In the wake of the worst financial crisis since the Great Depression, regulators and government officials around the world have been scrambling to avoid a repeat performance. Although the prognosis isn’t good, policymakers of the Group of Seven nations can avoid being condemned to a series of ever-increasing boom-and-bust cycles if they are willing — and able — to perform the following radical procedures on their economies:
1 Impose fiscal austerity to deal with short- and long-term sustainability issues in all G-7 economies. The weakness of the euro zone’s “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) already imperils the European Union’s single currency, but so far the bond vigilantes have steered clear of the larger fiscal laggards: France, Japan, the U.K. and the U.S. This situation will not last forever, though, and addressing ballooning national debt at a time when stimulating growth is arguably the better short-term course is a harrowing political and economic balancing act. Predicting a happy ending for all these economies is more than bullish — it’s bullheaded.
2 Craft, explain, sell and then enforce structural reforms of G-7 economies. The medicine required is harsh and must be customized for each country. In the U.S., for instance, public pensions and health care spending must be reined in, the influence of money on legislators defrayed and the admirably flexible American labor market augmented with jobless benefits designed for the realities of the postcrisis world. Additionally, tax policy must address stagnating middle-class wage growth and the yawning gap between rich and poor, all while encouraging growth.
The list would be very different for the euro zone (raising retirement ages, liberalizing hiring and firing regimes, removing disincentives to work) and Japan (opening the domestic market to competition, allowing women to enter the workforce en masse and on equal footing with men, tackling political corruption). For decades dozens of reform initiatives like these have fallen prey to vested interests. Why the political equation will produce a happier result this time is far from clear.
3 Properly supervise the financial system to avoid asset bubbles and the booms and busts of credit. Crisis goes hand in hand with capitalism, just as bumps and bruises are facts of everyday life on earth. But, as we’ve just witnessed, to expect an invisible hand to lance an expanding blister risks a gangrenous, possibly fatal outcome. Asset bubbles and credit crises must be tackled with a more flexible monetary first-aid kit than anyone would have countenanced before the recent crisis began. Many central banks, the Federal Reserve in particular, have shown enormous creativity in their approach to managing liquidity and restoring faith in markets and the banking sector.
Reforms undertaken in Washington, London and Brussels contain useful safeguards, but most of them — including the recent U.S. financial regulatory reform — are too little, too late. Yet, as even the most prudent economies found to their dismay in 2008, good financial governance cannot protect a modern economy from a truly global financial conflagration. Nor can U.S., British or euro zone rules alone prevent regulatory arbitrage. The failure of the Group of 20 so far to coordinate, or even agree on, the necessary reforms of the global financial system leave wide-open the road to another, possibly larger crisis. Given divergent national interests and the varied nature of the economies in that unwieldy group, agreement on such broad principles may prove difficult.
4 Invest in human and physical capital and technological progress. Spending on education and infrastructure in the G-7 saw a small spike as stimulus packages ran through national arteries in 2008 and 2009. Unless a serious reversal of the current debate takes place, the stimulus moment has passed. The austerity that follows promises to pare back education and health spending; reduce construction of roads, ports, rails and other infrastructure; and will positively eviscerate European defense spending. Foreign aid budgets also will be targeted, with a commensurate reduction in international influence.
5 Deal with the environment and global climate change. The outright failure of the December 2009 Copenhagen summit on climate change popped another sort of bubble — one relying on hope to triumph over experience. For reasons that broadly parallel the G-20’s inability to take quick, coordinated action on financial reform, the developing world, led by China, balked at any agreement that would place serious limitations on greenhouse gas emissions at the expense of its industrial development.
The Obama administration, meanwhile, having overplayed its hand in Denmark, found few takers for either a cap-and-trade scheme or (blasphemy in many political circles) a carbon tax that would accurately reflect the true cost of pollution. Even a more direct regulation of the most-polluting industries failed to be passed by Congress; thus any chance of legislation to control carbon emissions is now out the window.
6 Forfeit some national sovereignty in favor of international coordination. The object lessons of the past several years suggest this is both a necessity and a very tall order. The G-20’s lack of concord and the Copenhagen climate talks represent only two examples; the interminable failure of the Doha round of trade talks and questions over the value of Basel III capital adequacy rules also require that national interest be leavened with some thought for consideration of the greater good.
Even within the EU, euro zone and non-euro-zone members remain far apart on rules regarding banks and hedge funds. And now there is disarray in the G-20 on the appropriate pace of fiscal austerity, while China and emerging Asia still drag their feet in terms of allowing greater currency appreciation. Coordination, however, is an obvious requirement for management of a globalized financial environment and the political risks that lurk within it.
7 Avoid protectionism and nativist policies. Although that’s a major challenge in the current environment, it’s one that G-7 nations must bear in mind if they are to emerge with a healthy growth trajectory after the extended anemic, below-trend period — what the folks at Pimco call the “new normal” — which may extend well into the next decade. Among the clearest lessons of the 20th century’s worst economic downturn was the disastrous effect of the Smoot-Hawley tariffs enacted in 1930 by Herbert Hoover’s Republican Congress, which placed more than 900 duties on imports and sparked retaliatory action.
Global trade, worth $5.3 billion in 1929 and a still-reasonable $4.9 billion in 1930, collapsed as the trade war raged, bottoming out near $1 billion in 1933. A recurrence of this nightmare must be avoided at all costs. The case against nativist, anti-immigrant policies — fought against both populists and xenophobes across the G-7 (with the exception of the exceptionally insular Japanese) — rests less on historical evidence than on two pillars of common sense: the need to continue replenishing the labor force, particularly in demographically challenged, aging euro zone economies, and worries that a wave of “buy American” or “buy Chinese” rules (both of which were enacted during the stimulus waves of 2009) would amount to a backdoor version of a trade war.
To our minds, this daunting list of pressing needs, reforms and psychological adjustments represents the minimum requirement for a return to growth in the G-7. To anyone who says this outcome is inevitable — or even preordained — we have just one word: “denial.”
See related story, “Paradise Lost: Why Fallen Markets Will Never Be the Same”.
