Europe is trying to solve its economic problems through further fiscal integration and greater financial oversight, but fears are high that the steps taken thus far are not enough to stem the crisis.
In a Q&A, Hans Timmer, the director of the World Bank's development prospects group, and Uri Dadush, editor of Carnegie’s International Economics Bulletin, assess the global economy, Europe’s response to the debt crisis, and what policymakers need to do to avert disaster.
- Is the world on the brink of an economic collapse?
- What is the biggest global economic concern today?
- How important was the latest deal at the European leaders summit on the eurozone?
- Is Europe doing enough to fix the crisis and save the euro?
- How badly would a collapse of the euro hurt the United States? Is there anything that Washington can do to help Europe?
- What effect does the euro crisis have on emerging economies and the global economy?
- What lessons can policymakers take from the crisis?
- Is there a positive economic story that is going unnoticed amid the crisis?
Is the world on the brink of an economic collapse?
Timmer: The probability of severe economic consequences around the world is substantial and increasing.The situation in Europe is not good. There is a major financial crisis building and this is reflected in the real economy with several countries either in or entering recession. But what worries us most at the World Bank given our mandate is the risk of the economic crisis spreading to the developing world.
Developing countries are dependent on exports—the weakened demand in Europe is already felt. The banking sector is already seeing the impact of deleveraging in European banks, especially toward Eastern Europe. That is serious, but also there are the connections between European banks and Latin American banks that are different in nature but still bring risk.
There is a possibility that the uncertainty will take its toll everywhere in the world and there will be weaker demand in emerging markets that have until now been the drivers of economic growth. This worry is already being seen in India, Turkey, and Brazil but the risk of seeing this in more countries is real.
Dadush: Outside the eurozone, the underlying dynamics are actually quite positive. The U.S. economy is on a recovery path with reassuring recent data. And the emerging markets were going to slow down simply because they were overheating and facing inflationary pressures and they need to tighten policy, but the emerging markets could have stayed on a strong, sustained expansion.
The European crisis directly relates to the inner workings of its monetary union and the problems that have built up over the past decade. This is the principal cause of the current uncertainties. And it is no simple matter as the eurozone is the largest bloc in the economic world.
What is the biggest global economic concern today?
Timmer: I disagree. The economic crisis is not necessarily a very specific shock coming out of Europe that is directly related to a malfunctioning of the European system. One could even argue that the current economic crisis has little to do with the euro.
We are in the midst of a serious financial crisis that could’ve existed with or without the euro. It is a reflection of the structural problems in high-income countries. For a long time the underlying growth rates have been very modest and the boom periods that come from time to time are more bubbles than real growth based on competitive economies. And the bubbles can’t last, and we see the consequences of this in Europe.
Imagining a world without a euro, crises can still occur and have occurred in the past. What we are seeing is the consequence of over-borrowing, underpricing risk, and the follow up of the huge financial crisis that we went through only a couple of years ago.
With this in mind, the biggest global economic concern today is the health of financial institutions. The health of the banking sector is incredibly difficult to control given the global nature of the sector and huge size of institutions. And we all know that the consequences for the real economy are enormous.
We don’t have the oversight and institutions to respond to these problems and to a certain extent we’ve made it worse over the last decade. Governments, to some degree, have reinforced the problem and are not strong enough to react, especially in Europe. This is a sign that there is not enough Europe, instead of a sign that there is too much Europe.
Dadush: There is a lot more going on than the euro, of course, but the big difference now versus ten years ago is that major European countries at risk had more instruments at their disposal. They could devalue their currency and print money. These were important safety valves that countries in the eurozone no longer enjoy—and this greatly exacerbates the worries in the markets.
So while the problem runs deeper than the euro, the inadequate institutional set up of the European Monetary Union greatly complicates matters.
Timmer: I don’t buy the argument that there wouldn’t have been a problem if European countries had flexible exchange rates and I also don’t buy the argument that a flexible exchange rate is needed to accommodate the structural differences across European countries. I agree more with the thinking that many of the countries were too small or the economies were too integrated to have independent currencies and monetary policies.
This would have been messy anyhow. The real problem is not that the countries don’t have the tools to react, but what happened in the boom period that led to this crisis. For all kinds of reasons, there was over-borrowing and an underpricing of risk. We are seeing the nasty consequences today.
How important was the latest deal at the European leaders summit on the eurozone?
Dadush: It was an important summit, but it was just a step in a multi-year process of redressing the situation. Under any scenario this is not a decisive moment in the crisis. Despite the agreements to tighten fiscal discipline and seek treaty change to cede some sovereignty over fiscal policies, there were three key things that were missing from the latest deal.
First, the European Central Bank has not committed explicitly or implicitly to providing a backstop for the long term. Second, while governments agreed to raise up to $270 billion for the International Monetary Fund to aid indebted countries, this is not enough money for an important, durable solution—or the so-called bazooka that people are looking for. And third, there is no clear path toward fiscal integration and eurobonds that could ultimately resolve the crisis. This is left as a distant possibility with Germany and France at this point dead-set against it.
So the deal reached at the European summit is only a step and leaves many questions unanswered. Much of the burden of the readjustment over the long term is on the countries in trouble. There continues to be a very serious question about their political capacity to follow through with what promises to be many more years of austerity and falling incomes.
Timmer: While it moves Europe in the right direction, the latest agreements won’t solve the problems. The deal for greater fiscal discipline will help provide political cover to governments implementing steps—this is important. But what I find best about this effort is the move to revise the treaty to further centralize policies. For that some autonomy needs to be given up.
The move to a more centralized Europe is the right solution. There are people who say that this is not the issue and won’t calm the markets, but this is actually extremely important. Europe can’t wait to show where it is headed.
Europe is at a fork in the road and can either go for more centralization or fragmentation. There are pros and cons to both, but I think it’s helpful that Europe is choosing the path to greater centralization.
Is Europe doing enough to fix the crisis and save the euro?
Dadush: European leaders are not doing enough. While they have come a long way and now understand the full gravity of the situation—something that didn’t exist even six months ago—the German and French approach is far too demanding on peripheral countries and doesn’t offer enough support.
To give more support to countries at the heart of the crisis, Europe could undertake more expansionary policies with the European Central Bank. Europe could also put more money into the European Financial Stability Facility and push much harder for a larger IMF package that would need support from the United States, China, and others. And debt restructuring is another possibility that has been explicitly ruled out at this stage.
Expansionary policy and a bigger bazooka would help facilitate the very difficult adjustment in the troubled economies. People who think that the periphery is not adjusting painfully are simply not looking at the data. These countries are going through some of the worst downturns in history. These are painful processes that need and deserve more support.
How badly would a collapse of the euro hurt the United States? Is there anything that Washington can do to help Europe?
Dadush: When the United States says that this is Europe’s problem to deal with and Europe is rich, it should bear in mind that a collapse of the euro would be disastrous for the United States. It should also bear in mind the magnitude of the suffering in the European periphery.
It is true that Washington hasn’t even begun to scratch the surface of the fiscal problems in the United States, but it can and should still help. Unfortunately, the United States has told its traditional European allies that it won’t help with the crisis beyond the federal reserve bank providing some swap lines.
But the euro crisis is a global problem. It is a European problem and it is an American problem. The United States will ultimately pay for the euro crisis—the question is only how it will pay. There are two options. It will either take out relatively cheap insurance through an expansion of the IMF that is needed anyway or it will pay in a terrible world recession. Washington can’t stand on the sidelines.
What effect does the euro crisis have on emerging economies and the global economy?
Timmer: There are three transmission mechanisms that make this a global phenomenon. First is the trade channel. We live in an integrated world and increasingly everyone is trading with everyone else. This network effect was seen after the earthquake and tsunami in Japan earlier this year when for a few months there were sharp declines in industrial production in every corner of the world.
For developing countries this is not the most important channel anymore given the increase in trade among themselves and the importance of their own domestic demand and productivity. Developing countries are increasingly the driver of the global cycle, so what is happening in their own economies is more important than what the American consumer is doing.
The second channel is financial. There is a reversal of capital flows and this can immediately cause problems in economies that are running current account deficits. This can instantly slow down an economy if there are not quick domestic responses to compensate for the financial capital.
Still, unlike in the past, developing countries are not dependent on the capital flows and there are not that many countries running large deficits. The situation in Asia reversed after the Asian financial crisis in the 1990s and Latin American countries are much more prudent. Brazil and Turkey are running significant current account deficits, but those are more exceptions than the rule.
The most important channel is that the world is becoming more integrated in economic behavior. Investment decisions and even consumption decisions are linked. Household purchases depend on global economic news, expectations, and uncertainty.
It is often not a question of whether to buy or not, but whether to postpone or not. If more and more of these decisions are being postponed, then there is a downward cycle. This helps explain the extraordinary collapse in trade and production in only a few months’ time during the global crisis a few years ago.
When we look at the data, the situation has gotten worse since August, partially because the financial contagion can now be clearly seen.
Dadush: The European problem will be significantly augmented with the flow of money to the safe haven, which remains the United States. Emerging markets are still viewed as relatively risky investments, whether this assessment is true or not. But the U.S. outlook is extremely uncertain given its fiscal situation and the sense that it is not taking tough decisions. At some point there will likely be increases in taxes and cutbacks in spending that will cut growth. But when that will happen remains unclear because Washington is so politically divided.
The emerging markets are expected to suffer disproportionally through the safe haven effect and also through additional uncertainty generated in the United States and Europe.
What’s at stake is broader than the short-term economic outlook. A situation where Europe is unraveling, the United States is indecisive, and Japan is facing major long-term problems, calls into question the belief system and power system that has driven the global economy for the last fifty or sixty years.
How this translates into geopolitical issues is anyone’s guess. But I consider the phone call that French President Nicolas Sarkozy made to Chinese President Hu Jintao in October seeking financial support a historic event. When Europe was in trouble it didn’t call the United States, it called China. That is a very different world than the one we’re used to.
There is no clear leadership in the global economic architecture. This is seen in global trade talks, the inability to raise more money for the IMF, climate change policies, and international aid. No one is capable of taking the role America has filled for decades.
But to fix the problems requires global economic cooperation, so the United States still needs to play a more prominent role. It needs to develop a more cohesive view of what it wants and fix its own problems. The Cold War was a sad and dangerous episode, but at least it gave the United States direction. U.S. international economic policy is now lacking focus and this must change.
What lessons can policymakers take from the crisis?
Timmer: One lesson is the realization that the world has changed with the deep crisis in the advanced countries and everyone has to adapt to that. These are the kind of crises that really reshape the world—the global economy will never be the same again. The economic relationships have changed. That was a gradual process, but the crisis really brings the point home and accelerates the transformation.
This change has consequences. Businesses and policymakers will need some time to adjust to this. In the coming years, the main question for leading companies in high-income countries will be how to compete with globalizing companies from emerging markets.
Emerging countries will need to find their voice and play a more assertive role. They have always been in the position to react to proposals, but they will increasingly need to come up with global solutions themselves.
There is still a reluctance to fully accept the fact that the world is bigger now and there are more seats needed at the table of global governance. It is healthy that emerging markets have increasing influence and global governing bodies should change to reflect this.
The second lesson is that there are enormous vulnerabilities in the integrated financial system and the world lacks the governing system to keep this under control. Ultimately this is an example where institutions are running far behind the actual economy. They need to catch up. We need better global governance and Europe is the perfect example.
Instead of pulling back and thinking that governments need to leave it to the markets, the solution is to fix the governance issues.
And finally, high-income countries are in envy of the success of emerging markets and they try to understand what makes them so successful. Part of that success is just that developing countries are catching up, but part of it is also that there is better focus on long-term strategies in emerging economies. This is something that is missing in high-income countries today.
Dadush: We have confirmed that fiscal stimulus and monetary stimulus are needed in times of crisis. By acting promptly and avoiding protectionism stimulus helped the world to avoid a depression a few years ago. But we have also learned that once you have the fiscal stimulus, withdrawing the fiscal stimulus is very hard.
Fiscal stimulus is meant to be timely, temporary, and targeted. This means it’s easier to have automatic stabilizers or enough safety nets built into the system. When the economy slows this kind of spending increases automatically, and when economic growth accelerates again there is a gradual withdrawal. Unfortunately, this is not the case in the United States—all of the decisions are held hostage to the politics of the day.
Finally, in my view the crisis has confirmed the importance of flexible exchange rates. The European crisis has shown that if countries are going to fix their exchange rates they need to do many other things to support the system.
Is there a positive economic story that is going unnoticed amid the crisis?
Timmer: Africa. The continent can be the surprise of the next twenty years. Africa is on the mend and in many countries there have been dramatic changes in policies. This goes largely unnoticed because the problems are so huge.
But the consistent high growth rates over the last ten years show that countries have undertaken significant reforms. Africa will be able to catch up by creating the right environments. There is a huge opportunity in Africa with enormous global demand for commodities and the private sector can thrive in reformed economies.
