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Meeting Global Economic Challenges: How Europe can Support a Multilateral Approach, Speech by Rodrigo de Rato, Managing Director of the International Monetary Fund
January 17, 2007
1. Thank you very much. The School of Foreign Service and Georgetown University have provided some great leaders and some great public servants, and I am very pleased to have the chance to talk to you today. The last time I came to this school many in the audience were students from Europe, and I'd like to focus mostly today on some of the economic challenges facing European countries. But I also want to link what I have to say on Europe to a broader issue—the importance of multilateralism in economic policies. Let me begin by drawing to your attention three events that took place at the end of last year, events which may seem unrelated but which were significant in themselves, and also significant for what they symbolize about international cooperation.
2. The first event was the accession of Bulgaria and Romania to the European Union. It would have been unimaginable 20 years ago. It marks a great achievement for the citizens of Bulgaria and Romania and also a great achievement for the European Union, the latest stage in a remarkable unification of Europe.
3. The second event was the announcement by the Philippines that it intended to repay early loans from the International Monetary Fund, the organization that I head, contracted during 1994-98. The Philippines' ability to make this repayment reflects an impressive reform effort. It follows early repayments by Korea, Thailand, and Indonesia, and is the final repayment of loans contracted by Asian emerging markets during the Asian crisis of a decade ago.
4. The significance of the third event is mostly symbolic. On December 29, the United Kingdom repaid the final installment of loans from the United States and Canada contracted in 1945, to finance the reconstruction of Britain after the Second World War. The loans were the precursor of the Marshall Plan. This was one of the elements, along with the United Nations and the Bretton Woods agreement that created the IMF and the World Bank, of a new approach to international relations. That new approach has brought both European countries and other countries around the world 60 years of economic development and prosperity.
5. These three events bring to mind three thoughts. First, Europe has reached another milestone. But its journey is far from complete. I will not explore today Europe's political options in the years ahead, but I do want to talk about its economic options, what European countries can do to ensure that they continue to advance in development and prosperity. Second, the International Monetary Fund faces a changed world. Indeed, we have known this for some time, and we are adapting to it. We are now in a world where large-scale economic crises are, for the moment, in the past. As a public institution, providing public goods, our greatest efforts must be made in identifying the problems that could lead to future crises and in persuading our members to adopt policies that will prevent them. Finally, the repayment of those long-ago loans to Britain should remind us of how much the world owes to the spirit of multilateralism and how important it is to rekindle that spirit today. Europe and the International Monetary Fund can both contribute to such a rekindling, and they can help each other. Let me now elaborate on these thoughts, beginning with the economic challenges facing Europe.
Economic Policy Priorities for Europe
6. The European economies are currently in a strong position. One welcome feature of global economic growth of 2006 was that it became better balanced regionally. In the recent past, growth has largely been driven by demand in the United States. But now, China and India have become important engines of growth for the world economy, and we are also seeing a long-awaited pickup in investment and in employment in Europe. The Fund estimates that growth in the euro area in 2006 was just above 2½ percent, and that it will be slightly over 2 percent annually in both of 2007 and 2008.
7. Of course, there are risks to this benign outlook. One that is particularly troubling is a possible resurgence of protectionism. One of the greatest sources of global growth in recent years has been increased freedom of trade, achieved in particular through multilateral trade reform. For this reason, governments and citizens all around the world, including in Europe, should be very concerned about the negotiations in the Doha Round. There is a shared responsibility among all countries, but particularly the larger economies—both advanced and emerging market countries—to bring the Doha Round to a successful conclusion.
8. I have made the point that Europe is growing, but it starts from a position in which per capita output has remained stubbornly lower than that of the United States—per capita GDP has been about two-thirds of the U.S. level for the last thirty years. Meanwhile, unemployment remains stubbornly higher. Unemployment in the euro area fell to about 7½ percent in November, but again this contrasts with an unemployment rate of about 4½ percent in the United States. I am therefore pleased that Germany, which assumed the revolving presidency of the EU this month, has proposed as a priority setting the future path of Europe, including the most appropriate socio-economic model to promote jobs and growth. In the spirit of contributing to this debate, I would single out two areas where I think European countries could most usefully concentrate their efforts: consolidation in fiscal policy, and structural reforms.
9. High structural fiscal deficits and government debt are still problems in many countries, including in Europe. It is both easier and more 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 many European countries, more ambitious action is needed to tackle structural deficits. The Fund has recommended that those 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, and in those countries that have set more ambitious fiscal targets, the policies to achieve the adjustment planned have mostly not been specified yet. A look at the public debt dynamics reinforces the importance of such adjustment. A report last year by the European Commission forecast that without revenue or expenditure measures public debt would hit 200 percent of GDP by 2050. However, if countries meet their medium-term objectives by 2010, debt would be only 80 percent of GDP. So a little more adjustment now can head off serious long-term problems.
10. The issue is also urgent because populations are aging in most advanced countries and the demands on governments are likely to increase over time. The old-age dependency ratio in the euro area is projected to double over the next forty years. Our most recent estimates are that population aging will add about 3¾ percent of GDP to public expenditure through 2025, and the effects could 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.
11. Let me turn now to structural reform. 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 over the medium term. I will mention today two areas that the Fund believes are particularly important.
12. 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 successful reformers: Denmark, Ireland, the Netherlands, and the United Kingdom. Each did different things, and each made important progress. Moreover, 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.
13. The second important set of measures is in the area of financial sector reform. Banks, and financial markets more generally, play a vital role in directing capital towards the most productive investments, and increasing productivity is itself vital for Europe's growth prospects.
14. In the area of banking, I see three priorities: 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.
15. Capital market development is also important. Relative to the size of their economies, EU capital markets are much smaller than those in the United States, and this may have costs for the EU in terms of productivity and growth. There is some evidence that financial systems dominated by arm's-length transactions (markets with less bank density and greater disintermediation) do better in reallocating resources from declining to expanding sectors than systems dominated by relationship-based transactions. Arm's-length transactions tend to be more characteristic of capital markets than of banks, so that economies with more developed capital markets tend to be more flexible and dynamic, and therefore more likely to experience higher productivity and growth, than those with bank-based financial systems. Integration of equity markets in Europe also remains incomplete, and research by the Fund indicates that the partial integration that has taken place between some countries often results in diversion of investment rather than its allocation in the most efficient way possible. A combination of market-based and public policy initiatives is needed to both to encourage capital market development and to overcome this fragmentation.
The IMF is Adapting to Changes in the Global Economy
16. Let me now shift focus to the International Monetary Fund. I said earlier that the Fund was adapting to a world in which work on crisis prevention was likely to be more important than crisis resolution. In fact, this shift is part of a broader change caused by financial globalization that not only the Fund but all of our members, including European countries, need to adapt to.
17. For example, financial globalization has made possible the financing of global economic imbalances on a scale previously unimaginable. Those range from large current account deficits in Eastern European countries financed by Western European banks, to global imbalances between the United States and its trading partners. Europe has not been a major contributor to global imbalances, but it has been affected by them. And were global imbalances to adjust abruptly—through a sharp contraction in U.S. demand or through financial market disruptions—Europe would certainly be adversely affected. Europe can also help to reduce global imbalances. The same structural reforms that I discussed earlier, all of which are in the interests of European countries and are worth undertaking for their own sake, can also help to provide an alternative source of demand in the global economy, and—alongside actions from the other major players—help to produce an orderly reduction in global economic imbalances.
18. Among the other aspects of financial globalization are increased interconnectedness of economies, and increased importance of financial sectors in influencing economic conditions in many countries. In the Fund we are adapting to these developments by changing the way in which we conduct surveillance of the global economy. By surveillance, I mean both monitoring of the global economy and the Fund's discussions—consultations—with individual members on their economies. We are increasing the attention that we pay to spillovers between countries—that is, the effects of one country's action on its trade with other countries and on financial flows. We have initiated together with a number of major economies a multilateral consultation on what can be done to manage global imbalances. We are also increasing the attention that we pay to financial markets and financial sector issues. And more broadly, we are examining the foundations of our surveillance work. We want to make sure that our legal mandate corresponds to what we actually do—and what we should do—to effectively monitor the global economy and the economies of individual members. In all of these changes, we will need the support of our members, and I hope we can count on the support of European countries, whose influence in the Fund is great and who have long been articulate voices for measured change.
19. The reforms of surveillance that I have just discussed are part of a broader, Medium-Term Strategy for the Fund, which also covers many other aspects of our work. For example, we are exploring how we can improve the usefulness of IMF support for emerging market economies, again adapting to the priority on crisis prevention. We are renewing our commitment to help low-income countries meet the Millennium Development Goals, and improving our effectiveness by focusing on what we do best, and on tasks where we can make the greatest contribution. The Fund's efforts in this area are, or course, part of the efforts of the international community, and we will be cooperating with others to promote these broader efforts. We are also reforming the way we finance our activities. For much of the Fund's existence we have financed public goods—such as surveillance and the technical assistance we provide to members—largely from interest income from loans to countries that borrow from us. As we move from a focus on crisis resolution to a focus on crisis prevention, this method of funding is no longer viable. We are therefore exploring alternative funding approaches, with the support of a group of external experts led by the former head of the BIS, Andrew Crockett.
20. Another major change that we are making is in the Fund's own governance. At the Fund's Annual Meetings last September in Singapore, our members voted overwhelmingly in support of governance reforms that will increase the representation of many emerging market countries to reflect their increased weight in the global economy. Equally important, our members agreed that we must strengthen the voice and representation of low-income countries that continue to borrow from the Fund but have only a limited share in Fund voting. In these areas too, the support of European countries will be crucial. Some people have suggested that the governance reforms we are undertaking will reduce the influence of Europe in the management of the global economy. But these reforms are not a zero-sum game. All of our members, including European countries, benefit from an effective Fund. And to be effective, the Fund must be legitimate in the eyes of its members and of the world, and must represent all of its members.
The Importance of Multilateralism
21. Let me conclude by returning to the third point I made at the outset. This is the vital importance of maintaining and rekindling the spirit of multilateralism in the face of global challenges. In a perceptive speech at the end of last year, Mervyn King, the Governor of the Bank of England, stressed the importance of international institutions in defending an open and liberal international economic order. He pointed out that the need for international institutions has increased as globalization has taken hold, and people's standards of living are more than ever affected by decisions taken elsewhere. In a similar vein, Raghu Rajan, who was until December the Fund's Economic Counsellor, has pointed out that for international organizations to be successful there must be genuine multilateral dialogue. I agree with both these points. Great international efforts—whether through global institutions like the Fund, or groups of nations like the European Union—are more than ever necessary to tackle major economic challenges. And such efforts will only come to fruition if national leaders are prepared to take multilateral dialogue seriously, and to invest in the institutions that have served them well for the past sixty years.
22. The School of Foreign Service here at Georgetown is a good place to summon up the spirits of the Marshall Plan and recall the impulse to multilateralism that produced the United Nations, the Bretton Woods institutions, and the European Union. I have talked today about some of the things European nations can do, and about what the Fund can do and is doing to help our members meet the challenges they face. Some of you will have a chance to shape international policy in the future, and be the successors to those who founded the international order of the last 60 years. I wish you sound judgment, a healthy sprinkling of idealism, and good luck. And now I look forward to your questions.
23. Thank you very much.
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