Recovery, Interrupted

NEW YORK – Since the 2008-2009 slump lifted in mid-2009 – and especially following the exposure of the massive public-debt problems in Greece, Ireland, and elsewhere in Europe – most G-7 governments have reversed their earlier counter-recessionary positions.

NEW YORK – Since the 2008-2009 slump lifted in mid-2009 – and especially following the exposure of the massive public-debt problems in Greece, Ireland, and elsewhere in Europe – most G-7 governments have reversed their earlier counter-recessionary positions.

With the important exception of the United States, G-7 leaders have been pushing since mid-2010 for urgent fiscal consolidation, effectively overturning their earlier recovery efforts, and urging austerity measures to balance their budgets, despite the weakness, unevenness, and uncertainty of the economic upturn.

Austerity-based fiscal consolidation is likely to fail, because sustainable public budgets are best achieved on the basis of strong economic growth. Indeed, the logic of fiscal consolidation requires those economies that have recovered strongly to phase out their recovery efforts, while those that have not continue such efforts.

The virtual abandonment of recovery efforts in most developed economies presumes that stronger Asian economic growth outside Japan can lift the world economy from its current trajectory.

However, even continued strong performance by Asia’s emerging markets is unlikely to be enough to secure a strong global recovery. In fact, the likely renewed slowdowns in the G-7 economies will jeopardize growth in emerging markets as well. This prospect has been ignored, despite warnings by the International Monetary Fund, the United Nations, and others.

Moreover, the shift from recovery efforts to fiscal consolidation and, more recently, to current-account rebalancing, has undermined the initial G-20-led coordinated recovery efforts. Instead, finger-pointing grew more widespread in 2010, impeding policy coordination and cooperation – the very sources of the G-20’s earlier success.

The outcome of early November’s US mid-term elections has effectively denied the Obama administration the option of fiscal expansion. Instead, the US Federal Reserve has turned to a second round of “quantitative easing.” QE2 does not really create new money; that will happen only if the banks lend, which they have not been doing so far. Rather, it will increase banks’ excess-reserve balances.

Critics suggest that QE2 is really intended only to create inflationary expectations and thus encourage acquisition of more risky assets by reducing rates on Treasury bills with longer-term maturities (5-7 years and 7-10 years).

Many observers consider QE2 a blunt instrument that is unlikely to achieve its objectives, although it may weaken the dollar, which many think will redress recurrent US trade deficits. But critics argue that QE2 may instead merely encourage more private investors to hold emerging-market debt, which would have an impact on the currency, due to the price change, rather than on the quantity of money. Indeed, after an initial dip, the dollar started to strengthen again, later reinforced by the return of euro risk.

After making limited progress on encouraging faster renminbi appreciation, the US has tried to limit current-account surpluses, with China the main target. Understandably, China has resisted, probably mindful of the post-1985 yen appreciation’s association with the end of Japan’s four-decade-long post-war boom.

The UN and others have long drawn attention to global imbalances. However, these imbalances did not trigger the crisis alone, and reducing them certainly is not the most urgent priority, given the prospect of protracted stagnation in most of the G-7 and its likely adverse consequences for the world economy.

The US enjoys a privileged role in the international monetary system as issuer of the world’s de facto reserve currency. Hence, the US current-account deficit cannot be addressed without dealing with related problems: first, the lack of a proper international reserve-currency arrangement, and, second, the perceived need of emerging-market economies with liberalized capital accounts to accumulate reserves for protection against volatile capital flows.

These issues can be addressed only through systemic reform over the medium term, while the recovery effort should remain the global priority in the near term.
Meanwhile, agreeing on Basel 3 banking standards in just two years is commendable, especially as Basel 2 took a decade to negotiate.

However, Basel 3 only indirectly addresses the “shadow banking system,” despite its role in triggering the crisis and the future threats it poses for financial stability.

More worryingly, Basel 3 retains, if not deepens, biases in the Basel 2 rules against bank lending to developing countries, such as for trade finance.

With the G-7 struggling and emerging-market countries expected to support, if not lead, global recovery, that is an astonishingly short-sighted decision.

Jomo Kwame Sundaram is United Nations Assistant Secretary-General for Economic Development.

Copyright: Project Syndicate, 2010.


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