Remarks by Angel Gurría, OECD Secretary-General, delivered at the INET Annual Plenary Conference - PANEL: The Challenge of Deleveraging and Overhangs of Debt - Inflation and Austerity
13 April 2012
(As prepared for delivery)
Ladies and Gentlemen:
It is a great pleasure to participate in this INET’s Annual Plenary Conference here in Berlin.
The theme of this Conference, “Paradigm Lost: Rethinking Economics and Politics", is a major call to action. Since the Great Crisis hit the global economy, we have been reacting to the emergencies, but we have not yet fixed the economic system that broke down.
We have been running our economies more or less with the same “policy softwares” which brought us where we stand – and that is dangerous. It is time for new economic thinking and acting; time for better, more coherent and more integrated policy approaches to common challenges. For that, it is essential to build a better economic policy framework; one that is more transparent, more inclusive and more sustainable. I very much hope this Conference will help us draw that new roadmap.
The topic that we are addressing in this panel, “The Challenge of DeLeveraging and Overhangs of Debt: Inflation and Austerity”, is one of enormous relevance.
Our economies are choking under the heavy burden of debt
In many countries, government debt is now at levels unprecedented in the post-war era. This is true for the United States, Japan and many European countries. Average gross government debt across all OECD countries stands at around 100% of GDP, and it is still climbing.
In the case of Europe, high government indebtedness, and the crisis that it has triggered, is a symptom of a deeper, more fundamental malaise: a lack of effective governance arrangements to promote fiscal discipline in a monetary union.
High debt is not a privilege of governments: the crisis also left an equally large overhang on the balance sheets of banks and households. To varying degrees, the real estate boom that emerged before the crisis in some countries, and easy access to credit, often with limited regard for the creditworthiness of borrowers, have allowed households to live beyond their means and accumulate large debts. Excessive risk-taking, in part due to poor regulation, has inflated the balance sheets of banks.
Rebuilding confidence is strategic to move forward
It is clear that many governments, banks and households have overstretched themselves. This situation is not sustainable. Some deleveraging is not only desirable but also necessary.
Of course, the optimal timing for deleveraging among households, banks and the government is the key point in the discussion. This has been highlighted in economic literature since Irving Fisher’s work in the 1930s and Hyman Minsky’s ideas in the 1970s. I must admit there are convincing academic arguments showing how “deficit-financed government spending can allow the economy to avoid unemployment and deflation while highly indebted private-sector agents repair their balance sheets”.
But in some cases, high debts combined with a sudden fall in growth prospects can adversely affect confidence. This can have dramatic financial, economic and social consequences, as we have witnessed all too starkly over the past 18 months in parts of Europe.
I am not arguing along the lines of one of the former German Chancellors, Ludwig Erhard, that the “economy is to 50% about psychology” but this crisis has taught us that we need to look much more into behavioural aspects of economic actors in our analysis. New Economic Thinking is also about creating the right incentives for economic actors, how they interact and how confidence can be restored!
Herd behaviour is a case in point. A loss of confidence in the ability of policymakers to deal with current challenges affects the decisions of households to consume, of businesses to invest, and of financial markets to intermediate transactions. A lack of trust in the ability of agents to honour their debts can generate herd behaviour of the same sort: without a clear and consistent strategy for deleveraging rampant indebtedness can seriously undermine confidence. The rollover of public debt becomes impossible if markets perceive a high risk of default. And because financial markets are interconnected, there is contagion across countries.
We’ve got to be careful: deleveraging in a slump can be highly risky
Although deleveraging can restore confidence, it cannot take place in a theoretical vacuum, guided only by our models and policy targets. Deleveraging strategies and austerity measures have a direct impact in the lives of human beings. Their timings and intensity are critical because economic activity, companies, banks, jobs, people, are highly sensitive to these measures.
The transmission mechanisms are simple: deleveraging necessarily means higher savings, and that means lower consumption and therefore lower demand. And lower demand means even lower employment and even lower incomes for households and lower revenues for governments. And both of these mean slower deleveraging. It is a vicious cycle.
In the case of financial institutions, the drop-off in loan portfolio quality that typically follows a credit binge forces banks to tighten their underwriting standards. They begin to extend fewer new credits or actually cut the size of their balance sheets. The crunch is most pronounced for bank-dependent borrowers, such as households and small businesses, who may find it not only more difficult or costly, but simply impossible, to obtain credit.
In short – and we all know this – deleveraging in the private sector compounded by fiscal consolidation can drive the economy in a tailspin with ever lower activity, depressing output and employment.
What the textbook does not teach us is that the damping effects of deleveraging on aggregate supply and demand can have a perverse impact by increasing income inequality. This is very important. Any policy response that overlooks distributional effects may miss its target, since it can face rejection and opposition in its implementation.
We need to act on several parallel policy tracks
The debate about the timing and pace of fiscal consolidation will continue, but now most governments and international organisations agree on one crucial point: we will not bring confidence and growth back by only promoting austerity.
What can we do instead?
First, monetary policies can help us buy time. For some countries, unconventional measures, such as quantitative easing, are a useful devise for avoiding a credit squeeze while governments gradually consolidate and get structural reform going, and while deleveraging in the private sector runs its course. Even without inflationary effects, though, quantitative easing has clear limits and costs: as it slows down balance sheet adjustment of banks and keeps zombie banks and zombie debtors alive. This trade-off needs to be taken into account.
Second, where possible, fiscal policy can cushion the effects of deleveraging among households and firms. Governments which still have fiscal margin, or can create it by adopting credible medium-term fiscal frameworks, can let the automatic stabilisers work in the event of worsening economic conditions.
Third, governments should “Go Structural” and “Go Social”. We have increasing evidence that shows that the right mix of structural reforms while investing in people and support the most vulnerable can have the double dividend of boosting growth as well as helping to balance budgets. For this it is crucial to identify the most fruitful reforms.
For example, reforms that promote competition in services and open up opportunity for investment in protected sectors can create jobs and generate revenue for the budget. Such reforms have no upfront budgetary costs and can yield concrete dividends in times of austerity. Recent work by the OECD has shown that such reforms have positive impacts on growth and employment after a couple of years, even if it takes longer for their full effects to materialise.
Finally, governments should take bold action to improve public institutions and regulatory frameworks. Another key element to strengthen confidence and facilitate deleveraging is to improve economic governance. As the recent book by Daron Acemoglu and James Robinson, “Why Nations Fail”, argues, institutions play a critical role in a loss or gain of confidence, and therefore should also be part of the deleveraging story.
At the OECD we have been insisting that these simultaneous and mutually reinforcing actions have to be implemented in coordination with three other major all-of-government strategies: investing in people’s skills and education, improving people’s employment perspectives and a fully reap the benefits of new sources of growth like innovation and green growth.
Ladies and Gentlemen,
We are facing unprecedented challenges. Like never before, policymakers are struggling to make the right decisions at the right time while dealing with financial market tensions and addressing social pressures arising from record unemployment and growing inequality.
Deleveraging is necessary, but it leaves policymakers with fewer tools to address multiple demands and needs. Ridding our economies of the excesses that led to the crises will take time and will need to be achieved while minimising the costs of adjustment to be borne by households.
Let’s not forget that the ultimate goal of economic policy is to ensure broad and stable human prosperity.
Thank you very much.