It is a pleasure and privilege for me to address you today here at the Peterson Institute. Over the past decades, this institute has been a sharp and critical, and as such, helpful, observer of European economies and economic policy. So I am delighted to discuss Europe's economic agenda with you today.
Many of Europe's problems are a manifestation of broader global challenges. By the same token, it is important for Americans to understand well what is going on in Europe, and perhaps some of our experiences are useful on this side of the Atlantic, too.
US reactions to Europe's sovereign debt crisis have typically expressed incomprehension. Against this background, I will outline my view of the crisis, and Europe's approach to coping with it.
2. The Debt Crisis and Fiscal Policy
The financial and economic crisis which started three years ago with the Lehman collapse has come to a new phase. The financial panic in the autumn of 2008 was contained by extraordinary fiscal and monetary policy measures: cutting interest rates to almost zero, pursuing massive fiscal expansion, and setting up unprecedented guarantee and recapitalization schemes for banks.
While a meltdown of the financial system was avoided, a major recession was not: GDP declined by 4.2 percent in the European Union, 2.7 percent in the United States, and 6.3 percent in Japan in 2009. Growth was dented even in China and other emerging economies.
Thanks to the strong global stimulus measures and the resilience of the emerging economies, growth resumed in 2009 and in 2010 the figures were well in the black again (European Union close to 2 percent, United States close to 3 percent, and Japan close to 4 percent).
Recently, however, growth has decelerated markedly in all these areas. While year-on-year growth of the EU economy will still reach 1.7 percent in 2011, growth is coming to a virtual standstill towards the end of the year. A significant slowdown is in the cards for the United States as well. While we do not forecast a recession or double dip for Europe, the change in the outlook is both disappointing and worrying, particularly given the current high level of unemployment.
Why is growth stalling? There is substantial historical evidence that recoveries from financial crises tend to be slow and bumpy, so in that sense we should not be surprised. But in order to understand the policy dilemmas and the somewhat different approaches taken on the two sides of the Atlantic, we need to be a bit more specific.
The run-up to the crisis was associated with a rapid build up of private debt both in the United States and Europe to finance consumption and real estate investments. In Europe, public debt remained rather stable as a share of GDP, as booming economies produced tax revenues to keep deficits low despite a secular increase in expenditures. In the United States, federal debt kept growing even in these good years. In many countries this borrowing spree led to large external (i.e., current account) deficits.
The bursting of the financial bubble revealed the shaky ground underlying economic growth—a foundation based on piling debt. The private sector was forced to increase savings tremendously to be able to service debt and to get it back to a sustainable level. And in doing so, it inevitably deepened the economic downturn.
Fiscal stimulus, and in several countries, bank support, has added substantially to public debt. As a result, gross general public debt will increase from about 60 percent of GDP in 2007 to 82 percent of GDP this year in the European Union, and from about 63 percent to 102 percent of GDP in the United States over the same period.
It is obviously necessary to put a stop to this accumulation of public debt. Therefore, the stimulus measures in both the United States and European Union were designed to be temporary. The effects of the measures are now fading. That, in combination with the continued deleveraging of the private sector is, to my understanding, the main reason for the slowdown of US growth.
In Europe, the scenery is more complicated. While the average debt level in Europe is lower than in the Unites States, some member states' public finances are in an unsustainable condition. That is why people are talking about a sovereign debt crisis in Europe.
Three member states (Greece, Ireland, and Portugal) have effectively lost access to the private debt markets and have to rely on conditional financial assistance from other European Union member states and the International Monetary Fund (IMF) to refinance maturing debt and existing deficits.
In Ireland, the assistance program has already stabilized the situation, and markets have reacted quite positively. I'm confident that the Irish are on their way to sustained recovery. Portugal, where the program has been in place for just a few months, is on track and making progress.
However, the situation in Greece is much more complex. Greece has not fully implemented the measures to strengthen public finances and to improve the economy's competitiveness, which the European Union and the IMF required as a condition for financial assistance in May 2010. Greece's growth performance has also been disappointing. Thus the deficit reduction is not proceeding as fast as projected earlier.
This has spooked the markets, leading to speculation about Greece's imminent default and/or exit from the euro area. These fears have also had an impact on other countries. Several countries' borrowing costs have increased. Given the tight links between the quality of sovereign credit and banking sector health, banks have been affected as well.
The intensification and broadening of the sovereign debt crisis has had a significant negative impact on business and consumer confidence. When you add to this the exit from fiscal stimulus and weakening export market growth, it is no wonder that growth is decelerating in Europe.
What is the right fiscal policy response to the slowdown? The EU position is clear. The slowdown is no excuse to stop putting our fiscal houses in order. That is necessary to restore confidence.
However, this basic orientation means different things for different EU member states. The EU/IMF program countries and those countries which face market pressures should continue to pursue their deficit targets. This is essential for them to regain and/or maintain access to market financing at tolerable costs.
At the other end of the spectrum, countries that have some fiscal space should allow automatic stabilizers to function to soften the blow of the contractionary impulses. But even these countries should pursue their medium-term fiscal objectives to achieve the agreed structural balance.
I know that there are some eminent economists who consider this orientation misguided and demand aggressive stimulus instead. My answer to this critique is that in some countries there is simply no room for maneuver: The sovereigns either do not have access to market financing or it is becoming prohibitively expensive.
Given the long-term pressures stemming from ageing populations, even most of the countries with good market access are well advised indeed to improve their structural balances.
When discussing the different policy approaches of the two sides of the Atlantic, it is important to note that the situation in the United States is different. First, as evidenced by bond yields, the United States continues to enjoy the trust of the markets, which is largely thanks to the dollar's position as the top international reserve currency. Second, the automatic stabilizers—including social safety nets—are much weaker in the United States, which is why more discretionary measures are needed for a given total fiscal policy impulse.
Nevertheless, in the United States, too, measures should be taken to improve the long-term sustainability of public finances. The stronger the action on this front, the less need there is for consolidation in the short term.
3. The European Crisis Response
Crisis management in the European Union may have given the impression of a rather belated, piecemeal and not well-communicated affair. I cannot deny that the decision-making process of 27 member states and 27 different election cycles is a complex structure. Still, I would argue that what we have achieved in managing the current crisis is significant, though by no means enough.
The immediate financial and fiscal actions to contain the fallout of the Lehman collapse were taken in Europe as swiftly, and in the same order of magnitude, as in the United States. With regards to addressing the buildup of public debt, the European Union has been very much a forerunner.
In recapitalizing the banking system, our efforts have been better than their reputation. The stress tests have led to a substantial raising of capital in a preemptive manner. The national governments have made clear commitments to provide financial backstops, if needed.
The most challenging area for us has been the handling of the sovereign debt crisis. But we still have been able to reach a number of important decisions to contain the crisis.
In May 2010, we set up, almost literally overnight, euro area financial stability mechanisms to provide temporary and conditional financial assistance to member states. This summer the EU leaders have taken important decisions to expand the capacity of the European Financial Stability Facility (EFSF) and make its intervention powers more flexible.
Meanwhile, the European Central Bank (ECB) has provided ample liquidity to the banking system and also intervened in the sovereign bond market to ensure the smooth functioning of the monetary policy transmission mechanism. A week ago, the ECB and two other European central banks agreed with the US Federal Reserve on measures to ensure dollar liquidity for European banks.
While the "fire fighting" has been going on almost without interruption for the past one and a half years, we have embarked on reforms which will contribute to financial stability over the longer term.
We have created three EU-level bodies to coordinate financial supervision of the member states and a separate body for macroprudential oversight as of the beginning of this year. Just two months ago the Commission made legislative proposals to implement—as the first jurisdiction to do so—the globally agreed Basel III recommendations for stronger bank capital standards.
4. What's Next—The Way Forward
But we are of course not out of the woods yet. The immediate challenge is to stabilize the situation in Greece. The euro area leaders decided on July 21st to approve a new assistance package for Greece.
The package involves more, longer, and cheaper financial assistance to Greece, and for the first time, voluntary rollover of private credits with a present value loss to the creditors. A condition for the new program is that Greece implements all the corrective measures required, without any wavering. In the past couple of weeks Greece has gone a long way toward meeting these demands, but we are not quite there yet.
In this context, it is important to underline that the European Union is not going to abandon Greece. An uncontrolled default or exit of Greece from the euro area would cause enormous economic and social damage, not only to Greece but to the European Union as a whole, and have serious spillovers to the world economy. We will not let this happen.
Second, the other decisions of July 21st must also be implemented without delay, especially the critical one to allow the financial backstop EFSF to function more effectively. This is indeed critical, as the reformed EFSF with its powers to intervene in secondary markets and provide precautionary credit lines will be key in containing contagion.
Third, the member states must continue the consistent implementation of fiscal consolidation. At the same time, they have to frontload growth-enhancing structural reforms much more widely than has been the case so far. This is a major challenge. Reforming labour markets, pension systems, health care, and education has been very difficult in many European countries. But the harsher budgetary realities and unrelenting global competition will not leave any choice if Europe wants to be competitive and create jobs.
Fourth, the G-20 must step up efforts to rebalance global demand, including through market-determined exchange rates. In this endeavour the transatlantic partnership plays a decisive role. The Cannes Summit should agree on an ambitious Action Plan to keep the global recovery on track.
Finally, the European Union and the euro area need to further reform economic governance. Next week we expect the European Parliament to take the final vote to approve a large legislative package on stronger fiscal and economic surveillance. While this reform is very important in its own right, it is also a necessary foundation for further reforming economic governance.
And there is more yet to come. A monetary union with only relatively loosely coordinated economic and fiscal policies is not powerful enough to prevent the kind of imbalances that brought us to the current crisis. Neither is it strong enough to counter a crisis we are facing today.
Therefore, the euro area member states need to go further in pooling economic sovereignty to prevent policies that harm other member states and financial stability. We need to go further in making our financial backstops more flexible to contain market turbulence. In general, we need to make the decision making more agile and effective.
Successful strengthening of the Economic and Monetary Union along these lines could also make the consideration of some type of common bonds more realistic. The Commission will present a feasibility study on Eurobonds in the coming weeks. While not a matter of today or even tomorrow, I see deeper economic policy integration and perhaps Eurobonds as the music of the day after tomorrow—as an expression of Europe's evolutionary road.
It has been said that Europe's economic governance is incomplete, as Europe never had its own Alexander Hamilton who engineered the US federal economic government some 220 years ago. Recalling the less than fortunate fate of Hamilton after the deadly duel, there may not have been such a queue for that honour!
Be that as it may, Europe is facing a crucial moment now—maybe its Hamiltonian moment—in a sense that it needs to take a quantum leap forward in its economic policy integration. That's the very topical and tangible challenge of our generation in Europe today.
Thank you very much for your attention.