to remedy weaknesses in supervision within the euro area.
Incentive alignment:
- As institutions become safer, shareholders and bondholders may accept lower returns; compensation should align with lower risk profiles.
- Shift appropriate burden from taxpayers to other stakeholders.

Financing growth: three priority actions for the financial sector

Repair:
- Focus on problem areas and act fast to clean up banks and prevent emergence of “Zombie banks,” which are detrimental to growth.
- Highlight vulnerability of banks dependent on wholesale funding; even deposit-rich banks are not completely safe.
Build buffers:
- Banks must continue to build capital and liquidity buffers steadily and consistently in line with Basel III requirements.
- IMF finding: reasonably higher capital and liquidity buffers contribute to lower financial stress and to higher and more stable growth, particularly when buffers are high quality and more liquid.
Integration and risk-sharing:
- Understand implications of globalized financial systems; solutions to a global crisis must be global.
- Response to contagion should be better institutional integration and cooperation, not fragmentation.
- Strong support for establishing a banking union to reverse fragmentation, end financial repression, and enable efficient cross-border resource allocation within the common currency area.

Conclusions and policy message

The real choice is not between austerity and growth or stability and growth, but between:
- Making tough political decisions to address root causes decisively now; and
- Postponing necessary measures with the false hope that time is on our side.
Recommended policy package:
- Smart demand management, structural change, and regulatory reform together to foster confidence, restore stability, and support growth.
- Reboot the financial system onto a safer path so it can channel resources to stronger and more stable growth.
Call for leadership:
- Turn intention into reality; decisive leadership is required so “this time it must be different.”

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.