In the Wake of the Crisis - Foreign & Security Policy

Macroeconomic Dilemmas and Financial Regulation Challenges for Europe, America and the World

On December 1, the Brookings Center on the United States and Europe and the Heinrich Böll Foundation North America gathered some 30 economists, experts and analysts from both sides of the Atlantic for a closed-door workshop on the challenges confronting Europe and America in the wake of the global economic crisis. Organized in partnership with the Global Economy and Development and Economic Studies programs at Brookings, the day-long workshop also benefitted from the cooperation of the Embassy of Greece in Washington and the Stavros Niarchos Foundation.

During the opening workshop session, participants assessed the competing pressures to stimulate the economy and ensure fiscal sustainability in the long term. The second panel took into consideration the regulatory reform measures that the United States and the EU have started to enact in order to address the core financial problems that led to the crisis. To encourage frank and open discussion, the sessions were held under the Chatham House Rule. However, the four working papers which served to introduce the debates are accessible on this page. Some of the most salient points of the debates are also summarized below.

Event description and download materials courtesy of Brookings

Agenda

Session 1 - Getting out of the downturn while ensuring the future: United States and European macroeconomic dilemmas

Carlo Cottarrelli (IMF): Supporting the Global Recovery While Ensuring Fiscal Solvency: A Delicate Balancing Act (6 pages, pdf, 144KB)
Donald Kohn (Brookings): Getting out of the Downturn While Ensuring the Future - the U.S. Situation (7 pages, pdf, 53KB)

Session 2 - Enough to prevent the next crisis? An assessment of the state of financial regulation reform in Europe and the U.S.

Douglas Elliott (Brookings): Some Thoughts on US Financial Reforms (7 pages, pdf, 79KB)
Nicolas Véron (Bruegel/ PIIE): Some Thoughts on EU Financial Reforms (6 pages, pdf, 70KB)

America and Europe in the Ditch: How Similar Macroeconomic Dilemmas Create Convergent Global Interests

A Summary of some of the points made during the conference

The macroeconomic pressures resulting from the most acute crisis of the last decades have left the United States and Europe contemplating roughly similar policy dilemmas. Long term fiscal challenges in particular will drain substantial resources away from growth enhancing policies, which will jeopardize the economic perspectives in both areas. Fiscal positions, considering the status of the real economy, have not been so bad since the 1930s. The interesting and somehow surprising political implication is that for all their divergent views, a long term strategy of fiscal containment, inevitable in both areas, should drive Europe and America towards joint action at the global governance level, to solicit the emerging economies to support the world’s economic activity. The question, of course, is whether the Transatlantic partners will obtain sufficient demand to alleviate their predicament.

This question was among the many points discussed in the course of the Brookings Transatlantic seminar entitled "In the Wake of the Crisis". The seminar addressed the main consequences of the financial turmoil not only in the degraded fiscal position of the United States and Europe, but also in the difficult process of coordinating financial reforms and financial regulation.

Until the summer of 2010, the European and American positions were considered quite distant from one another. The United States seemed reluctant to withdraw stimulus-oriented fiscal policies, while Europe was urging an exit from fiscal largesse. In due time, in both the United States and Europe, worries about fiscal sustainability have come to gain priority. A general agreement has emerged about the necessity to dispose of a medium-term fiscal framework granting stability to governments’ public accounts and anchoring fiscal credibility even for those countries that for different reasons need to exploit further margins of tax reductions or public expenditures.

Unfortunately, no such medium term framework seems available yet. In advanced economies, while public debt has reached disturbingly high levels, most governments have announced plans for adjustments extending only over the next few years. The weak U.S. economy and the outbreak of the debt-crisis in the euro area have deterred most countries from announcing longer term fiscal strategies. Aside from Greece and Ireland, whose policies are now dictated by international agreements, structural reforms affecting fiscal balances have been held back in most of the euro area, and only France enacted a pension reform after the crisis. No European country is tackling the worrisome looming deficits of health systems burdened by rapidly aging populations. In the United States, where the fiscal balance deteriorated even more than in Europe over the 2007-2011 period, political commitment toward consolidation seems weaker while the net fiscal effect of the 2010 healthcare reform remains disputed.

In these conditions, should the fiscal tightening begin right away, in 2011? A proposed criterion for answering this question is to assess the size of the output gap (the shortfall between current output and its potential level) in each economy. Countries suffering from market pressures like Greece, Ireland, Portugal Spain, Italy or the UK, should ensure that fiscal restraint remains credible, while other countries like the United States, Japan or Germany should start tightening now– even though not by the same degree as the others. The case of the United States, however, is a matter of debate, as some observers – most of them in America, not in Europe – think that there is no way to liken the US fiscal credibility to that of any other country. With a Central bank that can simply print dollars and monetize public debt, the United States is in a different position, they argue, than any other country whose currency is not at the same time a national currency and a reserve currency. Therefore, the cost-benefit analysis of increasing public debt in the United States should take into account a much lower cost than in the European balance.

Some Europeans tend to dispute this view, asserting that a loss of credibility is always possible – even for the dollar. The possibility to depreciate one's currency may even become a source of instability in an environment of very nervous financial investors and of frequent market overshooting. Greece itself revealed the extremes of market reaction: the spread between Greek and German interest rates widened from 100 basis points to 1000, in only a matter of months.

Still, when addressing future public debt trajectory, Americans focus more on supporting growth than on keeping deficits under control. But concerns about future tax levels and spending are creating uncertainty for economic investors and this could affect growth significantly. Furthermore, when dealing with growth-friendly policies, attention must be paid to the composition or "quality" of the stimulating policies – which public expenditures are cut and by how much, or which tax is raised and by what rate. Indeed, it seems encouraging that in the current policy debate, a number of suggestions regarding fiscal reforms put the accent primarily on the issue of broadening the tax base, therefore creating scope for lowering the marginal taxes. While a focus on public policies brings into account the need for Europe to reduce the burden of regulation, it emphasizes for the U.S. the need to support investments. There seems to be no doubt that the U.S. has to rely less on consumption, residential spending and financial innovation and more on competitive production in investment goods that can enhance the American export capacity.

In both the United States and the EU, fiscal policy adjustments should therefore remain growth friendly while avoiding distortions. But the net contractionary effect of fiscal retrenchment leaves unanswered the question of where global demand will come from. Indeed the experience of the fiscal crisis is likely to leave most European countries inclined to avoid current account deficits, exactly as the Asian countries did in the aftermath of the Asian crisis, and try instead to accumulate current account surpluses. The objective is to reduce their capital dependence on the rest of the world and the drawbacks of an abrupt change in market assessment of risk aversion. But since the U.S. itself is projecting a transformation of its economic model towards an export-driven economy, and for at least the years required to achieve the deleveraging process, the EU and U.S. economies will indeed need the rapidly developing emerging economies to support their domestic demand.

Considering emerging economies to be a homogeneous group is misleading, however. Currently not only India, but also Turkey, bear substantial deficits on their balance of payments. Therefore the attention of the EU and the United States is expected to turn primarily towards China. It is very likely that the common interest of the new—though perhaps unintentional—U.S.-EU convergent strategy will be to induce China to strengthen its domestic demand and to support the global demand through an increase in its domestic consumption. This could happen primarily through a reinforcement of China’s social safety network. By spending an additional 1% of its GDP on healthcare and pension provisions, via additional deficit, it is calculated that China would increase domestic consumption by 1.5%.

In this perspective, an alignment of American and European interests seems within reach and even likely. But, in order to reinforce each other’s strategy, the current rhetoric on both sides of the Atlantic must change and abandon a frequent populist streak that has marred bilateral economic relations. There are indeed divergent tones in the assessment of many common economic problems, including the size of output gap; the effects of fiscal policy on economic growth; the nature of the incentives needed to foster investments; the perception of the U.S. default risk; and the credibility of national or supranational fiscal institution. But what seems to be creating more hurdles is the deterioration of bilateral communication on economic policy issues. In this regard, the margin for improvement is huge and likely to be exploited in the next years.

Financial regulation reform

One of the most important test cases of Transatlantic cooperation concerns financial regulation. Structural differences between Europe and America have led to insufficient coordination of banking regulations, and even in banking, a traditional transatlantic industry, multipolarity is the new name of the game. United States and EU regulations should not refrain from considering emerging financial markets as strong actors and real competitors. The new composite reality of global markets suggests the need to distinguish between what really needs to be globally regulated and what does not need strict convergence or harmonization. Therefore the drive to heterogeneity— and maybe to reduced ambitions—in regulation remains most likely.

In fact, little by little, the sense of urgency derived from the crisis and the need to get back to normalcy have weakened the appetite for radical reform. Increasingly, signs of regulatory capture are in the air, whereby national authorities are inclined to protect, rather than to discipline, the industries they supervise. This is a further reason why interdependence of different regulations should be considered a valuable form of checks and balances against national regulatory captures. In the United States, a vast reform was approved, but less has been done about regulatory reform than about the private sector. In Europe, a sense of financial protectionism is lingering after the banking systems have proven to be both the epicenter and the weak spot of the current debt crisis.

What seems to keep Europe behind the curve in financial regulation overhaul is the lack of an available narrative to drive the vision of comprehensive reform. During the era of deregulation, a strong narrative was available —that of the Single Market, which was consistent with the idea of economic and political integration. But once achieved, the same narrative seems less convincing in an age of re-regulation. On the other hand, historically European “negative integration”, i.e. the abatement of national regulatory barriers, has been easier than “positive integration”, i.e. focus on new shared objectives and the national legislation or institutions instrumental to achieve them. Still the financial crisis should continue to stimulate new legislation, for instance on the size of financial firms, and the process in Brussels is ongoing and in some aspect even promising. Eventually the EU and U.S. visions will need to be reconciled with the work of the Financial Stability Board and the IMF that was instrumental in shaping a global vision, but which is now facing the challenge of translating their background work into shared and effective legislation.

Global financial regulation will be a crucial test-case for the lessons of the crisis, and Europe and the U.S., where the crisis originated, should demonstrate their determination to avoid similar occurrences in the future by leading supranational coordination.

A revealing aspect of the enduring consequences of the crisis, and of the national interests affected by new regulatory interventions, is that new legislations are favoring financial investments in sovereign bonds instead of other financial assets. The issue is being raised in the EU as well as in the U.S. by new pieces of legislation (insurance industry solvency, new rating criteria and others) that provide incentives for financial firms investing in sovereign bonds. Paradoxically, this will reduce the policy strains of financing public debts by strengthening the connections between financial and sovereign risks that were a hallmark of the global crisis, and not only in Europe.  It will also prove once more the delicate equilibrium between politics and finance, in a world that seems condemned to face a future with increasing public debts.