Amsterdam - The latest economic data suggest that recession
is returning to most advanced economies, with financial markets now reaching
levels of stress unseen since the collapse of Lehman Brothers in 2008.
The risks of an economic and financial crisis even worse
than the previous one - now involving not just the private sector, but also
near-insolvent sovereigns - are significant. So, what can be done to minimise
the fallout of another economic contraction and prevent a deeper depression and
financial meltdown?
First, we must accept that austerity measures, necessary to
avoid a fiscal train wreck, have recessionary effects on output. So, if
countries in the eurozone's periphery are forced to undertake fiscal austerity,
countries able to provide short-term stimulus should do so and postpone their
own austerity efforts.
These countries include the United States, the United
Kingdom, Germany, the core of the eurozone, and Japan. Infrastructure banks
that finance needed public infrastructure should be created as well.
Second, while monetary policy has limited impact when the
problems are excessive debt and insolvency rather than illiquidity, credit
easing - rather than just quantitative easing - can be helpful. The European
Central Bank (ECB) should reverse its mistaken decision to hike interest rates.
More monetary and credit easing is also required for the US
Federal Reserve, the Bank of Japan, the Bank of England, and the Swiss National
Bank. Inflation will soon be the last problem that central banks will fear, as
renewed slack in goods, labour, real estate, and commodity markets feeds
disinflationary pressures.
Third, to restore credit growth, eurozone banks and banking
systems that are under-capitalised should be strengthened with public financing
in a European Union-wide programme. To avoid an additional credit crunch as
banks deleverage, banks should be given some short-term forbearance on capital
and liquidity requirements.
Also, since the US and EU financial systems remain unlikely
to provide credit to small and medium-sized enterprises, direct government
provision of credit to solvent but illiquid SMEs is essential.
Fourth, large-scale liquidity provision for solvent
governments is necessary to avoid a spike in spreads and loss of market access
that would turn illiquidity into insolvency. Even with policy changes, it takes
time for governments to restore their credibility. Until then, markets will
keep pressure on sovereign spreads, making a self-fulfilling crisis likely.
Today, Spain and Italy are at risk of losing market access.
Official resources need to be tripled - through a larger European Financial
Stability Facility (EFSF), Eurobonds, or massive ECB action - to avoid a
disastrous run on these sovereigns.
Fifth, debt burdens that cannot be eased by growth, savings,
or inflation must be rendered sustainable through orderly debt restructuring,
debt reduction, and conversion of debt into equity. This needs to be carried
out for insolvent governments, households, and financial institutions alike.
Sixth, even if Greece and other peripheral eurozone countries are given significant debt relief, economic growth will not resume until competitiveness is restored. And without a rapid return to growth, more defaults - and social turmoil - cannot be avoided.
Three unworkable options
There are three options for restoring competitiveness within
the eurozone, all requiring a real depreciation - and none of which is viable:
- A sharp
weakening of the euro towards parity with the US dollar, which is unlikely, as
the US is weak, too.
- A rapid reduction in unit labour costs, via acceleration of structural reform and productivity growth relative to wage growth, is also unlikely, as that process took 15 years to restore competitiveness to Germany.
- A five-year
cumulative 30% deflation in prices and wages - in Greece, for example - which
would mean five years of deepening and socially unacceptable depression; even
if feasible, this amount of deflation would exacerbate insolvency, given a 30%
increase in the real value of debt.
Because these options cannot work, the sole alternative is
an exit from the eurozone by Greece and some other current members. Only a
return to a national currency - and a sharp depreciation of that currency - can
restore competitiveness and growth.
Leaving the common currency would, of course, threaten
collateral damage for the exiting country and raise the risk of contagion for
other weak eurozone members.
The balance sheet effects on euro debts caused by the depreciation of the new national currency would thus have to be handled through an orderly and negotiated conversion of euro liabilities into the new national currencies.
Appropriate use of official resources, including for
recapitalisation of eurozone banks, would be needed to limit collateral damage
and contagion.
Seventh, the reasons for advanced economies’ high
unemployment and anaemic growth are structural, including the rise of
competitive emerging markets. The appropriate response to such massive changes
is not protectionism.
Instead, the advanced economies need a medium-term plan to
restore competitiveness and jobs via massive new investments in high-quality
education, job training and human capital improvements, infrastructure, and
alternative/renewable energy. Only such a programme can provide workers in
advanced economies with the tools needed to compete globally.
Eighth, emerging market economies have more policy tools
left than advanced economies, and they should ease monetary and fiscal
policy. The International Monetary Fund and the World Bank can serve as lender
of last resort to emerging markets at risk of losing market access, conditional
on appropriate policy reforms.
And countries like China that rely excessively on net
exports for growth should accelerate reforms, including more rapid currency
appreciation, in order to boost domestic demand and consumption.
The risks ahead are not just of a mild double-dip recession,
but of a severe contraction that could turn into Great Depression II,
especially if the eurozone crisis becomes disorderly and leads to a global
financial meltdown.
Wrong-headed policies during the first Great Depression led
to trade and currency wars, disorderly debt defaults, deflation, rising income
and wealth inequality, poverty, desperation, and social and political
instability that eventually led to the rise of authoritarian regimes and World
War II.
The best way to avoid the risk of repeating such a sequence
is bold and aggressive global policy action now.
- Reuters
* This piece originally appeared on Project Syndicate. The
opinions expressed are the writer's own.