As governments in the Western World strive to revive their recession hit economies a new danger has emerged: The earlier massive stimulus packages have induced unsustainable budget deficits, that are forcing fiscal belt tightening in the relatively stronger countries such as the US, Germany and Britain, inspite of continued high levels of unemployment. At the same time the relatively weaker countries such as Greece, Portugal, Ireland and Spain face acute financial distress, requiring massive new bailout packages from their European partners who have very limited fiscal space for maneuver. In May this year, the EU and IMF had to put in place a Euro 750 billion bailout package for Greece. In November the Irish government was forced to seek an emergency rescue package of about Euro 85 billion. Spain, whose budget deficit as a percentage of GDP had reached 11 percent last year, may be the next in line to sound the alarm. The way this latest crisis is addressed, will shape the new global financial architecture.
4. The earlier erroneous belief that markets are self regulating and always deliver efficient outcomes, needs to be put to rest. The very nature of individual risk and the asymmetric information with respect to sellers and buyers of financial products in global markets create a systemic risk of market failure. (See my article in the Express Tribune of 30th November 2010). The aim of the new financial institutional framework should be to provide strong disincentives to individuals and firms to being carried away by escalating speculative risk. Essentially the new rules should aim at ensuring that finance serves its primary goals: allocate savings to high return projects and enhance the sharing of risk to avoid crises.
Europe faces a dilemma. Financially stressed countries such as Spain, since they are bereft of their national currencies having adopted the Euro, now do not have the option of achieving export competitiveness (and thereby pulling out of recession and revenue problems) through an exchange rate devaluation. On the other hand they will find it politically difficult to achieve export competitiveness through domestic wage cuts and industrial layoffs. That is why it is time to think the unthinkable: Can the institutional framework be put into place to enable orderly sovereign defaults?
In the current crisis, reducing the economic trauma for the defaulting country and collateral damage to others, will require new rules for empowering supra national organizations to oversee and facilitate sovereign debt restructuring and orderly time bound settlement of creditors’ claims.
An agenda for action is needed to develop a new regulatory institutional mechanism to avoid future financial shocks and reduce the danger of another recession such as the one that grips most of the world today. Based on historical experience and the latest economic research, some of the elements of this agenda of action can be indicated as follows:
1. A global institutional mechanism needs to be put into place without delay to manage the debt restructuring of countries on the verge of default. The framing of the rules and procedures for such a mechanism requires the participation of not just the US and Europe but also the new economic power centres such as China and South Asia.
2. Leaders across the world need to unite against unilateral actions such as competitive devaluations and protectionist measures that could push the world into a deeper recession.
3. The recent massive stimulus packages have increased the fiscal deficits in Europe four fold, to an average of 9 percent of GDP. Similarly public debt has reached unsustainable levels in rich countries, increasing from 80 percent of GDP to almost 100 percent of GDP in two years. The IMF estimates that it will increase further to 120 percent by 2015. Therefore the problem of supporting failing banks and financially distressed countries has to be put into the context of a new global debt restructuring mechanism. At the same time the composition of public expenditure needs to be changed towards generating revenue streams for the government in the future.