Yesterday, the Bank of England Governor, Mervyn King, delivered an important speech on the challenges facing the global economy (h/t Macca).
The speech covers a range of inter-related topics, including: the global imbalances that facilitated the unsustainable build-up of debt across Western nations; the conundrum facing the world’s governments whereby the short-run need to stimulate domestic demand in order to prevent rising unemployment is diametrically opposed to the long-run necessity to reduce imbalances and repay debt; and the need for debtor and creditor nations to work together to rebalance spending.
The key message from Mr Kings speech is that the world’s governments must fix the global imbalances or expect a prolonged recession.
At only six pages, I recommend that you read the speech in full for yourself (provided below). However, for the time-poor, here are some key extracts:
Four years into the crisis it is surely time to accept that the underlying problem is one of solvency not liquidity – solvency of banks and solvency of countries. Of course, the provision of additional liquidity support to countries or institutions in trouble can buy valuable time. But that time will prove valuable only if it is used to tackle the underlying problem.
After the crisis began, it took a year before governments in Europe and the United States were persuaded that the problems of their banking sectors resulted not from a shortage of liquidity – that was merely the symptom – but from massively over-leveraged balance sheets. Eventually, in October 2008, banks were recapitalised, albeit, especially on the Continent, inadequately so. But the underlying problems of excessive debt have not gone away. As a result, markets are now posing new questions about the solvency of banks, and indeed of governments themselves.
What were the causes of the unsustainable build-up of debt in Europe and elsewhere? They lay in the continuing imbalance between those economies running large current account surpluses and those running large current account deficits. Persistent trade surpluses in some countries and deficits in others did not reflect a flow of capital to countries with profitable investment opportunities, but to countries that borrowed to finance consumption or had lost competitiveness. The result was unsustainably high levels of consumption (whether public or private) in the United States, United Kingdom and a range of other advanced economies, and unsustainably low levels of consumption in China and other economies in Asia, and some advanced economies with persistent trade surpluses, such as Germany and Japan. The burden of debt will go on rising in the former group of countries until these spending patterns adjust and the latter group will find their loans eventually repaid in depreciated currencies, if at all. Surplus countries, a group which includes three of the world’s largest four economies, share a major responsibility to respond to our present dilemma by expanding domestic demand. By importing more they would provide deficit countries with the wherewithal to export and service debt repayments.
When the crisis hit, the starting point was the need for a substantial rebalancing of demand and a repayment of debt. In the deficit economies, there was an inevitable tension between the short run need to stimulate demand to prevent rising unemployment and falling inflation, and the long run need to rebalance demand and reduce indebtedness. In January 2009, I described this as “the paradox of policy … almost any policy measure that is desirable now appears diametrically opposite to the direction in which we need to go in the long term”. The almost intractable challenge facing policy-makers is how to balance those short-run and long-run considerations. There is a long journey ahead before the world economy returns to a sustainable equilibrium, involving rebalancing and a reduction of debt burdens. For the time being, a significant degree of policy stimulus is appropriate to support demand. But that will delay and exacerbate the size of the adjustment ultimately required.
…three years later, the imbalances in demand remain. Around the world, short-run stimulus packages of various kinds, and unsustainably low interest rates, have bought time. So far that time has not been used to deal with the underlying imbalances, or the weaknesses in bank and sovereign balance sheets. Four years after the financial crisis began, the foreign exchange reserve holdings of China are substantially larger than at the onset of the crisis. Markets now realise that before the crisis banks were seriously undercapitalised and so react in a volatile way to any news about the health of the banking system. And the indebtedness of governments around the world is certainly greater. Time is running out.
So what is to be done? One way or another, domestic spending must be raised in the surplus countries and lowered in the deficit countries, relative to current trends. In the past, market-determined exchange rates have played an important role in rebalancing world demand and trade. Exchange rates are the natural safety valve, which can limit the extent of imbalances in demand across countries… But over the past two decades, some governments, particularly in Asia and the euro area, have tried to fix exchange rates without putting in place mechanisms to ensure that competitiveness could be rebalanced by other means. That has contributed significantly to the problems facing us.
It is crucial to the health of the world economy that we find ways of allowing competitiveness to adjust so that trade imbalances, and hence the present scale of indebtedness, can be reduced. Neither liquidity nor austerity are answers to the question of how to restore a loss of competitiveness. Dealing with these structural issues will take time…
Let me sum up. From the very beginning of the global crisis there has been a reluctance by governments to face up to the underlying solvency problems generated by apparently unending trade deficits with no mechanism, whether flexible exchange rates or some other means, for correcting these disequilibria. Those solvency problems have shown up on country and bank balance sheets. The initial reaction has always been to provide liquidity: through central banks or an extension of official lending by governments. Providing liquidity to buy time to devise and put in place a coherent response to the underlying problem can be not only valuable but necessary. But liquidity can never be the answer in itself. And if the time bought is not used then the size of the debt problem becomes larger and its cost is gradually transferred from private sector creditors to taxpayers.
The main impediment to the strategy of rebalancing our economy is markedly slower growth in our major export markets, especially in the rest of Europe. That is why we are treading a fine line between stimulus to demand in the short run, and a rebalancing away from private and public consumption towards exports and import substitution in the longer run. Without monetary stimulus – low interest rates and large asset purchases – there is a risk that growth will stall and inflation fall below our symmetric 2% target. But easy monetary policy, by bringing forward spending from the future to the present, means that the ultimate adjustment of borrowing and spending will be even greater. That is our dilemma, and that of other deficit countries. The best way to escape this dilemma would be higher spending by the surplus countries – to make possible rebalancing by the deficit countries – and supply-side reforms in the deficit countries – to raise expected future incomes and ease the burden of debt repayments. Each country can put itself in a position to rebalance, as we have done in the UK. But in the absence of rebalancing, globally and especially in the euro area, we could be facing a recovery that is not merely reluctant but recalcitrant…
…the international financial system must be reconstructed to ensure a return to prosperity… without a rebalancing of spending in the world economy, a struggle between debtor and creditor countries will inflict economic pain on everyone. We must use the gravity of the global crisis to provoke a bold response. We acted together in 2009; we can do so again.
King’s Speech- BOE – Global Imbalances
