The Risk Tsunami

NEW YORK – It is time for the G-20 to take seriously its mandate to agree on steps to stabilize the global economy and launch it on a more sustainable pattern of growth. Instead, the G-20 is behaving like a debating society, with the cooperative approach that it fostered at the outset of the crisis devolving into an array of often-heedless unilateral actions by its members. Yet there are several significant risks to global economic stability and prosperity that must be addressed urgently. Ireland has thrown Europe into its second sovereign-debt crisis this year, and capital markets have become schizophrenic, with investment rushing back and forth across the Atlantic in response to contagion risk in Europe and quantitative easing in the United States. Meanwhile, capital is flooding into the higher-interest-rate emerging markets, causing inflationary pressures, driving up asset prices, and subjecting currencies to competitiveness-threatening appreciation – in short, distortions and policy headaches that require unconventional, defensive responses. Growth and employment forecasts in the advanced countries have been reduced – a delayed recognition of the reality of an extended and difficult recovery and a new post-crisis “normal.” With lower and more realistic growth forecasts, fiscal deficits in the short to medium term are viewed as more dangerous. In the US, a subset of policymakers believes that weakening growth and high unemployment require a policy response. With a cyclical mindset and fiscal space exhausted, a new round of quantitative easing (QE2) might be defended as a strategy for mitigating the tail risk of another downturn in asset markets (mainly housing) and households’ balance sheets – and with it the possibility of a deflationary dynamic. Worryingly, QE2 appears to be viewed in the US as a growth strategy, which it isn’t, unless one believes that low interest rates will reverse the private-sector deleveraging process, raise consumption, and lower savings – neither a likely nor a desirable scenario. It also assumes that addressing structural constraints on competitiveness can be deferred – perhaps permanently. The view from outside the US is that QE2 is either a mistake with negative external effects, or a policy with the clear but unannounced intention of devaluing the dollar – a move whose main negative competitive and growth effects would most likely be felt in Europe, not in China, India, and Brazil. Unilateral action in this and other dimensions has undercut the G-20’s mission of identifying and implementing mutually beneficial policies in a coordinated way. A minimal requirement for G-20 progress is that policies in emerging and advanced countries that have significant external effects are discussed and, if possible, agreed upon in advance. Apart from the need to deleverage for a few more years, the US economy faces longer-term problems with aggregate demand, employment, and income distribution that cannot be solved through consumption and investment alone. America needs to expand its share in external global demand, which requires public-sector investment, structural change, and improved competitiveness in the tradable sector. Meanwhile, Europe struggles to find a solution to its deficit and debt problems by treating them with short-term liquidity fixes whose purpose is to buy time for fiscal consolidation and, in the absence of the exchange-rate mechanism, some kind of deflationary process to restore external competitiveness. Success is by no means assured, and the most likely outcome is a sequence of contagion events and a broader loss of confidence in the euro. The core issue is burden-sharing across bondholders, citizens of the deficit countries, the EU, and, indeed, the rest of the world (via the International Monetary Fund). The emerging-market economies are at risk as a result. They can sustain relatively high growth rates in the face of weak and lengthy recoveries in the advanced countries, but not if there is a major downturn in North America or Europe (or both), a serious outbreak of protectionism, or instability in global financial markets. The major emerging economies also have growing systemic effects on growth and employment across a broad range of countries, including the advanced ones. They must understand this. The old asymmetries are fading away, and there are new distributional challenges at the core of global economy-policy coordination. For most of the postwar period, advanced countries grew by expanding the knowledge and technology base of their economies. In a rapidly opening global economy, emerging economies learned to access both technology and markets, thereby growing at unprecedented and accelerating rates.As global economic activity shifted and the structure of all economies evolved with it, the distributional effects were overwhelmingly benign. But that was not inevitable. It came out that way because, for most of the period, the advanced countries benefited from market-driven innovation, while the emerging economies imported knowledge, exported goods and services, and had limited systemic impact on advanced economies. That pattern is changing. Emerging economies’ scale is growing, and their positioning on the global value chain is shifting rapidly. Surveys of attitudes toward the evolving global economic system show a widening divergence among countries as well as subgroups within countries. These almost certainly reflect divergences in terms of that system’s distributional impacts. Guiding global interdependence in a way that ameliorates negative distributional trends is possible, but it will require wisdom and insight. That challenge must be at the core of the G-20’s mission. To put it differently, recognizing our collective interest in the openness of the global economy is not sufficient. We need a pragmatic willingness to adapt incentives and outcomes to achieve distributional results that allow the major players, with their domestic political constraints, to keep the system open. The alternative will be unilateral measures aimed at achieving the same goals, but leading to outcomes that leave everyone worse off. Michael Spence is Professor of Economics, Stern School of Business, New York University, and Senior Fellow, the Hoover Institution, Stanford University.