Global Downturn and Recovery – Learning the Right Lessons, my speech at the HSBC Global Investment Seminar, 16th October 2003

It is a great pleasure to be here today to contribute to your 21st Global Investment Seminar.

And the fact that there are so many delegates here today representing all parts, not just of the British but, of the international financial community is a tribute not just to the global reach of HSBC – now with 9,500 offices in 79 countries – but also to the continuing, indeed growing, strength of London as a global financial centre.

I have very much enjoyed listening to the first three presentations:

  • by Stephen King on the risks to the global outlook
  • by Jason James on equity markets
  • and by Mark Austin on currency markets

Some of the observations on the UK were indeed interesting. I will say something about the challenges ahead for the British economy at the end. But you will forgive me for not responding in detail today for, as you know, the Treasury updates our economic and fiscal forecasts only twice a year – at the Budget and then again in the forthcoming Pre-Budget Report.

What is clear already though – both for Britain and more generally in many parts of the world – is that, while the forecasts made in the UK at Budget time this April and by the IMF at the Spring Meetings were constructed at a time of particular political and economic uncertainty and tension, those political and economic risks have receded.

Since the Spring – and in particular in recent months – there are clear signs that economic activity is strengthening in some major economies and, more broadly, indicators point to the prospect of a steady and strengthening recovery going forward. Thanks to proactive monetary and fiscal policies, growth in some major economies is set to strengthen further. The UK is on track for stronger growth with low inflation.

Nevertheless risks remain in the global economy – in industrial, emerging market and developing countries – and it is important that policymakers stand ready to take the necessary policy actions.

So at this global conference it is the global economy that I want to address today – the lessons that we as policymakers must learn from the experience in 2001 of the first synchronised global downturn for three decades if we are to ensure that recovery is strong, sustained and shared by all parts of the world – developed, emerging market and developing countries.

I will start with:

  • the particular features of this downturn;
  • the risks that remain before us and the lessons that we need to combat those risks;
  • and end with how the UK fits into this global picture.

THE GLOBAL DOWNTURN

2001 saw the first synchronised slowdown in the US, Europe and Asia for almost 30 years, with all three of the world’s largest developed economies – the US, Japan and Germany – moving into recession. The unusual synchronisation of the 2001 slowdown can be explained in large part by its origin. The distinguishing feature of this slowdown is that it was one of the few business-led – rather than household-led – contractions in post-war economic history. Typically recessions in the world’s major economies have tended to be triggered by inflation, rising interest rates and then falling consumption, while business spending has usually played a secondary and passive role, reacting to changes in consumer demand.

But in 2001, while most major economies saw sharp falls in business investment and significant declines in equity prices, consumption held up – especially in the US and the UK. In the UK, private consumption grew by 3.1% in 2001, while in the US it increased by 2.5%.

Why was this slowdown so concentrated in the business sector? Part of the answer undoubtedly lies with the IT investment and associated asset price bubbles that built up, particularly in the United States, during the late 1990s and the sharp bursting of these bubbles. The strong global linkages between capital markets and increasingly product markets ensured that these effects quickly spread to most major industrial economies.

These developments took place against a backdrop of heightened uncertainty following 9/11, compounded during 2002 by a string of corporate governance scandals, the ongoing threat of terrorism, and concern about geopolitical developments in the Middle East. These uncertainties prompted further declines and volatility on global equity markets, high oil prices, sharp falls in business and consumer confidence, and significant movements in the major exchange rates.

Because this was a business-led recession, globalised markets ensured that the effects spread between economies even more rapidly than in past consumer-led recessions. Volatility and uncertainty was quickly transmitted from one country to the next. As a result, the impact on global markets for trade and investment became more intense and contagion between countries more pronounced:

  • World trade, which had grown by 12 per cent in 2000, barely grew at all in 2001.
  • In 2001, G7 industrial production – which had grown by 4.8 per cent in 2000 – fell by 3.2 per cent.
  • Emerging markets were hit not only by the slowing in trade, but also by much weaker capital inflows falling from $200bn in 2000 to just $120bn over the next 2 years. As a result, emerging markets have become substantial net capital exporters.
  • But growth in less developed countries has remained relatively resilient despite the global slowdown – albeit with substantial differences between countries

Country specific shocks have also played an important part in emerging market economies as the downturn exposed underlying vulnerabilities in some countries, such as Turkey and Argentina including: weaknesses in macroeconomic frameworks, the size and composition of public debt stocks, dependence on foreign capital, and the disappointing pace of structural reforms in recent years.

  • In Turkey a fragile banking system, widening current account deficit and banking liquidity problems triggered the beginning of a financial crisis in November 2000, a forced float and Turkey’s deepest recession since the 1940s.
  • In Argentina the collapse of an overly rigid exchange rate regime combined with an unsustainable fiscal policy to produce a devaluation and default that has crippled the economy over the past two years – with a clear contagion effect in Brazil, in the run up to the election last year where political uncertainty surrounding the future conduct of economic policy led to an abrupt sell-off by overseas investors.

But a crucial difference between this recession and the financial crisis in 1997 and 1998 was that investors discriminated better this time around between policies and economic fundamentals within emerging markets. This can be seen in high spread dispersion and significant tiering of spreads according to credit quality. In contrast to the previous downturn, contagion (measured by cross-correlation of bond spreads across emerging markets) has remained low – especially between regions. And this is being reflected in growth prospects.

Yet while the slowdown was synchronised, the recovery in different countries has been markedly different, depending on their policy responses, macro frameworks and flexibility of their markets.

  • In the past two years Canada and the UK have grown fastest among the G7 – despite the pressures faced by manufacturers and exporters – while inflation has remained close to target, thanks to continued strength in consumption and supported by accommodative monetary and fiscal policy.
  • US growth bounced back in the final quarter of 2001. It was fairly uneven in 2002 but more recently, as major uncertainties have receded, there are clear signs that confidence, corporate profitability, investment intentions and growth are strengthening.
  • But growth in Europe remains weak and activity in Japan is fragile. In Europe, having disappointed in the first half of the year, the signs are that growth will gradually recover towards the end of the year – but this looks set to be a slow process. In 2002 domestic demand grew by only 0.2 per cent – much lower than the UK and US. Meanwhile, in Japan recent data has been encouraging, but it is not yet clear that this will be sustained.

As a result of this continuing weakness in demand in Europe and Japan, and therefore what seems, after a synchronised downturn, to be a two-speed global recovery, current account imbalances, unusually, have continued to widen. The US current account deficit increased sharply during the late 1990s, reaching 4.5 per cent at the start of the recession in 2001. Since then it has continued to increase and imbalances in the global economy look set to persist, leading some to question the medium-term sustainability of recovery.

LEARNING THE LESSONS

I said at the outset – that there are now clear signs that economic activity is strengthening or set to strengthen in most major economies albeit at differential speeds. But real risks remain.

There is clearly – there is always – a long list of conjunctural risks – including risks to sentiment or the threat of further terrorist attack – which could derail recovery in part or all of the global economy.

But there are also important lessons which policymakers should learn from the downturn and recovery so far – lessons which if they are not learned will expose structural risks and vulnerabilities which could hamper the global recovery.

I want to highlight three areas where we must learn the right lessons – general lessons not just for developed countries but for emerging markets and developing countries too:

  • the importance of having credible, transparent, flexible and forward-looking macroeconomic frameworks based on the principle of constrained discretion;
  • the importance of focussing at all times – and at all stages of the cycle – on medium-term sustainability;
  • and the importance of effective structural reform – to promote dynamic and flexible markets with fairness and more balanced global growth.

First macroeconomic frameworks.

Even in the face of a series of large and destabilising shocks to the global economy, those countries with credible fiscal and monetary frameworks based on transparent, medium-term objectives have seen greater stability and stronger growth.

Continued confidence by households, and a return of investor confidence in many countries, has been vital to recovery. Significant and credible policy easing has been important. A flexible, transparent and forward-looking approach to macroeconomic policy going forward is essential if the recovery is to remain on an even keel and strengthen.

For policymakers, this is the reality of modern global capital markets. In a world of global capital markets, governments which pursue monetary and fiscal policies that are not seen to be sustainable in the long-term while delaying the necessary corrective action, are punished hard – and much more rapidly than thirty or forty years ago.

But in the recent downturn, governments with credible policy frameworks have been able, with success, to use monetary, and fiscal, policy to respond to macroeconomic shocks in the short-term.

In modern capital markets this discretion to act flexibly is possible only within an institutional framework that commands market credibility and public trust with the Government constrained to deliver clearly defined long-term policy objectives with maximum openness and transparency. That is why in setting down clear policy rules, new procedures and a new form of transparency, the modern “constrained discretion” approach to macroeconomic policymaking rejects both the combination of a lack of transparency and over rigid monetary targeting of the 1980s that, while rightly focused on anti-inflation discipline, could not work in open, liberalised capital markets; just as it rejects a return to the old Keynesian fine-tuning that wrongly sought to trade-off inflation for long-run growth.

Instead it is the credibility established by institutional commitment constrained to deliver long-term policy objectives which allows countries the flexibility and discretion to respond to temporary downturns with counter-cyclical fiscal and monetary policies.

This is most apparent in monetary policy. In this slowdown, by responding in a forward-looking and credible manner, central banks have been able to cut interest rates 13 times in the US, and nine times in the UK, without leading to increases in inflationary expectations and with policy symmetrically sensitive to the risks of inflation being too high and too low.

However, growth in the euro zone has continued to be weak and activity in Japan remains fragile. This is partly due to structural problems. But the inability of macroeconomic frameworks to allow monetary and fiscal policy to operate fully has also played a part. Since the last quarter of 2000 GDP has grown by almost 5 per cent in the UK and almost 4½ per cent in the US, but by less than 1 per cent in Germany, around 1¼ per cent in Italy and only around 1¾ per cent in France, the Euro area as a whole and Japan.

The lesson from the evidence is clear. Those countries where monetary and fiscal policy has been flexible, forward-looking and supported growth, with automatic stabilisers allowed to operate fully, have had shallower downturns and are leading the recovery.

The lessons in monetary and fiscal policy from our experience of the world downturn are lessons also critical to the future of emerging markets across the world.

Those emerging market economies which have fared worst in this downturn have been those where fiscal and monetary policy frameworks lacked the necessary credibility. A common feature of most major crises post 1995– Mexico, Thailand, South Korea, Brazil, Turkey, Argentina – was an attempt to buy credibility through the old approach of rejecting flexibility via a fixed or semi-fixed exchange rate peg. Ultimately, these all lacked credibility and proved unsustainable.

On the other hand, countries that have adjusted to the disciplines of global capital markets and put in place modern macro frameworks – with inflation targeting now the norm in Brazil, Mexico, Chile, Peru, Colombia, South Africa – have done better recently. And discerning international investors have had the confidence to maintain their investment in those countries which have demonstrated credible policy frameworks through the global downturn.

The second lesson – intimately related to the first – is the importance of maintaining a focus throughout the economic cycle on medium-term balance sheet sustainability.

Because in macroeconomic policy, credible sustainability is key to short-term flexibility. Flexible monetary and fiscal policy depends on starting from low inflation and fiscal strength. Central banks cannot cut interest rates in the face of weakening global demand if they face accelerating inflation and have to worry about undermining the credibility of their commitment to their inflation target. Governments cannot use fiscal policy to support growth in a downturn – through automatic stabilisers or discretionary changes – if they already have unsustainable levels of debt.
That is why net debt levels are so important.

Japan’s debt has reached more than 140% of GDP and is projected to rise further. Against this background, Japan is exercising fiscal restraint at a time of weak economic fundamentals and fragile recovery. And this problem is not confined to Japan.

In the Euro area, general gross debt averaged 75% of GDP in 2002; and some member states have debt levels above 100% of GDP. It is these high debt levels which make it harder for countries – credibly – to use fiscal policy and the automatic stabilisers to support growth in this below trend phase of the economic cycle.

That is why the UK has advocated a prudent interpretation of the Stability and Growth Pact, grounded in a robust economic rationale, which takes account of the economic cycle, sustainability and the important role of public investment. This approach would both promote growth and strengthen fiscal discipline – by better focusing policy in higher debt countries on the need for fiscal consolidation when the economy is above trend. The UK supports the direction in which the EU fiscal framework in evolving. And this principled approach has and will continue to govern the UK’s stance in EU surveillance procedures.

Having prudent debt levels is particularly important given the long-term demographic pressures facing many developed economies. These present a number of challenges. First, an ageing labour force might have an adverse impact on trend growth. In many countries, governments will have to encourage greater labour market participation to counter-balance this trend. Second, an ageing population can put pressures on fiscal sustainability. Public pension and health and long-term care spending are set to rise in most developed countries, and significantly so in some.

Increasingly, in global capital markets, it is a failure of countries credibly to address these issues of medium-term debt and demographic sustainability which then hampers their ability to run a credible and flexible macroeconomic policy in the face of short-run global shocks and instability.

And this focus on sustainability is necessary not just in the public sector – private and financial sector balance sheets are also important.

The need to focus on debt and balance sheet sustainability is particularly important for emerging markets. While the final collapse of fixed exchange rates has often been the key catalyst for recent emerging market crises, in fact the true origin of the crisis is often found in the accumulation of unsustainable public debt (as in Latin America) or in currency mismatches in public or private borrowing (as in South Korea and Turkey).

Experience shows that emerging market economies, generally characterised by heavy reliance on external borrowing and other capital inflows, are especially vulnerable to reversals in investor sentiment.

With global economic conditions and the outlook for EME financing improving, some investors (including “cross-over” investors) have moved back to emerging markets in search of higher yield. This development, while welcome, also presents a risk going forward that policymakers and investors themselves must be vigilant to – especially where debt levels are high. The IMF has also broadened its multilateral surveillance to include systematic monitoring of capital markets in order to better gauge the risk of contagion. It is at this stage of the economic cycle that the premium on effective surveillance and crisis prevention is at its peak.

The third lesson we should learn is that structural reform in the global system and in key countries is not just a matter of national concern but a global public good – essential for the achievement of a sustained and fair global recovery.

We know that open trade is a global public good – benefiting the world more than each individual economy and requiring multilateral commitment. The role of trade flows in this downturn in clear. And we also know that in the last forty years those developing countries that have managed to be more open and trade more in the world economy have seen faster growth rates than those that have remained closed. That is why the failure to secure a new multilateral trade round poses a real threat to the sustainability of the recovery and why following the bitter disappointment at Cancun there is a growing recognition that we must do more – for world trade and for the developing countries – to tackle the waste of the CAP, the scandal of agricultural protectionism around the world.

But while trade is a global public good, increasingly the same is true of structural reform. The world today is challenged not just by a global cyclical downturn but by very large and profound global structural changes – with the latest wave of globalisation now shifting many industries and services to the industrialising world and challenging us in the industrialised world to respond and adjust more quickly and more flexibly.

We know that in the recent downturn, some major economies have managed much better than others, reflecting their ability to absorb shocks.

  • In labour markets, more flexible economies have kept unemployment down and employment up – and shown that, through active labour market and welfare policies, it is possible – though far from inevitable – that flexibility and fairness can be combined.
  • More flexible product markets have also cushioned the shock. Innovations in inventory control and routing have made it cheaper to bring goods onto the world market.
  • And financial sectors generally, in both developed and emerging markets, have remained robust. Better risk management, through financial innovations – securitised bank loans, credit card receivables, the mortgage market, and financial derivatives – have allowed lenders to diversify, and borrowers have become far less dependent on specific sources of finance.

The lack of dynamism and flexibility in parts of the global economy is damaging not just for growth in those countries but for the sustainability of the global recovery.

Because these differences in flexibility and growth across countries are now an important source of large current account imbalances. Between 1991 and 2002 the US economy grew by more than 40% – double that in the euro zone and almost four times the growth of Japan. And current account imbalances have continued to widen.

That is why, to ensure that each country plays its part in ensuring higher growth, the G7 in September agreed an Agenda for Growth setting out the responsibilities of each major continental economy: to meet its responsibilities to ensure higher growth and to ensure stronger and more balanced growth over the longer-term, it called on each of the major economies needs to boost productivity, make markets more flexible and improve the climate for enterprise, innovation and wealth.

This then is the third lesson: rather than continuing to rely on the US as the engine for growth in the global economy – it is only through a concerted approach with a better sharing – short and medium-term – of the burden of sustaining growth that we will secure a gradual unwinding of these imbalances and ensure that the risks to the global recovery remain well managed.

THE UK EXPERIENCE

Let me end with a few brief observations on the UK.

It is clear that the UK economy was strengthening in the second half of this year. Household spending continued to grow strongly thanks to support from fiscal and monetary policy, the continued resilience of the labour market and a modern banking sector and financial sector that removed unnecessary credit constraints and enabled households to benefit from significant gains in housing wealth.

Ten years ago in a world downturn that was less severe for world trade, growth and equity markets, our country was unable to maintain growth because, with high inflation, interest rates had to be kept above 10 per cent for four years and rose to 15 per cent for one whole year. The result was one of the most prolonged recessions of the post war years.

This time, most now agree that central bank independence, the symmetrical inflation target, clear fiscal rules and a supportive fiscal policy at the right time in the economic cycle – have been right for the long-term national economic interest of the country.

The Monetary Policy Committee’s forward-looking activism, as well as the transparency afforded to the process, means that they have been successful in keeping inflation within 1 percentage point of the target. At all times the MPC has been – and will continue to be – both forward-looking and equally vigilant to the upside and downside risks.

And disciplined management of the public finances mean that fiscal policy could play its proper role in supporting monetary policy during this period of global weakness, allowing the full operation of the automatic stabilisers while the economy is below trend.

Which links to my second lesson.

The Government’s focus in the late 1990s on clear fiscal rules and medium-term sustainability has served us well. Tough decisions on tax and spending in the past – including the decision to use the proceeds from the 3G licence auction to repay debt – meant that the UK was well placed to deal with the impact of global events compared with other major economies. Incorporation of the golden rule and the sustainable investment rule into the fiscal framework ensured that the Government would solely borrow to invest and put a cap on public debt. When the global economy was growing strongly, around £50bn was saved on the current budget, which we could draw on in times of global weakness.

As a result the Government has been able to increase and sustain the amount of resources into the public service and infrastructure, reversing years of under investment, and support growth, net debt in our Budget projections is set to stabilise around 34 per cent in the period up to 2008, well below our 40 per cent ceiling.

That is why, with growth strengthening and given the tough decisions we took between 1997 and 2001 to cut net debt levels to 30 per cent – well below our 40 per cent ceiling and well below other G7 countries – we are on track to meet all our spending commitments and to meet our fiscal rules.

So tested in adversity, our monetary and fiscal regime is demonstrating its credibility and resilience – a new British approach providing a bulwark against the downturn and sustaining British growth.

The UK is also well placed relative to other G7 countries to deal with the challenges created by an ageing population. Demographics and the UK’s combination of a large private pension provision and a targeted system of state support will help to keep public pension spending under control in the coming decades, with spending projected to remain more or less stable in the UK compared with substantial increases, equivalent to between 4 and 8 per cent of GDP, projected elsewhere – as our annual Long-term Fiscal Sustainability Report has demonstrated.

But UK policymakers, as in all modern economies, have to be continually vigilant about balance sheet risks.

Despite increases in household borrowing, the simultaneous build up in housing assets has prevented the household financial balance falling into a significant deficit as in the late 1980s and kept the ratio of household debt to wealth stable while household interest payments as a percentage of disposable income are still very low by historical standards

And, despite the resilience of the financial sector in this downturn that I have noted, we have to be vigilant to potential financial sector vulnerabilities. The Tripartite Standing Committee brings together in a monthly meeting the FSA, Bank of England and HM Treasury and provides an early warning system to deal with potential systemic threats.

Finally, the UK – as the Chancellor has set out this week – has a lot of work to do to accelerate the pace of structural reform both at home and in Europe.

The combination of a robust and job-generating labour market in Britain over the past few years, alongside a national national minimum wage and the tax credit system, are demonstrating that it is possible to combine flexibility with fairness and social justice.

But there are big challenges ahead if we are to translate stability into higher productivity and entrenched full employment.

The UK has historically experienced low rates of productivity growth by international standards – too little competition, too little innovation and enterprise, weaknesses in skills, a low capital stock and universities often disconnected from the real world of business and commerce. The next steps in the strategy for promoting greater flexibility and strengthening the drivers of productivity growth will be announced in the Pre-Budget Report.

And following the June Euro assessment, we are facing up to the unique challenge of the British housing market. David Miles – Professor of Finance at Imperial College – has been asked to examine the case for and whether and how Britain can develop a market for long-term fixed rate mortgages – something that is important to the UK in or out of the euro, and more important in a single currency area. And Kate Barker, formerly of the CBI, now a member of the MPC, is examining how we reduce housing market volatility by tackling barriers to increased housing supply. Both will produce interim reports at the PBR.

In Europe, too, the UK must continue to make the case for reform – showing how – as the Chancellor has set out in an article this morning – Europe can move from organising itself as a old-style trade bloc to becoming a global Europe:

  • outward looking – investing as it does in the USA and building more effective trading relationships;
  • liberalising and reforming to meet the challenges of more intense competition;
  • and modernising its social dimension.

So these are the lessons we and others are learning and our reform agenda going forward.

Modernising monetary and fiscal policies to guarantee stability in a fast changing global environment.

Maintaining a clear focus on medium-term sustainability which is the key to forward-looking and flexible pro-growth macroeconomic policy.

Stepping up the pace of economic reform to deliver balanced global growth and create flexible economies that show that, in the modern world, enterprise and flexibility need not advance at the cost of fairness but both can advance together.

And globally renewing our commitment to stability and trade liberalisation to kick-start growth and ensure that all countries – developed, emerging markets and the poorest countries can share in stable and sustainable rising global prosperity in the years to come.

Thank you.

Posted November 26th, 2015 by admin