The financial and economic crisis and the OECD strategic response


Remarks by Angel Gurría, OECD Secretary-General, at a meeting with Slovak Economists, HN Club

Bratislava, Slovak Republic, 9 February 2009

Ladies and Gentlemen,

It is a pleasure to address such a distinguished audience.

The last time I visited Bratislava in early 2007 on the occasion of the launch of the previous Economic Survey of the Slovak Republic, the situation in financial markets and the outlook for the global economy was completely  different. Who would have thought back then that less than two years later the world economy will be facing its gravest recession in the post-war period? Who would have thought that in the space of one year, virtually all Wall Street investment banks would either disappear or turn themselves into commercial banks? Who would have thought that we would be facing what has been called “a once-in-a-half-century, and probably once-in-a-century type of event”?

The speed of contagion and depth of the crisis has been truly breathtaking. And as we deal with it, we should not forget the need to advance our structural agenda. What is more, both the short term and the long term measures should reinforce each other. This is the essence of the OECD strategic response on which I will elaborate further today.

The current crisis and its consequences

The current financial crisis is the most severe  in decades. While it shares some of the features of past crises, it is also unique in several ways. It resembles past crises in that it is an abrupt adjustment of past imbalances whose origins lie in strong credit growth and rising equity and house prices. This has happened before. Just think of Japan’s experience in the late 1980s, for example. The current crisis, however, differs from other episodes regarding the massive underpricing of risk and explosive lending to non-creditworthy economic agents prior to the summer of 2007. This was mainly the result of three factors:

  • First, global credit conditions: global imbalances underpinned by low interest rates in the west were combined with the build-up of large foreign exchange reserves in Asia.  This resulted in a steep increase of private debt, in particular consumer loans and mortgages,
  • Agency problems associated with the originate-and-distribute model of transferring risk (which rating agencies failed to identify), and
  • Third, a number of regulatory and supervisory failures, such as the lack of oversight over commercial bank’s off-balance sheet vehicles.

The financial crisis is having a strong impact in the real economy. The OECD’s last Economic Outlook, published in December, projects a sharp decline in GDP in the OECD economies in 2009, with many of them in the red and facing increased social pressures. Unemployment in OECD only is expected to be pushed up by some 8 to 10 million by the end of the decade. The uncertainties surrounding this projection are large, unusually large. Our scenario for the world economy remains valid qualitatively – we expect a recovery towards the end of 2009 or the beginning of 2010 –, but incoming data suggests an even deeper and possibly more protracted economic downturn.  For example, for the Slovak Republic, our forecasts envisaged GDP growth of 4% this year which now turns out to be too optimistic by a large margin.


Governments took immediate policy action

It is understandable that policy action has focused on first avoiding a collapse and stabilizing the financial sector. Many measures have been taken on this respect. On the fiscal side, governments have responded with large macroeconomic stimulus. In addition and in part prompted by the fact that usual monetary policy channels are not functioning normally, government recourse to fiscal action has been widespread. Many countries have put together significant stimulus packages.We welcome these efforts, because exceptional times require exceptional measures. But when doing so, we should not forget the need to restore the balance in public finances. We should not allow the emergency measures of today to prevent us from returning to a sound fiscal and financial system tomorrow.

As long as banks do not resume lending, we will not yet be at the end of the tunnel. After several months of policy action, we are at a moment where the “toxic” assets, and higher risk aversion, are preventing banks from lending again. This is an issue that we urgently need to address, as banks are the conveyor belts that allow the economy to function.

The OECD strategic response

How do we set the path to recovery while facing the incredibly difficult economic circumstances of today?  The OECD has developed a OECD strategic response to deal with the current situation, while at the same time addressing the interaction between different policy actions in our economies. We have adopted a comprehensive approach that takes into account competition, taxes, corporate governance and economic governance in general to deal with the crisis. We emphasize the need to align regulations and incentives in the financial sector to ensure tighter oversight and risk management. And we have also addressed the impact of the crisis in the real economy, including masive unemployment, social unrest and pressures in the pension systems of many countries. We have also urged governments to review and upgrade their national policies and improve international coordination in order to restore the conditions for global economic growth.

Towards new economic governance

The current crisis is characterized by massive regulatory, supervisory, risk management and corporate governance failures. Thus, we need in future is both a strong and effective regulatory framework and better supervision. Along the way, a healthy balance between markets and policy intervention is of the essence. As President Barack Obama said in his inauguration speech, the question is not whether government is too big or too small, but whether it works.

Governments will need to update and upgrade  their institutions, in order to remove incentives that contributed most to excessive risk-taking. The development of an overarching framework, supported by states and international organizations, that prevent excesses in the market and works to counter future crisis will be essential. The proposal to establish a “Global Standard” is welcomed in this regard.  Existing OECD instruments, including for corporate governance, for fighting corruption or for co-operating in fiscal affairs, have been suggested as the basis for a new charter for sustainable economic governance, along with those of other institutions. 

Fostering sustainable long-term growth

While recovery is vital, not any recovery will do.  We need a sustainable recovery.  First and foremost it is crucial to restore confidence in financial markets in order to detonate recovery. As I mentioned, banks have to start lending again. This is the first step of any plan for rebooting the economy. And we have to start by addressing the problem of bank solvency. OECD has been insisting on this since mid 2008.

There are 3 main elements to addressing the solvency problem: (1) deposit insurance to stop runs on banks; (2) removing the bad assets from banks’ balance sheets; and (3) recapitalise and then sell the bad-asset-cleansed banks. In our view, it has been an error to by-pass step (2) and we urge urgent action in this respect.

Concerted national macroeconomic responses are also crucial for a globally effective outcome. Despite the decisive actions by governments, market pessimism still shows no signs of abating. Confidence is low and dropping.

We also have to take care of the effectiveness and quality of the fiscal stimulus packages. We need better information on their content and effectiveness.

Besides being big, the fiscal stimulus needs to be smart. It is important that any tax cuts to boost the economy are designed to maximise their immediate impact. It is crucial that the tax cuts favor the most vulnerable sectors of the community.

It also is very important that rebooting the economy does not mean destroying the environment.  This crisis is a big opportunity to move to solar panels, to wind and nuclear energy and to “green growth”. It is a unique opportunity to confront the ever growing peril of climate change, to curb deforestation and ocean pollution. And it is also an opportunity to get rid of bad policies, such as subsidies to energy consumption or biofuels that have proved damaging for the environment or economically inefficient.

Finally, we need to avoid the risk of increased trade and investment protectionism. And a good place to start is to finish successfully the Doha Round. This is definitely the “low hanging fruit” of international cooperation.

One of the most efficient ways to kick-start our economies is by addressing our structural challenges.  Let me elaborate a bit on this point, given that we have released the 2009 Economic Survey of the Slovak Republic this morning, which addresses questions that are essential to long-run growth.

Turning first to fiscal policy, it is clear that government budgets will deteriorate as a result of declining revenues and rising outlays during this crisis. But we have to ensure that this does not lead us to an unsustainable accumulation of government debt, limiting our room for manoeuvre in the future. The sharp rise in government bond spreads  and the recent downgrades of some sovereign ratings in the euro area demonstrate forcefully that the risks to sustainability are real.

We therefore recommend that fiscal stimulus has to be timely, temporary and targeted. The short-term discretionary fiscal stimulus should not be used to enact long-term spending programs. We would also advise governments – and this is one of our key recommendations for Slovakia – to ensure that a credible fiscal framework is in place. Experience across OECD countries suggests that a fiscal rule oriented at structural deficits is helpful in this respect. It allows not only the anchoring of public expectations, but also guarantees the working of automatic stabilisers in a downturn.

The question of long-run fiscal sustainability is also inextricably linked to the pension system – which is a key driver of ageing-related spending. There is much discussion about this issue in Slovakia currently, in particular on how to deal with a fully-funded second pension pillar in times of worldwide declining asset prices. However, this is a case where short-term action – such as letting people switch back to the pay-as-you-go first pillar – can lead to long-term consequences for fiscal sustainability. We therefore recommend considering the longer-term fiscal effects when making decisions today. It also pays to stress that the yield of the second pension pillar (even assuming an investment in safe government bonds) will be higher than the yield from the first pillar for all individuals retiring after 2019.

Finally, continuing with labor market reforms is particularly important in these circumstances. In the Slovak Republic, raising labor mobility would help in the adjustment to shocks. In our Survey we therefore recommend to foster the establishment of a private rental market.

The OECD stands ready to work with its member countries to identify and to meet these challenges. It is in this spirit that we look forward to continuing our successful collaboration with the Slovak Republic.

Thank you for your attention.