Some reflections on the financial and economic crises

1. Some reflections on the financial and economic crises Luc Soete UNU-MERIT, University of Maastricht The Netherlands Maastricht University alumni meeting, Brussels 03-06-2009

2. Outline • A historical day… tomorrow European elections in the midst of the worst economic crisis since the 2nd World War. • A unique crisis… major macro-economic challenges. Very different scenarios of what the crisis will bring us. • Specific focus on the impact of the financial crisis on knowledge investments • European and global long term challenges

3. 1. The financial crisis • A double squeeze: a financial crisis having affected the real economy with a mutual reinforcing double squeeze on the economy. • Practically all large international operating banks were technically bankrupt, slow but still difficult improvement. • An economic recession which cannot be addressed using traditional financial tools, banks no longer being in a position to carry out that function. • Large financial banks have become “dead bodies”: black holes in our economy, absorbing public money but no longer emitting any economic dynamism. • As a result a declining financial sector in most (small) countries in coming years with large public funding involvement.

4. Systemic failures of credit markets • High leverage levels • Globally interconnected • High uncertainty McKInsey Analysis • Why this crisis is unique and very different • A number of credit markets have come to a stand still at the same time • High leverage levels in combination with asset write downs result in a credit contraction that slows GDP as no cash for investments is available • Almost all economies and markets across the globe are hit, limiting the possibility of recovery through strong demand or capital injection from other regions • Two mutually reinforcing forces (the financial crisis and a recession) are having impact on the economy which makes potential outcomes very hard to predict and potentially very negative

5. 0,16 Mutually reinforcing effects • Banks try to restore solvency • Over the past 8 years, leverage has reached unprecedented levels • Sell assets to restore capital ratio • Asset • Price • Rise • Financial • Innovation • Commercial paper markets collapse • Further asset write-downs • Cheap Credit • Lowers asset prices • US Subprime crisis • Lehman Failure • Commercial paper collapses (counter-party risk) • Adverse selection further depresses market • Economic contraction • Companies who can turn to bank credit lines • Economy contracts • Banks further tighten lending standards • Markets are trying to adjust to the changed conditions, but it is unclear what the end-state will be and how long it will take to get there • Increase in non-performing loans Source: Morgan Stanley; Federal Reserve; BEA; The Economist; McKinsey analysis

6. A simple way to think about policy measures in a downturn (McKinsey Global Institute) • ‘End state’ • Economic activity • Time • 3. Create stronger end state • 2. Accelerate the recovery rate • 1. Limit the slide down • Working through the cycle to a stronger end point • Combine short term correction with longer term strengthening • Mix financial recovery with economic recovery • Differentiate a mix of measures for three recession scenario’s (moderate, strong and “deep freeze”)

7. “Limit the depth” “Accelerate recovery” “Shoot higher” • Protecting business in distress • Stimulate demand/ economy • Strengthen/ maintain fundamentals Example measures • ILLUSTRATIVE • Example interventions • Support work time reduction • Support specific companies/ sectors (e.g., construction) • Improve bankruptcy legislation (tax claims, ch.11) • Creating bank rescue funds • Create company refunding fund • Reduce tier-1 ratio’s in banks • Improve bankruptcy legislation (Ch.11, tax) • Protect investments in new technologies/Research • Create credit guarantees • Move forward large investment projects • Reduce taxes/ defer tax payments • Stimulate car purchases • Stimulate entrepreneurship • Support adult training in down-time • Purposeful government buying • Stimulate higher efficiency/ renewable technologies • Purposeful government buying • Show commitment to foreign companies risking to move • Stimulate investment in education • Reduce corporate tax (to attract and improve business) • Focused attraction of foreign business • Protecting investments in R&D

8. “Limit the depth” “Accelerate recovery” “Shoot higher” • Germany • € 62 bn • 2.6% GDP • France • € 26 bn • 1.4 % GDP • UK • € 23 bn • 1.5% GDP Countries response so far focuses largely on short term • Investment in infrastructure • Reduce tax for low incomes • Cuts in social security cost • Credit guaranties for SME • € 500 bn bank rescue fund • € 100 bn credit fund • Recycle premium for old cars • Recycle premium for old cars • Not clear • Investment in infrastructure • Support car industry • Support for construction, energy, transport sectors • Investment in social residences • Faster returns of VAT • Credit support for SME • € 350 bn bank rescue fund • Forward investment in education and defense • Increased funding for energy efficiency of houses • Increase subsidies for energy efficient cars • Reduce VAT 17.5 to 15% • Delay increase in corp tax. • Allow deferred tax payment • Exempt foreign dividends • Forward investment in roads • Loan guarantees for SME • 400 bln bank rescue fund • Forward investment in schools and home insulation • Subsidy for hiring new employees • 75.000 training places for unemployed • Funding jobless to set-up business • Not clear

9. Alternative crisis scenarios • Regeneration of globalization Recession 3-4 quarters, then strong growth • New, effective regulatory regime • Recovery is broad-based • Credit markets recover, safe leverage ratios, cost of capital to historic norms • Global trade recovers rapidly • Battered, but resilient Recession 2-5 years, then strong growth • New, effective regulatory regime • Recovery led by regions (eg. US, China) • Credit Markets recover, safe leverage ratios, cost of capital to historic norms • Slow recovery of global trade Early Recovery Capital Markets Crisis • Disruption Recession > 10 years (“Japan-style”) • Major disruptions bringing about new national regulatory policy experiments • Credit markets rely on government input, cost of capital and energy high • Global trade drops, knowledge as well highly skilled labour mobility increases • Stalled Gobalization Recession 1-2 years • Recovery is based on national markets and national industrial policies. • Financial and credit markets renationalize and downsize. • Recovery growth quickly runs into foreign energy dependence so that global trade recovers only slowly Continued Slowdown Severe Moderate Economic Global Recession Source: McKinsey Global Institute

10. Global developments • Slow but balanced growth • Redirection of global financial flows in a more balanced way • Growth in US and UK savings, reduction in reserves in China and S-E Asia – new role for IMF • Stronger representation of emerging countries in international financial organizations • Growing international trade conflicts • No change • At first rapid recovery • Limits to unsustainable growth (oil price, raw materials, agriculture increases) expressed in re-occurrence of crises in new areas (water, health, environmentally induced migration, …) • Rising inequality and exclusive growth, resulting in unsustainable social exclusion, increased security costs Early Recovery Capital Markets Crisis • Knowledge globalization • Dramatic slowdown in trade of goods, with severe structural unemployment & new specialization patterns emerging • Long disruption period with globalization governed by green concerns: priority on global implementation of environmental technologies • High skill labour mobility • Financial nationalism • Focus on protecting national savings, going for national and international “trust” investments (local banks and global “community” banks) • Regional disparities with growing labour migration pressures • Financial global imbalances limit national growth opportunities Continued Slowdown Severe Moderate Economic Global Recession Adapted from McKinsey Global Institute

11. 2. Impact of crisis on research • Traditionally, one would view private research investments as evolving in an anti-cyclical way: • The negative impact of the recession on profitability forces firms to focus on the most productive segments of their output: the opportuntiy costs of achieving productivity growth is lower in recessions, providing incentives to undertake research activities in downturns (Aghion and Saint-Paul, 1998; Canton and Uhlig 1999); • R&D-personnel will be subject to “labour hoarding”; the most qualified scientists and engineers will be kept at the expense of lower skilled personnel. • However, with respect to innovation, the cyclical view appears the most common: • Innovation or the implementation of new ideas, wil be postponed in a recession till the boom period (Shleiffer, 1986 and Francois and Lloyd-Ellis, 2003); • The so-called innovation acceleration hypothesis of Gerhard Mensch (1975) whereby radical innovation would be favoured in depressions out of despair remains subject to debate (Clark, Freeman and Soete, 1981). • Well illustrated in the case of ASML, the Dutch litographic machine maker: • R&D intensity increased significantly over the period 2001-2003 following the dramatic dowturn in IT sales in 2001; • innovation peaked with the introduction of a new generation of machines over the boom period from 2005 onwards.

12. ASML’s R&D ASML’s R&D budget = total revenues of one of its competitorsSecond largest, non-government R&D investor in the Netherlands 500 4000 R&D investmentM€Total sales M€ 450 3500 400 3000 350 2500 300 2000 250 1500 200 1000 150 500 0 0 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 Source: ASML Slide 12 |

13. Knowledge investments not part of recovery plans? • As a result traditionally macro-economists will not consider supporting research, higher education and innovation a priority in addressing the economic crisis: • Prioirty goes to short term, demand led economic recovery plans as opposed to more long term structural reform plans such as R&D and human caoital investment support; • Given the counter-cyclical nature of research and productivity investments, the deeper the economic crisis, the quicker the structural transformation towards a knowledge economy. Thanks to the economic crisis, the EU might actually come nearer to its Lisbon and Barcelona targets in 2010! • While innovation will lag behind, there is little one can do about it... successful innovation is ultimately crucially dependent on entrepreneurial market expectations: it is endogenous to the business cycle. • The central assumption behind this view: firms will consider their R&D investments as costs “of last resort”: essential long term investments for the future of the company. However, this • Depends on the nature of the recession • The nature of funding of research and innovation (Barlevy, 2007).

14. Nature of the crisis • A rather unique crisis originating from within the financial sector and affecting the real economy under the form of a dramatic change in “risk aversiveness”. Private financial institutions which normally play the role of central agents in any counter-cyclical recovery policy have become by and large “dead bodies”, in some countries even “black holes”. • Spreading of lack of trust in future risks with private investors as a result of the huge write-offs over the last year and growing distrust in society: a fertile ground for growing financial nationalism; • The current dominant philosophy of “Cash is king” has a direct negative impact on knowledge investments: • Within stock listed companies, the CFO’s pressure to distribute as much of the limited profits as dividends – in a recession a crucial differentiating factor signalling solvability and managemnet reputation– is likely to prevail over long term R&D investment commitment. • Within SMEs as credit is becoming difficult to get, the focus will shift to organisational and easy to implement process innovations reducing costs and inventories. New product innovations and renewal investments will be postponed. • Finally high-tech starters will postpone the introduction of new product innovations. As a result seed money providers are having difficulties in finding sufficient worthwhile investment proposals. The venture capital market collapses.

15. Policy responses • On the supply side: structural policy reforms in research: • Broadening of existing R&D support schemes for the private sector but also closer private-public interaction: • Need for complementary policies within broader trend of increased (global) specialisation of private R&D within large firms with a growing trend towards “outsourcing” in the direction of small firms. • Use opportunities for increased “outsourcing” of a number of specific R&D-activities in the direction of public sector (universities and other public research institutions); • New role, with partly public (local) funding support for some of the large private R&D labs as “open” systemic innovation infrastructure; • Arguments similar to support for systemic banks but with one major difference: not aimed at stabilisation but at enhancing growth dynamics. Example of dismantling of Bell Labs in the 80’s and impact on private R&D in US of many of those underutilized R&D managers.

16. Long term growth opportunities • On the demand side focus on sustainability: • Fasten the development of various possible “lead markets” using technology procurement following the US example with respect to DARPA, NASA, NIH, etc.; involve the private sector more actively in technology development and innovation in so-called societal innovation programmes (health, education, mobility and logistics, security); • Thanks to internal EU rules, such national “innovation procurement” will not result too easily in hidden support for the own national industry.; • Use the immediate local growth and employment opportunities associated with the application and diffusion of green technologies to the full. E.g. “green” construction represents a long term productive investment both for the public and private sector, including house owners; • Focus the recognition of “grand challenges” on sustainable development. Use this new “mission” focus so as to bring about a brake in the current lack of trust with private investors and starters in future risk taking; • Make investments in sustainable investment shares and bonds fiscally more attractive.

17. A less flat research area in Europe after the crisis? • Historically there have been continuous shifts in public versus private funding of research and innovation, sometimes in favour of public funding (2nd World War and post-war period), sometimes in favour of private funding (80s and 90s). • Today given the risk aversiveness on the financial side, there is a need for stronger role of public funding; • Crucial for the effectiveness of research and innovation is not so much the funding origin but the performance location. • EU countries with high R&D investments (Finland, Sweden, Germany) typically embrace the view that the financial crisis offers opportunities for domestic structural reforms strengthening R&D and innovation, including the deployment of “green” technologies and eco-innovation; countries with low private R&D investments appear to only marginally refer to research and innovation stimulation measures within their domestic recovery plans; • In the long term these different policy responses are likely to signal a further growing divide between EU countries: a forced crisis knowledge specialisation • technologically leading countries which have the policy room for investing more public resources in knowledge taking a further lead • and a group of falling behind countries adjusting their specialisation towards less technologically advanced goods and services. • The public resources for knowledge and innovation investments are up to now nowhere under pressure (even not in Island). Most planned expansionary R&D and innovation investments appear to be continued; the real test though will only come when countries will see their budgetary deficits increase rapidly over 2009 and 2010.

18. 3. Globalisation and the crisis: a historical return to normal? • What remains striking from ahistorical perspective is how the two largest countries in the world: China and India, saw their share of world population and their share of world GDP more or less continuously fall over the period 1820 till 1973. Actually, I would hypothesize that in 1973, the imbalance between the world’s concentration of GDP and the world’s concentration of population was the highest the industrialized world ever winessed. • This extreme geographical inequality in world GDP has formed the basis of the unilateral focus of both social scientists and policy makers on domestic competitiveness and in particular on technological competitiveness as the essential feature for a country’s future economic growth. • As Ulrich Beck put it: “The consequences of globalization for sociology have been spelt out most clearly in the English-speaking countries, but above all Britain, where it has been forcefully argued that conventional social and political science remains caught up in a national-territorial concept of society. Critics of ‘methodological nationalism’ have attacked its explicit or implicit premise that the national state is the ‘container’ of social processes and that the national framework is still the one best suited to measure and analyse major social, economic and political changes. The social sciences are thus found guilty of ‘embedded statism’ and thought is given to a reorganization of the interdisciplinary field”.

19. China and India’s late industrialisation However, the recent rapid industrialisation of China and India appear e.g. from the available Cambridge world economic model simulations (Izurieta and Singh, 2008) non-sustainable. It will ultimately lead to financial imbalances with a huge current account deficits for the U.S. economy but also other resource constraints. Furthermore from an environmental perspective at current levels of technology, growth rates of 3% per annum in the advanced G7 countries and rapid sustained growth in emerging economies are unsustainable in terms of agriculture production, access to water and climate impact. At the same time, fast economic growth in India and China appears a social necessity because of the need to shift hundred of millions of people from farms to industry. In the Indian case there is an additional compulsion of providing jobs for a labour force which is growing at 2% per annum. The advent of the ICT revolution in the 90’s has radically challenged the national-territorial bias in research and policy making. The cluster of ICT represents from a global perspective a historically unique process of technological, organisational and above all social transformation in terms of speed and world-wide impact. A level playing field in aspirations: in consumption, income and quality of life.

20. G-5 share of population and GDP

21. The 21st Century and some EU international implications • The advent of the ICT revolution in the 80’s and 90’s has radically challenged the national-territorial bias in research and policy making. The cluster of ICT represents from a global perspective a historically unique process of technological, organisational and above all social transformation in terms of speed and world-wide impact. • In a certain way this means that compared to GDP as in the past, population is likely to become the indicator of future market opportunities. • For countries like the EU ones, it means that their future global role will decline, first because decline of share in world population, given the demographic structure of EU population with the ageing of the baby boomers, and second because likely relative lower labour based GDP growth compared to emerging economies. • Migration and/or enlargement should from this perspective be seen as an important future additional growth factor for the EU. • As Gijs Beets illustrated of the 15 most populated countries in 2025 (countries with more than 100 million), not a single one will be a European country. In short, the EU is primarily composed of small countries, and thus also small markets. Only if the EU-27 would act as a singly country, as in the case of WTO, will the EU still play an important international role.

22. The global knowledge challenge

23. Conclusions • Crisis is unlikely to disappear with partial recovery of stock markets, interaction between real and financial sector works both ways. Negative influence today and probably in the coming year from the real economy to the financial sector. • Limited public sector room for further interventions… It will be essential for the Ministries of Finance to get the surplus value on their financial participations. Danger of being governed by strict but overly negative accounting rules. • Long term challenges to European knowledge investment. E.g. the European Barcelona 3% R&D/GDP target arose from concerns that Europe’s industrial R&D appeared to lag too far behind that of the other technologically leading countries such as the US and Japan. The assumption was that more R&D carried out in Europe would be a crucial factor behind Europe’s attempt at becoming the most competitive region in the world. It was always obvious that R&D as an investment cost target is somewhat of an odd policy target. More important is the question what the results are… • iT is time to think of a new Lund green R&D investment/GDP target whereby the focus would not just be on research but also include knowledge diffusion and application. This new Lund target would ultimately also have to focus on implementation outside of Europe. European competitiveness will ultimately be most dramatically strengthened if doing so directly contributes to the global grand challenges. • As European citizens we are ultimately dependent on the speed of (green) knowledge diffusion in both our countries as well as those in the rest of the world.