The World Economy: Where Do We Go from Here? GLOBAL ECONOMIC RISKS AND OPPORTUNITIES IN 2011

1. The World Economy: Where Do We Go from Here?GLOBAL ECONOMIC RISKS AND OPPORTUNITIES IN 2011 Joseph E. Stiglitz London May 18, 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?

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 Asia and other emerging markets • China projected to grow at slightly less than 10% • Though government is trying to cool economy

4. Prospects for US and Europe: A Japanese-style malaise • Continuing weaknesses in Europe and the U.S. • Growth too slow to create enough jobs to bring down unemployment • Official unemployment rate 9% • Teen unemployment 23% • African-American teen unemployment 37.5% • 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 • Breaking of bubble left in its wake legacy of excess capacity in real estate and debt

6. 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

7. Weak prospects for US • 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

8. What US needs – and what we are 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

9. What US needs – and what we are 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 in one year’s time?

10. What US needs – and what we are likely to get in deficit reduction • US had a surplus of 2% of GDP in 2001 • Remarkable turnaround—to 10% of GDP • Four major causes—suggesting solutions

11. What US needs – and what we are likely to get in deficit reduction • Four major causes—suggesting solutions • Economic downturn • “Put America back to Work” • Tax cuts • Argued for on the grounds that we were about to pay down all of national debt, and without debt, Fed couldn’t conduct monetary policy • Couldn’t afford tax cut then—and even less so now • New Medicare Benefit—with government not allowed to bargain with drug companies (costing $1 trillion over 10 years) • US would have no deficit if our health care system was as efficient as that of Europe

12. What US needs – and what we are likely to get in deficit reduction • Very expensive wars • Up front costs over $1 trillion • Future costs for disability almost $1 trillion • Total economic costs over $3 trillion • New war on terror—without ending Cold War • Could get more security with less spending • Further measures that could be taken • Ending corporate welfare (subsidies to coal, oil, and ethanol) • Restructuring taxes to encourage investment • Better sale of national assets (spectrum, timber, natural resources)

13. BOTTOM LINE • There is an alternative to austerity • Restructuring expenditures and taxes and can stimulate the economy—and lower national debt in long run (and maybe even in the short run) • Austerity will slow the economy today and in the future, reduce tax revenues and increase expenditures—minimal improvement in fiscal position

14. what we are likely to get in deficit reduction • Gridlock—Two different visions • Accounting tricks—basis of compromise • Resolutions about cutting spending in future • Fiscal Stringency today • A combination that will not reassure markets, but will dampen the economy

15. What US needs and what we are likely to get • Restructuring mortgages • ¼ of all mortgages underwater • Nothing likely to happen • Inducing banks to lend at affordable interest rates • Money went disproportionately to banks that were not engaged in SME lending • Restructuring of banking system led to less competition, increased gap between lending rate and deposit rate • Dodd-Frank bill did little to redirect attention of banks towards lending • Securitization model for housing has not been repaired—and not likely to be—implying increased reliance on banks • Government has been buying all mortgages—not a sustainable policy • Deficit reduction pressure likely to highlight tax preferences for real estate, leverage

16. Monetary Policy likely to be relatively ineffective • Quantitative easing has considerable risks, few benefits • Short-term interest rate already near zero, small change in long-term interest rates not likely to have much effect • Large firms awash with capital • Banks unlikely to increase significantly lending to SME’s at more favorable terms • Other channels quantitatively small (except possibly competitive devaluation) • Impact on inflationary expectations can make QE counterproductive • Some interest rates, such as 5- and 10-year Treasury rates, have already increased over the last 6 months.

17. Monetary Policy likely to be relatively ineffective • Costs • Expected capital loss by government • Lower income to older individuals relying ongovernment interest rates • Increased uncertainty— • Bubbles • Inflation • Future conduct of monetary policy • Responses of competitors to competitive devaluation—likely fragmentation of global financial markets

18. Europe is 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—it was predicted at the onset

19. 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

20. From Bank bailouts to Sovereign Bailouts • 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 • Uncertainty will cast pallor over Europe and global economy

21. Strong growth in Asia and other emerging markets • Asia is different • Had learned lessons from previous crises—need for good financial regulation • Strong public finances provided them resources to respond to crisis • Adopted effective Keynesian policies—and they worked • Strong infrastructure investment will simultaneously provide basis for long term economic growth

22. Strong growth in Asia • Helping other developing countries (Latin America, Africa) • But Asia is still too small to restore growth in advanced industrial countries • Partial decoupling

23. Strong growth in Asia • Big Question: Can Asia sustain growth with Europe and America in malaise? • Likely answer: YES—huge domestic markets to be developed • Will need to continue restructuring away from export-led growth • Green investments will be important

24. Japan: Still in a Malaise? Facing both macro- and micro-problems Proximity to high-growth countries in Asia major advantage But need to recognize rapid changes in dynamic comparative advantages Earthquakes and its consequences Worry that debt levels are unsustainable What would happen if interest rates should rise, to levels facing other countries with comparable debt/GDP ratios? But under current conditions, more austerity could (as elsewhere) lead to economic downturn Need to focus on direction of government spending, e.g. investments in technology, improvements in quality of education

25. Both macro- and micro-problems Non-competitive exchange rate In volatile world, stability of Japan an advantage But the advantage has turned into a disadvantage, as excessively high exchange rate makes exports non-competitive Other countries (emerging markets) engaged in massive interventions Japan needs to consider further interventions Strong manufacturing sector But intense competition, with declining returns Long recognized that there is a need to strengthen other sectors More active industrial policies (arguably basis of earlier successes)

26. Demographic transition Exploring problems that will be faced by many other advanced industrial countries Adapting Changing retirement ages Cutting retirement benefits And responding— Opening up migration? Encouraging population growth? Political economy Aging population distorts spending toward elderly and away from investments in young With adverse efficiency and distributional consequences Focuses attention of BIG questions Sustainable growth World will have to learn to live with stable populations (global warming) GDP increases do not accurately reflect improvements in well-being

27. Global Perspective • Political gridlock in US combined with new enthusiasm for austerity likely to prolong recovery • Underlying problems in US not being addressed • In world of globalization, what matters is global aggregate demand; underlying weaknesses due to • Growing inequality • Precautionary savings—build up of reserves—in aftermath of East Asia crisis • Crisis may have exacerbated problems, not reduced them • New global reserve system could make a big difference—but the US is resisting change • With end of fiscal policy, ineffectiveness of monetary policy, attention will switch to trade —protectionism and competitive devaluations • Heightening tensions, uncertainty

28. Currency war • Beggar-thy-neighbor policies won’t lead to global recovery • Worry about asset bubbles (especially in emerging markets) is leading to currency interventions, capital controls, taxes, etc • Global imbalances are a major source of worry • Didn’t cause the last crisis • But could cause the next • Moderate changes in exchange rates not likely to affect global imbalances significantly • But large changes in exchange rate could contribute to global instability and impair recovery

29. What the world needs • The problem—both before the crisis and today—is not a savings glut, but the failure of financial markets to recycle savings to where there are high social returns • Infrastructure and technology, especially in emerging markets and developing countries (especially Africa) • Retrofitting the world to respond to climate change • Had Copenhagen succeeded in ensuring a high price of carbon, demand for investment would have increased markedly, and, if finance were available, that could have led a “green” recovery • The ultimate market failure: unused resources and unmet needs

30. What is needed: a growth compact • If US, Europe reignite growth, currency realignment would be much easier • Both China and US need to increase wages, reduce inequality • Both China and US need economic restructuring • US: away from consumption, away from sectors in which they have lost global comparative advantage; need to repair dysfunctional financial sector • China: away from dependency on exports, toward service sectors; recycle savings in a way that is more productive

31. What is needed: a growth compact • China and US and rest of world need to improve energy efficiency, respond to challenge of global warming • Infrastructure and other investments to “retrofit” economies all over the world to changing economic circumstances and environmental demands could be crucial element in pulling the global economy out of its current malaise

32. Concluding Comments • We have pulled back from the brink of disaster • But the world faces important uncertainties • Most likely prospect remains Europe and US mired in a slow and unsteady recovery • Strong growth only in Asia • Not just “more consumption”: the planet will not survive if everyone attempts to imitate US profligate style • But more investment—including those necessary to reduce environmental consequence of growth • And growth over next decade likely to be somewhat slower, less resource-intensive • With differences in conditions and perspectives making global coordination—the kind of coordination that might succeed in ensuring a shared and stable growth--unlikely