The largest financial crisis in history is spreading from private to sovereign entities. At best, Europe’s recovery will suffer and the collapsing euro will subtract from growth in its key trading partners. At worst, a disintegration of the single currency or a wave of disorderly defaults could unhinge the financial system and precipitate a double-dip recession.
How did it come to this? Starting in the 1970s, financial liberalisation and innovation eased credit constraints on the public and private sectors. Households in advanced economies – where real income growth was anaemic – could use debt to spend beyond their means. The process was fed by ever laxer regulation, increasingly frequent and expensive government and International Monetary Fund bail-outs in response to increasingly frequent and expensive crises, and easy monetary policy from the 1990s. Political support for this democratisation of credit and home-ownership compounded the trend after 2000.
Paradigm shifts were invoked to justify debt-fuelled global growth: the transition from cold war to Washington Consensus; the re-integration of emerging markets into the global economy; the “Goldilocks” combination of high growth and low inflation; a much-ballyhooed convergence ahead of monetary union across Europe; and rapid financial innovation.
The result was a consumption binge in deficit countries and an export surge in surplus countries, with vendor financing courtesy of the latter. Global output and growth, corporate profits, household income and wealth, and public revenue and spending temporarily shot well above equilibrium. Wishful thinking allowed asset prices to reach absurd heights and pushed risk premiums to incredible lows. When the asset and credit bubbles burst, it became clear that the world faced a lower speed limit on growth than we had banked on.
Now, governments everywhere are releveraging to socialise private losses and jump-start private demand. But public debt is ultimately a private burden: governments subsist by taxing private income and wealth, or through the ultimate capital levy of inflation or outright default. Eventually governments must deleverage too, or else public debt will explode, precipitating further, deeper public and private-sector crises.
This is already happening in the front-line of the crisis, eurozone sovereign debt. Greece is first over the edge; Ireland, Portugal and Spain trail close behind. Italy, while not yet illiquid, faces solvency risks. Even France and Germany have rising deficits. UK budget cuts are starting. Eventually Japan and the US will have to cut too.
In the early part of the crisis, governments acted in unison to restore confidence and economic activity. The Group of 20 coalesced after the crash of 2008-09; we all were in the same boat together, sinking fast.
But in 2010, national imperatives reasserted themselves. Co-ordination is now lacking: Germany is banning naked short selling unilaterally and the US is pursuing its own financial sector reform. Surplus countries are unwilling to stimulate consumption, while deficit countries are building unsustainable public debt.
The eurozone offers an object lesson in how not to respond to a systemic crisis. Member states started going it alone when they carved up pan-European banks along national lines in 2008. After much dithering and denial over Greece, leaders orchestrated an overwhelming show of force; a €750bn bail-out bolstered confidence for one day. But the rules went out of the window. Sovereign rescues are legitimised by an escape clause from the “no bail-out” rule intended for acts of God, not man-made debt. The European Central Bank began buying government bonds days after insisting it would not. Tensions in the Franco-German axis are palpable.
Instead of Balkanised local responses, we need a comprehensive solution to this global problem.
First, the eurozone must get its act together. It must deregulate, liberalise, reform the south and stoke demand in the north to restore dynamism and growth; ease monetary policy to prevent deflation and boost competitiveness; implement sovereign debt restructuring mechanisms to limit moral hazard from bail-outs; and put expansion of the eurozone on ice.
Second, creditors need to take a hit, and debtors adjust. This is a solvency problem, demanding a grand work-out. Greece is the tip of the iceberg; banks in Spain and elsewhere in Europe stand knee-deep in bad debt, while problems persist in US residential and global commercial property.
Third, fiscal sustainability must be restored, with a focus on timetables and scenarios for revenues and spending, ageing-related costs and contingencies for future shocks, rather than on fiscal rules.
Fourth, it is time for radical reform of finance. The majority of proposals on the table are inadequate or irrelevant. Large financial institutions must be unbundled; they are too big, interconnected and complex to manage. Investors and customers can find all the traditional banking, investment banking, hedge fund, mutual fund and insurance services they need in specialised firms. We need to go back to Glass-Steagal on steroids.
Last, the global economy must be rebalanced. Deficit countries need to boost savings and investment; surplus countries to stimulate consumption. The quid pro quo for fiscal and financial reform in deficit countries must be deregulation of product, service and labour markets to boost incomes in surplus countries.
Nouriel Roubini is founder and chairman of Roubini Global Economics. Arnab Das is RGE’s managing director for market research and strategy
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