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Tuesday, Aug. 9, 2011

'Financial repression' and other remedies


By ANDERS ASLUND

CHARLESTON, South Carolina — Early in the financial crisis, a major emerging-market investor told me: "This is not a global, but a semi-global financial crisis." He was right: it really was a crisis of the United States, Europe and Japan. Among emerging markets, only Eastern Europe was badly hit. Indeed, the crisis marks the emerging economies' overtaking of the major Western countries, with huge consequences for global power, finance, politics and economics.

The eurozone sovereign-debt crisis appears to have been the worst-managed financial crisis since Argentina's default in 2001. The European Union and eurozone leaders have seriously discredited themselves. Europe requires institutional changes that are much more fundamental than anything discussed so far.

The International Monetary Fund has never bet such huge sums on a single country as it has on Greece. As a result, the IMF, a custodian of some of the international reserves held by the world's central banks, risks losing tens of billions of dollars. Is this a responsible use of international taxpayers' money?

Would the IMF not have insisted on a much tougher program for any country outside the eurozone?

The apparent explanation for the IMF's extraordinary gamble is that the managing director who made the decision to support Greece so heavily hailed from the eurozone and, at the time, was barely disguising his ambitions to run for the French presidency — that is, before his arrest in New York on charges of rape.

Europeans, moreover, dominate the Fund's leadership. It is a discomforting conflict of interest that debtors dominate an international institution that lends them vast sums. This mismanagement should disqualify any eurozone policymaker from the IMF's managing directorship, and yet Christine Lagarde, French finance minister, was named to succeed her compatriot Dominique Strauss-Kahn after his resignation.

Who would seriously have suggested a Russian to lead the IMF after its financial crash in 1998, or an Argentine after its default in 2001?

Today, the eurozone is equally toxic. The EU, the United States and Japan are in fiscal jeopardy, and several countries — Japan, Greece, Italy and Belgium — have public debts exceeding their GDP.

Increasingly, people recognize that loose fiscal policy was poor economic policy, with serious implications for macroeconomic thinking, politics, and constitutions. In macroeconomic theory, Keynesianism is due for its second demise. Milton Friedman's monetarism delivered the first death blow in the 1980's, but it did not generate useful policy rules or predictions. During the crisis, prevailing macroeconomic theory counseled massive fiscal stimulus, thereby aggravating the public-debt crisis.

How could people and governments accept these enormous debts and even recommend further fiscal stimulus? Many public expenditures and budget deficits have no justification other than populism, and the big political loser of the crisis has been European social democracy.

All too often, social democracy has amounted to populism, opposing any cuts in public expenditures and even deregulation, which would have enhanced productivity. European voters are now punishing social-democratic parties, which have become weaker than at any time since World War I. Instead, a fiscally responsible center-right alignment of political forces has taken power in all but three of the 27 EU countries.

Western democracies have prided themselves on institutional checks and balances, but obviously these mechanisms did not work during the crisis or the preceding boom. They have been a recipe for policy paralysis in America's long debate about the national debt ceiling.

As Chinese and Russians officials attack democracy, old questions about democracy's efficacy and stability are raised anew. There is no denying that advanced democracies largely failed to preempt the financial and sovereign-debt crises, while most emerging economies pursued better economic policies.

After the World War II, many European countries enshrined extensive social guarantees in their constitutions. Now many of these guarantees will need to be thrown out. Instead, a number of European countries are discussing the introduction of stringent fiscal rules into their constitutions, and are contemplating even more far-reaching changes.

Excessive fiscal deficits in many Western countries must be reduced. The average public debt in the eurozone has soared to 85 percent of GDP. Some European countries can reduce their debt through continuous budget surpluses, as Bulgaria, Finland, Russia and Sweden have done in the last decade. Privatization of public corporations and property is another possibility.

My Petersen Institute colleague Carmen Reinhardt suspects that financial repression will be the main debt-reduction method: Governments will rely on regulation and manipulation to force savers to pay down public debt through negative real returns on their bond investments.

Meanwhile, central bankers everywhere ask themselves: Why keep ever-larger international reserves in two of the world's most mismanaged currencies, the U.S. dollar and the euro? However rare changes in reserve currencies have been historically, the current situation is no longer tenable, but a switch could further destabilize the world economy.

The West's economic mismanagement will also reduce its military power. At present, the U.S. accounts for half of all global military expenditures, but cuts are due. Relative U.S. military power is not likely to be this great ever again, and China's military rise looks as inevitable as its economic success. Even so, some economists still advocate more fiscal stimulus. Instead, Western leaders need to focus on fixing their state budgets in order to salvage what they can.

Anders Aslund, a senior fellow at the Peterson Institute, is the author of "The Last Shall Be the First: The East European Financial Crisis, 2008-10." © 2011 Project Syndicate


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