Monday, December 8, 2008

We Cannot Know that 2009 will NOT Witness Start of a Recovery

Published in Editorial Page of Financial Times, 4 December 2008

Letter to the Editor

Dear Sir/Madame,

Professor Roubini’s fairly grim assessment of the 2009 global economic outlook (“How to avoid the horrors of ‘stag-deflation’”, 3 December) is a detailed analysis of why the horrors are, in fact, unavoidable. It is consistent with his unremittingly pessimistic views not only about the depth of the crisis, but also about the ineffectiveness of policy to mitigate its aftereffects. He speaks with considerable credibility on these issues, having anticipated the deleterious impact of the bursting of the U.S. housing bubble on the financial markets and the real economy. While he may well be right, I would like to suggest that, in fact, we do not know whether 2009 will not witness the beginnings of a recovery, in response to an unprecedented combination of looser monetary policies, fiscal stimuli and the whole battery of government-sponsored interventions which have taken place over the recent past and are likely in the pipeline.

While the present crisis is of a totally different scale when compared with previous episodes of financial market turmoil, it is the case—as argued by the IMF—that during the US stock market crash of 1987, the Russian crisis of 1998 and the associated collapse of Long Term Capital Management, the technology crash of 2000, and the aftermath of 9/11, the near term outlook was also grim. All of them involved a sudden increase in uncertainty and created conditions where policymakers and markets found it difficult to assess risks. All of these episodes were characterized by increased market volatility and a flight to safer assets. But, with some lags, it soon became evident that the world was not coming to an end. Output growth in the U.S. picked up after 1987 and 1998 and was largely unaffected by the events of 9/11. The bursting of the technology bubble in 2000 was followed by a short recession.

The main danger we face is not, as professor Roubini suggests, that “in the next few months, the flow of macroeconomic and earnings news will be much worse than expected” (!) but rather that by late 2009 the global economy will be perking up again (because the housing sectors will have bottomed and the unwinding of commodity prices will boost consumption among oil importers) and governments will go back to business as usual, missing a once-in-a-life-time opportunity to address the serious vulnerabilities in the world’s financial system which the current crisis has revealed. In that scenario, the next crisis would find us with little ammunition left. That is the real danger.

Thursday, October 9, 2008

A Global Economy Needs Global Economic Governance

Mr. Peter Mandelson, the European Union's Trade Commissioner, has written a thoughtful Op Ed (In defence of globalisation, The Guardian, October 3 2008) whose key message—namely, that "a global economy needs global economic governance"—is not only extremely timely, but may, in fact, be broadened in the scope of its underlying recommendation. The process of globalisation is unfolding in the absence of equivalent progress in the creation of an international institutional infrastructure that can support it and enhance its potential for good. There is no global environmental authority; policy in this area is being done via ad hoc approaches involving elements of international cooperation, voluntary compliance, and large doses of hope. In the absence of a body with jurisdiction over the global environment and the associated legal enforcement authority, de facto, the international community has abdicated management of the world's environment to chance and the actions of a few well-meaning states. The global economy has no lender of last resort—there is no reliable, depoliticised mechanism to deal with financial crises. Whether a country gets an IMF bailout or not in the middle of a financial meltdown is a function not of a transparent set of internationally agreed rules, but rather several other factors, including whether the IMF's largest shareholders consider the country to be strategically worth supporting. There is no agency charged with the responsibility for giving legal meaning to the noble principles enshrined in the Universal Declaration of Human Rights. According to the US State Department, there are 44 nations with the capacity to build nuclear weapons—nuclear proliferation remains yet another example of global institutional failure. Major planetary problems are being neglected because we do not have effective, problem-solving mechanisms and institutions strong enough to deal with them. What the latest developments in the financial markets show with sobering clarity is that global crises cannot be solved outside a framework of global collective actions involving supranational cooperation and a fundamental rethinking of the "national interest." Clearly, an integrated global community of nations needs to lay the basis for effective mechanisms of global governance.

Thursday, September 25, 2008

The EU Needs a New Business Model

Note: A keynote speech delivered on 19 September 2008 at the
European Business School Symposium in Frankfurt.

Words ought to be a little wild, for they are the assault of thoughts upon the unthinking.
J. M. Keynes

The rejection by the Irish of the Lisbon Treaty has led to much soul-searching in Brussels and elsewhere in Europe. Putting aside the question how the EU got itself in this particular predicament, namely, allowing 1 million voters, accounting for 0.2 percent of the EU's total population to veto a 269-page treaty teeming with bureaucratese of mind-boggling opaqueness, the debate-still on going as we speak-is not likely to go very far. The fact is that it is not the Irish that are to be blamed-one should in general not put to referenda questions which cannot fit in less than one page and even that is risking it.

It might be useful to review briefly here, at the outset, the content of some of this soul-searching. One can identify several schools of thought.

• There are some who think that the problem with the EU is that it is too diverse to expect that all member states will ratify any given treaty or wholeheartedly approve any given policy. Unanimity and uniformity are relics of the past and the sooner the EU abandons them, the better. This, by the way, would be making explicit what is already implicit, when you remember that the United Kingdom and Denmark opted out of the Maastricht Treaty, that the Schengen open-border area includes Iceland, Norway and soon Switzerland, but excludes the UK, Ireland, Bulgaria and Romania, that the eurozone has 15 members, not 27, that the Lisbon Treaty would exempt Britain and Poland from the Charter of Fundamental Rights, and so on.

The list is long. So, from this perspective, the way forward is to abandon the unanimity rule for treaties, and accept a process of integration that allows for different speeds. All members must be democracies, there must be respect for human rights and countries must participate in the single market, but, beyond this, countries may choose which policies they are able to participate in, depending on their individual circumstances.

• A second school of thought goes as follows: the Lisbon Treaty is a side show. The problem with Europe is that, notwithstanding impressive achievements during the past several decades, its influence in the world is waning because it has failed to implement the sorts of reforms which will make it the most competitive economy in the world. All this hand wringing about Lisbon misses the fact that the EU continues to be saddled with inefficient policies-the Common Agricultural Policy, obsolete regulatory regimes, a system of higher education which, long ago, abdicated leadership to the United States.

Former Swedish Trade Minister Leif Pagrotsky put it very well recently when he said that "today, when US or Swiss banks risk collapse, nobody approaches Europeans for support. They go to the Middle East, Singapore, or China for lifelines." Yes, he adds, "democracy and the market economy have been consolidated and the lives of millions of people improved", but "increasing irrelevance is staring us in the face."

From this perspective the focus should shift from Treaty negotiations-a favorite pastime of politicians-to ensuring that the EU stops spending more on declining industries than in research and development (Israel, with 6 million inhabitants, has more companies listed in the Nasdaq than any other country in Europe, by a huge margin), that it makes it easier to facilitate cross-border mergers to build world champions instead of capitulating to national interests, that it creates a European patent. In other words, put aside the glamorous work of Treaties and Constitutions and get to work on the nuts and bolts of economic and institutional reforms. Concentrate on the content and not so much on the glamour and the form.

• No, actually, the problem with the EU say others is not that its citizens are confused-such as the Irish-rather they are cynical and the leadership is to be blamed because they themselves are cynical. EU policies do not particularly address citizen's concerns. "There is now a widespread impression across Europe-and especially among the young-that it is in danger of offering pseudo-democracy, remote bureaucratic government thinly disguised by a European parliament," is how an Oxford professor put it (Larry Siedentop, FT, 2 July 2008). So, the problem is one of political legitimacy.

I think that there is much in some of these observations that is probably on target. There is a lot in these schools of thought-as I have called them-that makes much sense. My thesis, rather, which I would like to share with you is that the EU's business model is broken and until a new one is brought out the EU will simply continue to find itself plunged into crises of this sort, as happened in 2005 when the French and the Dutch rejected the EU's first Constitution-another phonebook of a document that even senior politicians admitted not having read.

For the past half century the two driving forces of the EU have been history and geography. The EU was born out of the ashes of World War II and reflected an understandable and rational desire on the part of Europe's leading politicians to secure a more stable basis for peace and prosperity, and to anchor Germany in formal schemes of international cooperation. The creation of the European Coal and Steel Community in 1951 was an inspired start, as was the goal, years later, under the Treaty of Rome which created the European Communities to focus largely on liberalizing the trade regime and facilitating access to each other's markets.

This is not to say that the Treaty of Rome did not have overtly political undertones and it is clear that Jean Monet, the Community's father and chief ideologue was, then, seeing well into the future. I have always found his statement that "for national sovereignty to be effective, in an expanding world, it needs to be transferred to larger spheres, where it can be merged with the sovereignty of others who are subject to the same pressures" and that "in this process, no one loses; on the contrary, all gain new strength" to be a particularly effective roadmap for the EU's evolution.

The second driving force for the EU has been geography. As time went by new members were brought in, able to abide by a set of common policies. Naturally, this process took in countries in the periphery and it came to a climax in 2004, with the accession of 10 new members. There is little doubt that this first phase of growth has been brilliantly successful.

War among member states has been vanquished, its members are among the most prosperous nations in the world, differences are settled-in not always efficient ways-through negotiations and boring committee meetings, and a set of supranational institutions has been created which, for all their limitations, are showing increasing degrees of maturity and effectiveness. Witness the largely positive assessments in recent weeks of the first 10 years of the European Central Bank.

But there are several reasons why this model is not likely to work anymore. Here is why.

Globalization has reduced the relative importance of geography as a determinant of economic growth and prosperity. Sharp reductions in the cost of transport and communications have drastically reduced the importance of location. More and more, the most competitive economies in the world are those that have managed to boost the skills of the labor force, that have develop open, transparent, and reliable institutions, and that offer a measure of political and social stability. Success seems to depend far more on policies and institutions than on where the country happens to be located.

In light of this, it would appear then that the EU ought to be thought of less as a political geography and more as a group of member states sharing mutually agreed rules, policies and institutions which, to a great extent, have less and less to do with location. The recent voter fatigue with EU expansion may have less to do with a waning of EU citizen's commitment to the sense of community that underpins the EU and more to do with the perception that, since political leaders have largely seen expansion as a process fuelled by geographical considerations, they have been forced to take in members which are not yet ready to assume the full responsibilities of membership.

The recent incorporation of Bulgaria and Romania is a case in point-two countries with levels of transparency in government far behind the rest of the EU. If the EU were to be seen increasingly as a union based on shared policies and institutions and respect for commonly agreed rules, it is doubtful that it would have expanded quite so quickly, opting perhaps for a longer period of institutional consolidation in some of its candidate states. Similar comments apply to Turkey, a country where only recently there was high likelihood that the constitutional court could have banned the country's main political party and, hence, its duly elected government, a decision that would, no doubt, have led the European Court of Human Rights to rule that its charter on human rights had been violated.

The above suggests that EU leaders intent on consolidating the achievements of the past 50 years should not confine their vision for the EU to bringing in those states currently in its periphery but rather should focus their attention on those states which, having established a credible track record of good policies, sound institutions and shared political values, would agree to submit themselves to the competitive pressures of the EU market, the discipline of its institutions and its agreed rules, regardless of where they may be located.

Let the EU turn itself into an open club of like-minded nations. Let it change its name, if necessary, from the EU to the UNW-a union of the nations of the world. Rather than sowing the seeds of a dozen crises in the future-on Turkey, on Ukraine and the many aspirants currently on its periphery but which are not likely to be ready for a long time to come, on whether the Irish will eventually bend to pressures and approve the Lisbon Treaty, on whether the EU will find a coherent way to deal with an emerging and authoritarian Russia on which it is dangerously energy-dependent, let it focus instead on inviting the Koreas and the Chiles of this world, countries that, except for (increasingly irrelevant) geography are already operating at levels of efficiency and competence well above the EU average.

Let me focus, for a minute or two, on these two countries, purely by way of an example. On why Chile might be an ideal candidate: It has already surpassed most EU members in the quality of its macroeconomic management. Chile's institutions: property rights, a judicial system, a regulatory framework, a trade regime, and social security system are already operating at well above average EU levels. In terms of corruption, the clarity of its rules, the general investment climate-Chile is already well ahead of such EU members as Italy and Greece and most of the new EU states in Central and Eastern Europe. Aside from the obvious fact it does not share a physical border with the EU, Chile-the only country in Latin America to have a free trade regime with the EU-is already an EU member in spirit.

As for Korea, well, it is a powerhouse for technology and innovation-a huge market with a sophisticated and highly trained labor force, already well ahead of much of Europe in such areas as the quality of its higher education, company spending on research and development, patents registration, the penetration of all the latest technologies-internet, broadband, mobile telephones. Korea is, without doubt, one of the most successful development experiences of the past 50 years.

Chile's membership in the EU would have implications that go well beyond the addition of one more small state to its growing list of small economies. It would give the EU an important institutional presence in Latin America, a region with which it has rapidly growing trade links. The EU would benefit from bringing into its midst an economy with an enviable growth record and in a privileged position in all competitiveness rankings.

Most important, Chilean membership in the EU would unleash a powerful chain of incentives in Latin America, as happened in Central and Eastern Europe during the past decade and a half. With Chile in, one can easily foresee that the political debate in Latin America would take on a more high-minded character. Uruguayans and Costa Ricans might immediately ask themselves: "what do we need to do to qualify?"

This is exactly the sort of question that should be raised in the region, to shift the focus of attention away from the sort of populist demagoguery of recent years, which, if allowed to run its course, could well turn the region into an increasingly irrelevant appendage of the global economy.

Looking ahead one thing is clear: the relentless pace of technological change is rapidly creating an integrated global economy and leading to a growing consciousness of global citizenship. As EU political leaders seek to address the consequences of the Irish veto, they might well discover that the time has come to think of "Europe" less in the traditional-and necessarily limiting-paradigms of physical proximity and more in the new language of the 21st century, where physical barriers, borders and notions of distance, are giving way to the realities of the oneness of mankind.

Friday, July 18, 2008

The Challenges of Sustainable Development

Note: A slightly edited version of this article appears in the Spanish August/September issue of the journal Foreign Policy.
A broadly accepted definition of “sustainability” is that put forward by the Brundtland Commission convened by the United Nations 25 years ago, which stated that sustainable development is development “that meets the needs of the present without compromising the ability of future generations to meet their own needs.” One implication of the core idea embodied in this definition is that sustainability is not a goal to be reached, but rather a balance to be maintained across space and time in which there are complex interactions at play between the environment, the economy, human institutions and values.[1]

Two central questions in this debate are: what has actually happened to development during the past half a century and are we on a sustainable development path? Development as a global objective for improving human welfare is a relatively recent concept. It was first embodied in the UN Charter, which said: “the United Nations shall promote higher standards of living, full employment, and conditions of economic and social progress and development.”

In time, at least among practicing economists in academia and policymakers in government “development”, came to be seen as improved economic opportunity through capital accumulation and rising productivity. The implicit assumption was that growth would lead to rising living standards, increases in longevity, reduced mortality, and so on. Between 1950 and 2001 world GDP/capita expanded at an annual average rate of 2.1 percent and this expansion—although with considerable regional variations—was associated with a remarkable evolution in three key indicators of human welfare. In the 40-year period to 2000: infant mortality fell from 140 to 52 per 1000 live births, average life expectancy at birth rose from 43 to 64 years, and illiteracy (percent of adults) fell from 53 to 28 percent. Equally impressively, there was a sharp drop in the incidence of poverty. Data from a World Bank study shows that between 1981 and 2001, the globalization phase of the 20th century, the share of the world’s population living in extreme poverty fell from 40.4% to 21.1%.[2] While this still left about 1.1 billion people living under harsh conditions, the trend was undeniable and it led many to ask themselves what could be done to accelerate growth everywhere, particularly in Africa where the incidence of poverty actually rose.

The American economist William Easterly said that he cared about economic growth because “it makes the lives of poor people better, it frees the poor from hunger and disease” and then proceeded to show how growth improves infant mortality, how, for instance, in Africa 500,000 deaths could have been averted if growth in the decade of the 1980s had been 1.5 percent higher. The above insights, in turn, have led to a remarkable re-examination among professional economists and policymakers about the relative importance of various factors in creating the conditions for growth.[3]

In parallel to these encouraging trends, scientists began to ask themselves: are the processes underlying our development path sustainable? Regrettably, the answer increasingly seemed to be NO. Among environmentalists, the focus was on climate change, biodiversity loss and pollution. That the earth has self-correcting mechanisms, that the physical processes underpinning changes in the environment have huge inertia, did not hide the growing consensus in the scientific community that, at the margin, the trends were not sustainable. To take just a few examples: global carbon dioxide emissions from fossil fuels have sharply accelerated since 2000, reflecting a quickening in the pace of growth of the global economy, a rise in the use of coal in China and the weakening of natural carbon sinks such as forests and seas. Not surprisingly, large volumes of the permanent ice in the Arctic Ocean have melted and accelerated flow in Greenland glaciers is contributing to a rise in sea levels.

But even beyond purely environmental concerns, there are other forces at work which are already having a major impact on our system’s institutional underpinnings, which have been at the center of the progress achieved during the past half century. Key among these one can point to population growth and the corresponding pressures on resources. According to the International Energy Agency energy demand will grow by 50 percent by 2030, reflecting the addition of some 2.2 billion people to the world’s population and the corresponding needs for housing, transportation, heating, illumination, food production, waste disposal and the push for sustained increases in the standards of living. Powerful demonstration effects are at work; the spread of instant communication and the internet have led billions of people in China, India, Latin America and other parts of the developing world to aspire to lifestyles and patterns of consumption similar to those prevailing in the industrial world. As if these demand pressures were not enough, there are emerging supply constraints as well. World cereal production per person has been on a downward trend since the late 1980s. It is estimated that by 2025 the number of people living in regions with absolute water scarcity will have risen to some 1.8 billion. Climate change, soil erosion, overfishing are expected to dampen food production and are known to have been a key driving force in the major surge seen in food prices during the past year.

The question is then, how will we reconcile the legitimate aspirations of citizens in the developing world for the high economic growth rates that in the post-War period led to such remarkable improvements in the global standards of living, with the challenges of an economic system under severe stress as a result of the pressures put on it by the very same economic growth?

The solution is likely to involve actions on at least three fronts. First, we will have to invest in conservation and in redressing some of the damage done to the environment through decades of neglect. According to the Earth Policy Institute something like US$100 billion need to be spent annually to protect topsoil in croplands, to stabilize water tables, to restore fisheries and protect biological diversity. A key finding of the Stern Report on climate change was that the annual cost of introducing control measures for greenhouse gases is far, far smaller than the potential cost of uncontrolled climate change. The UN’s Intergovernmental Panel on Climate Change estimates that stabilizing greenhouse gases by 2030 would slow global economic growth by slightly more than 0.1 percent per year. We will also need to invest in energy infrastructure, to replace ageing capacity and meet growing global energy demand, but also to boost efficiency. Second, technology can clearly play a key role. More efficient use of energy has reduced the size of energy consumption in global GDP by more than 30% in the past 20 years; much more can be done in this area, particularly by resort to new technologies of conservation, including greater use of solar power, wind and alternative fuels. The recently issued Growth Commission Report lucidly defines our challenge: “We do not know if limits to growth exist, or how generous those limits will be. The answer will depend on our ingenuity and technology, on finding new ways to create goods and services that people value on a finite foundation of natural resources. This is likely to be the ultimate challenge of the coming century. Growth and poverty reduction in the future will depend on our ability to meet it.”

The third and arguably the most important element of a strategy aimed at sustaining growth will have to be a significant strengthening in the current mechanisms of international cooperation, which have turned out to be highly inadequate to the global challenges that we face. Whether we focus our attention on climate change and the broad range of associated environmental calamities, nuclear proliferation, the workings of the world’s financial system, or growing income disparities, the fact is that major planetary problems are being neglected because we do not have effective problem-solving mechanisms and institutions strong enough to deal with them. Or, put differently, a range of inherently global crises cannot be solved outside a framework of global collective action involving supranational cooperation and a fundamental rethinking of the “national interest.”

The forces of integration underlying the processes of globalization have been, on the whole, beneficial to humanity and have contributed to growing prosperity: about 65 percent of the world’s population today live in high-income or high-growth economies, compared to less than 20 percent in 1978. However, to establish a firmer foundation for sustainable development it will be necessary to take concerted action on the above three fronts. Failure to act will increase our vulnerability to multiple, interrelated crises, with unforeseen costs for human welfare.

[1] A good practical example of this concept at work can be seen in the Nordics approach to budgetary management. These countries have been running budget surpluses for many years because they face an emerging ageing population problem. If the state is going to be able to provide in the future pensions and social protections that will be broadly equivalent to those enjoyed by its citizens today, it must begin to save now. Citizens of Nordic countries have agreed for their governments to spend less than they collect in taxes, so that future generations’ standard of living will not be impaired.
[2] The study is: “How have the world’s poorest fared since the early 1980s?”, prepared by Shaohua Chen and Martin Ravallion, Development Research Group, World Bank, available at
[3] One area that has received particular attention has been the role of technology and innovation. Economic output, it seems, is no longer just a function of capital and labor but, increasingly, knowledge and the acquisition of new knowledge.