As governments in the western world strive to revive their recession-hit economies, a new danger has emerged. Earlier massive stimulus packages have induced unsustainable budget deficits that are forcing fiscal belt-tightening in relatively stronger countries such as the US, Germany and Britain, despite continued high levels of unemployment. At the same time, weaker countries such as Greece, Portugal, Ireland and Spain face acute financial distress, requiring massive new bailout packages from their European partners who have limited fiscal space for manoeuvre. In May this year, the EU and IMF had to put in place a €750 billion bailout package for Greece. In November, the Irish government was forced to seek an emergency rescue package of about €85 billion. Spain, whose budget deficit as a percentage of its GDP had reached 11 per cent last year, may be the next in line to sound the alarm. The way this latest crisis is addressed will shape the new global financial architecture.
Europe faces a dilemma. Financially stressed countries such as Spain, bereft of their national currencies after adopting the Euro, do not have the option of achieving export competitiveness (and thereby pulling out of recession) through an exchange rate devaluation. They also find it difficult to achieve export competitiveness through domestic wage cuts and industrial layoffs. That is why it is time to think the unthinkable: Can an institutional framework be put into place to enable orderly sovereign defaults?
The current crisis requires new rules for empowering supranational organisations to oversee and facilitate sovereign debt restructuring and orderly, time-bound settlement of creditors’ claims.
An agenda for action is needed to develop a new regulatory institutional mechanism to avoid future financial shocks and reduce the danger of another recession. Some elements of this agenda are as follows:
1. A global institutional mechanism needs to be put into place to manage debt restructuring of countries on the verge of default. The framing of the rules and procedures for such a mechanism requires the participation of not just the US and Europe but also new economic power centres such as China and South Asia.
2. Leaders across the world need to unite against unilateral actions such as competitive devaluations and protectionist measures that could push the world into a deeper recession.
3. The recent massive stimulus packages have increased fiscal deficits in Europe fourfold, to an average of nine per cent of GDP. Similarly, public debt has reached unsustainable levels in rich countries, increasing from 80 per cent of GDP to almost 100 per cent of GDP in two years. The IMF estimates that it will increase further to 120 per cent by 2015. The problem of supporting failing banks and financially distressed countries has to be put into the context of a new global debt restructuring mechanism. At the same time, the composition of public expenditure needs to be changed towards generating revenue streams for the government in the future.
4. The erroneous belief that markets are self-regulating and always deliver efficient outcomes needs to be put to rest. The very nature of individual risk and the asymmetric information with respect to sellers and buyers of financial products in global markets create a systemic risk of market failure. (See my article on these pages on November 30). The aim of the new financial institutional framework should be to provide strong disincentives to individuals and firms to being carried away by escalating speculative risk. These new rules should ensure that finance serves its primary goals: allocate savings to high return projects and enhance the sharing of risk to avoid crises.
Published in The Express Tribune, December 7th, 2010.
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