Tuesday, June 22, 2010

Two Sceptical Officials

I recently attended speeches from both Christian Noyer, the Governor of the Bank of France and Angel Gurria, the Secretary-General of the OECD. Both were very candid about the economic situation in Europe and laid out the conditions for growth friendly policies to work. They both said that unless a serious "fiscal consolidation" effort was credibly put in place, any additional stimulus would be be wasted.Here are my notes from the speeches:

Christian Noyer,
Governor of the Bank of France

The Governor certainly showed that he understands the dynamics of what is happening now. After the typical warning that his words could not be interpreted in any ways as an indication on the next move by the European Central Bank, he was quick to ask the right question: in the face of persistent global imbalances, can Europe’s fragile recovery be sustained? He answered yes if it is accompanied by structural reforms. The Greek crisis illustrates the risk associated with postponing adjustments as well as the political difficulties that governments have in adopting austerity measures and their limited capacity of implementing cooperative solutions to address such issue.

What is needed, according to Christian Noyer, is to send clear signals of budget cuts without compromising growth. This is the essence of the fiscal consolidation story. The central banker is lucky in the sense he does not have to implement this policy. Once stability is back, it is the government’s role to restore credibility by convincing investors that they deserve their confidence. The wish list of the Central Banker is quite long: improving the flexibility of the labour market, bringing regulation reforms to the goods and services markets, stimulating innovation by adopting structural measures. In theory there are not obstacles to growth if we do all the right things.

Angel Gurria (pictured above),
Secretary-General of the OECD

The OECD Secretary General went even further than the Governor. The world is growing at 3 speeds: Europe is stagnant, North America is OK and emerging economies are still on fast track. Because of growing fiscal imbalances in developed countries, these nations are going to have to pull their biggest balancing act in a long time. The story has to be one where industrialised nations will convince the public of the necessity of a belt tightening exercise by increasing the fear and the danger of not doing anything. It is a legitimate strategy because the danger is real. Otherwise, markets will create rampage and dictate the rules in a disorderly manner. Take the case of Spain. It had five years of surplus but we are now putting it in the same basket as Greece. There is a real danger that if we let financial markets dictate the pace of reforms we will be in real trouble.

Growth friendly policy is the new catchy phrase. A new balance has emerged:Keep the stimulus, keep zero interest rates for a while but also make sure that you sent clear signals about "fiscal consolidation". Don't start cutting government deficits now but don't start spending before you come up with specific announcements about what you intend to do to in order to reign in futures expenses with specific deadlines and measures. Are there some exceptions to this? Yes, because it is already too late for some countries like Greece.

Growth will not happen without fiscal adjustments or consolidation. We will need to put fiscal rules in place first. Exchange rate adjustments should come in second. And structural adjustments and reforms should complement these measures (competition, education, R&D, more flexible markets, more flexible labour markets, etc.)

Should we bail out Greece? It's too late to ask this question, we already did. We can do a lot of things with the $ 110 billion that we provided to Greece, a relatively small country. Now we have time to restructure the debt and implement the needed reforms.

But Greece is not really the problem; the question of Europe's fiscal outlook is the issue. Europe put $ 1 trillion to address the problem and it's not working. Fiscal consolidation needs to be articulated through fiscal rules in order to be made credible.

Hungary was an unfortunate translation problem. But it underscores the problem of lack of credibility that Europe has: Everyone is asking: "Can these people put something together and get something done?"

We were first worried about financial instability. We took care of that with the G-20. The new debate is very different from what it was a year ago. Now it is about coming up with a credible fiscal consolidation strategy with clear fiscal rules.

How do we do this?

First, we need to finish cleaning the banks balance sheets (we have barely started to address this issue as a lot of write downs still have to be taken before we are done). Second, we need to create the proper regulatory environment (this is still under heavy discussion) for credit to grow. For now, we don't know if there really is a credit crunch because the demand for credit is still very weak. But it is going to be interesting when demand comes back and picks up some momentum. We will have to have the framework to make it work. But we don't yet have a consensus on what we should do. Tax the banks, tax their capital, tax their loan portfolio, tax assets, tax profits, etc. How should we regulate? It is still very much in the making.

But we won't be able to address the issues and come up with a credible fiscal consolidation strategy if we don't address the roots of the problem. The problem is that there was a major failure in governance: Failure of the regulators, failure of corporate governance and failure in risk management. We will need to solve these issues. These imbalances ultimately occurred because of these failures and they are going to remain (in fact in the short run the imbalances are all worse than they were at the beginning of the crisis) until we solve the governance issue.

A word on Canada: Canada has to remain aware that there is a problem out there. Also the good times in Canada may be hiding deeper structural issues. Canada started off in a better position. Maybe Canada does not need a fiscal rule because it has credibility after 10 years of surplus. Yet, even the most credible countries are putting fiscal rules in place. This will be a credibility game.


Now this is me, Luc, talking. It certainly sounds that entrenched interests or insiders were able to grab some of the political power, influence regulators and then gradually rigged the initially levelled playing field in their favour. This led to the build up over a few years of greater and greater imbalances which were able to grow unchecked precisely because of the influence insiders had on the policy-makers who designed the economic and financial system and on the regulators who were supposed to be supervising their activities. Obviously, the benefits of these imbalances fell mostly on the insiders whereas most of their potential, yet unavoidable eventual negative consequences fell on us, the taxpayers.

When Angel Gurria talked about a failure of governance that's what he meant.We did not remain alert enough to the potential failures of the system. Not necessarily that policy-makers and regulators “were in on it” but that we all drank the insiders’ kool-aid about how little risk was falling on us while insiders were drawing huge benefits from the system. When the system imploded, it was too late. The privatisation of the gains had taken place and the socialisation of the losses ensued to prevent the entire economy from collapsing. That it could happen as a result of letting the power of insiders grow without checks and balances should have been a history lesson. We might be somewhat responsible for forgetting it but this should not be preventing us from taking the proper measures to ensure it does not happen again.

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