International Financial Crisis The Aftermath

1. International Financial CrisisThe Aftermath Global Risks and Opportunities Joseph E. Stiglitz Trinidad and Tobago September 9, 2011

2. The big questions • Where are we now, four years after the breaking of the bubble, and almost three years after the collapse of Lehman Brothers? • How did we get here? • What are the choices we have? • What are the choices that are likely to be made—and what will they imply? • What does all of this imply for emerging markets and developing countries, including the Caribbean?

3. A divided world • Global growth reasonably good—for 2011, projected to be about 4.4% • Slightly lower than 2010 • But much better than 2009, when it shrank .5% • Continuing weakness in US and Europe • Europe 2011 projected to be only around 1.6% • But large differences within Europe—Germany 2.5% • Strong growth in emerging markets, especially Asia • China projected to grow at slightly less than 10% • Though government is trying to cool economy • Developing Asia projected to grow at 8.4% • Sub-Saharan Africa projected to grow at 5.5%

4. Prospects for US and Europe: A Japanese-style malaise • Continuing weaknesses in Europe and the U.S. • Some chances of a much deeper downturn (double-dip) • Growth too slow to create enough jobs to bring down unemployment • Official US unemployment rate 9% • Teen unemployment 23% • African-American teen unemployment 40% • Still, almost 1 out of 6 of those who would like a job can’t get one • Jobs deficit almost 25 million • More than 40% of the jobless are long-term unemployed

5. Fundamental problem • Lack of aggregate demand • Before crisis, US economy (and much of the world) was fueled by unsustainable housing bubble • Savings rate plummeted to zero • Bubble hid underlying problem • Structural transformation— • successes in increasing manufacturing productivity meant fewer jobs • Changing global comparative advantage • Growing inequality • Those whose incomes were stagnant and declining told to continue consuming • Not sustainable • Reserve build-up in emerging markets • Precautionary savings • Export led growth

6. Why prospects of US recovery are so dim • Breaking of bubble left in its wake a legacy of excess capacity in real estate and debt—exacerbating fundamental problems • Solving financial crisis by itself would not resolve underlying problems • But we have not fully addressed problems in financial sector • Continuing problems of lack of transparency • Continuing problems of excess risk taking • Continuing problems of undercapitalization • Problems of too-big-to fail worsened • Haven’t fixed problems in housing market • Prices continue to fall, foreclosures continue at rapid rate • Haven’t done anything to address underlying economic problems • Again, in some areas, they have become worse • Countries with large reserves did better—incentive to build up reserves further • High unemployment is contributing to increasing inequality

7. Why prospects of US recovery are so dim • Consumption likely to remain weak, given overhang of debt, high unemployment, weak wages • And it would be bad for long-run prospects if US returned to profligate consumption pattern • Investment likely to remain weak, given excess capacity, overhang from excess investment in real estate during boom years • Small businesses cannot get access to credit • Source of job creation • Banking system—especially the part engaged in lending—remains weak • Most borrowing is collateral based; collateral real estate; real estate prices down markedly • Exports uncertain, given weaknesses in global economy • US lost capacity for exporting in many industries

8. Weak prospects for US • Government, rather than offsetting weaknesses in private sector, is exacerbating them • End of stimulus implies fiscal contraction • Stimulus worked, but was too small and not well designed • Administration underestimated depth and duration of downturn • Thought that the underlying problem was just a banking crisis; repair the banks and the economy will be repaired • Even if banks were working perfectly, economy would be weak • Exacerbated by declines in state revenues • States have balanced budget frameworks • Responses of states—cutting expenditures rather than raising taxes—bad for short-run stability • Problems exacerbated by federal aid cutbacks

9. What US needs – and what it is likely to get • Needed: large second round of stimulus • Aimed at high return investments (in education, infrastructure, technology) • Stimulating the economy today • And providing basis for long-term growth • Helping address some of US long term problems • Aid to states, to prevent further cutbacks (total government employment now less than in 2008) • Can the U.S. afford stimulus? • Can’t afford not to • Long-term fiscal position will be improved if government spends on investments • “Balanced budget” multiplier also large • But Congress unlikely to agree to large increases in revenues

10. What US needs – and what it is likely to get • Actually getting: • Two-year extension of Bush tax cuts • Likely to stimulate economy only a little • But will probably increase deficit substantially: low bang for buck • One-year extension of payroll tax • Will have some positive effect • But what happens January? • Dose of austerity • Weakening the economy further—overwhelming evidence that austerity is wrong medicine, deficit reduction will not restore confidence in economy • Budget compromise entailed only small dose of austerity

11. Monetary Policy will continue to be ineffective • Played an important role in creating crisis • But much less effective in helping economy get out of crisis • Low interest rates have not worked • Low interest rates are not likely to work—even with commitment to keep them low • Excess capacity • SME lending still restricted—haven’t fully fixed banking sector • Large firms flush with money—credit is not the problem • Low interest rates contributing to jobless recovery • Inducing firms to substitute low cost capital for labor

12. QE II did not work • Money goes where returns are highest—emerging markets, not US • It goes where it’s not needed, not where it is needed • Consequence of global capital markets • May contribute to increase in commodity prices (inflation) • Responses of emerging markets contributing to fragmentation of global capital markets • May have had slight benefit in competitive devaluation • And in temporary increase in equity prices

13. Europeis equally frail • Some countries in particularly bad fiscal position • But even those that are not (such as UK) are engaging in austerity • We were all Keynesians, but for a moment • Austerity will slow growth markedly • Uncertainty in euro area • Took away interest rate and exchange rate mechanisms for adjustment, put nothing in place • Problem is not a surprise—predicted at the onset

14. From bank bailouts to sovereign bailouts • Bank bailouts meant socializing losses (Ireland) • Bad economics, bad politics • Hard to ask ordinary citizens to bear consequences for mistakes of private bankers—when they walked off with so much money • Even without bailouts, though, crisis caused by financial sector has weakened fiscal positions • But with the potential of future bailouts, bank balance sheets and governments are intertwined • Future bank losses likely to be borne by public • Including those arising from real estate (Ireland) or sovereigns

15. The end of the euro? • Bailout measures only temporary palliative—haven’t changed basic economics • Political issue: will they be able to create more permanent institutions? (“solidarity fund for stabilization”) • Or will they be even willing to roll over the debt? • Austerity measures imposed on Greece will depress economy, unlikely to produce hoped for improvement in public finances • Fire sale privatizations and further cutbacks are likely to be politically unacceptable • But will further assistance without still more measures be acceptable to the rest of Europe? • Without real assistance, default is inevitable • But default (restructuring) may not be enough—will need to devalue • Argentina showed that there is life after default and devaluation

16. The end of the euro? • I believe European leaders are committed to preserving euro • But strong opposition from voters in many countries for assistance to Greece and other countries • Process of reaching and implementing agreements very slow • Too slow for changing market realities • July agreement was a good one • Recognized principle of private sector involvement, importance of growth, need for assistance, interdependence of Europe • But there have been significant problems in implementation • Finish demand for collateral • Slovak refusal to bring to parliament • And even before implementation, events have shown not enough money • Uncertainty will cast pallor over Europe and global economy • Break up would have significant effects on global economy, banks • Already contributing to credit tightening, banking problems

17. So what does this mean for emerging economies?

18. Big questions for emerging economies • Can emerging economies have sustainable growth even in the presence of weakness in the West?  Answer:  Yes, on the strength of the growth of domestic demand. • Is there a risk of the emerging markets overheating—and then crashing?Answer: Yes, but China, at least, is acting to limit that risk.

19. Lessons from Asia: a changing global economic landscape • Unprecedented growth in Asia • Rapid convergence • China already 2nd largest economy • On the way to being largest economy • Already largest source of savings • “Correcting” a two-century-long aberration • Economic model markedly different from American-style capitalism (especially in East Asia) • Larger role for government • More government controls • Especially in financial markets

20. Asian economic model has worked • Not only to promote unprecedented growth • But also for stability • Avoided the excesses of the US • And even to manage the instability foisted on them

21. After the crisis • Recognized that excessive deregulation was responsible for the crisis • And financial and capital market liberalization may have contributed to the rapid spread of crisis around the world • Countries that had maintained regulations (including on cross-border capital flows) fared better • But US Treasury does not seem to have fully learned the lesson

22. A new global economic order:1. New Governance • Rules governing global economic system have largely been written by advanced industrial countries, for advanced industrial countries—or for special interests within those countries • Based on “free market” ideology • But justified in terms of “economic principles” • Similarly, for international institutions governing globalization • Marked by flawed governance

23. A new global economic order:2. New Balance of economic power • Rapid growth in emerging markets, continued slow growth in advanced industrial countries • High savings in emerging markets • Why should they rely on the flawed financial markets of advanced industrial countries to manage their finances? • Closing the knowledge gap • With many even becoming a source of innovation • Growth enhances fiscal resources, giving government more room to promote growth with equity • US wastes large amounts on defense, costly wars • Leaving less room for growth enhancing investment • Most Americans worse off than they were a decade ago

24. A new global economic order:3. New Ideas • The end of market fundamentalism? • Key lesson: need a balanced view of role of government and market, civil society • Not just size of each, but what each does and how they interact • Many models of market economy, some perform better than others • Scandinavian model has performed better than others • On a broad range of indicators • Key has been a larger role of government, more social cohesion, low levels of inequality • Markets on their own also do not “solve” other problems • Role of government in education, technology, infrastructure, social protection and promoting environment

25. Some implications for the Caribbean and Trinidad and Tobago • Close ties with US economy will have adverse effect on growth • Tourism likely to remain weak • Except high-end tourism • Persistence of /increase of inequality • But the price of oil is likely to remain high • Strong demand in China, other emerging markets likely to offset weaknesses in advanced developing countries • But large increase in supply of gas in US likely to moderate gas prices

26. Latin America increasingly reorienting itself toward Asia • May be able to sustain growth • For Caribbean (and others) obvious implications • Diversification • Reorientation

27. Some implications for financial markets • Equities (except for banks) may do better than one might expect, given weaknesses in economy • Low interest rates • Low wages • Cost-cutting measures • But these responses are likely to contribute to ongoing weaknesses in economy

28. But high degree of uncertainty—episodic “mini-crises” (e.g. associated with Europe’s problems) –will ensure high volatility, overall “flight to safety” • With some risk that one of these mini-crises becomes a real crisis • With center of crisis in Europe, euro may weaken, hurting US exports, weakening US economy further • Considerable uncertainty about US financial systems exposure to Europe • One of consequences of lack of transparency of financial system

29. Concluding Remarks • The policies that have been pursued by the US and some countries in Europe failed to enhanced the well-being of most their citizens and were not sustainable

30. Measuring success • GDP is not a good measure of success • Objective of economic policies should be sustainable, equitable, democratic development • Trickle down economics doesn’t work: most Americans are worse off today than they were a decade ago • Lower real incomes • More insecurity • Lower quality of life • Need to look at how benefits of growth are being shared

31. Sustainability • Many dimensions: economic, political, social, and environmental sustainability • US economic policies before the crisis were not economically sustainable—true for many other countries around the world • Current patterns of growth are not environmentally sustainable • The planet will not survive if everyone aspires to America’s profligate lifestyle • For the world, increasing sustainable investments is key to addressing the world’s short-run and long-run problems • Could help US and Europe emerge from the malaise into which they seem to be sliding • Countries that adapt to the new reality sooner are more likely to prosper

32. Managing Resources • Resource wealth has to be carefully managed • Countries like Chile that did so have weathered storm better • Maximizing value obtained • Using new global competition to extract the maximum rents • Making sure that resources are well used • Transparency is key • Macroeconomic management • High level of volatility • Risks of exchange rate appreciation (Dutch disease) • Many countries have failed • Low growth, high inequality • But some have succeeded • If wealth below ground is not reinvested above ground, country is poorer

33. Final Remarks • US, Europe, and the world are not likely to take the policy actions that would ensure greater stability going forward—or even a quick recovery for US and Europe • Smaller trade-dependent countries around the world have to adapt to this unfortunate turn of events

34. This makes it all the more imperative that they design policies to buffer themselves against this volatility and which promote growth, even when there is limited scope for expansion of exports to traditional markets • Monetary and exchange policies • Fiscal policies • Industrial policies • Education and infrastructure • Social protection • In doing so, they can achieve equitable and inclusive, stable and sustainable growth