After the Global Crisis

Conjectures about the post-crisis future of the global economy are path-dependent, i.e. they necessarily depend on the course of events envisaged for getting out of the crisis.

The current global crisis was the consequence of financial de-regulation and the general dominance of hyper-liberal policies in the United States, in the UK and in the global economy. It started around August 2007 as a US banking crisis arising from toxic sub-prime assets in banks’ balance sheets; it turned into a credit crisis that depressed enterprise investment; it spread globally through the decline of foreign trade and the slowdown and often reversal of capital flows, including Foreign Direct Investment; and then - with the large scale cost of rescuing financial institutions by government budgets, the rising cost of labour unemployment and the decline in governments revenue - it grew into a fiscal crisis and, ultimately, a widespread crisis of sovereign debt, particularly in the Euro-zone.

Initially the decline in industrial output, foreign trade volume and stock exchange values replicated the scale and the pattern of the 1929-32 crisis. Soon the impact of the crisis and cross-country contagion were mitigated by simultaneous, internationally co-ordinated, monetary expansion and fiscal stimulus, introduced at the end of 2008 and early 2009. But monetary expansion failed to re-launch economic growth, while concern about fiscal sustainability soon led to a simultaneous, premature exit from fiscal stimulus in most countries. Current prospects - apart from those of BRICS (China, Russia, India, Brasil, South Africa, now accounting for 18% of world GDP and the bulk of its growth) - are of widespread stagnation and double-dip, indeed of a second and even more serious recession.

The macroeconomic policies followed appeared to have a keynesian flavour, stimulating aggregate demand via tax cuts, monetary expansion and low interest rates. But keynesian remedies would have required public investment instead, whereas tax cuts temporarily fuelled private consumption, and the effectiveness of low interest rates - which mostly were not passed on to borrowers and simply involved higher profits for financial intermediaries - was limited by liquidity preference.

The rescue of financial institutions involved a massive transfer of wealth from taxpayers to bank creditors, including depositors and shareholders. This solution was clearly inferior to any of the alternatives, whether support for bank debtors, or partial nationalization of supported financial institutions, or outright loss-taking by imprudent lenders. Income inequality, whose depressive effect on effective demand had been reduced by credit expansion - one of the contributory factors of the crisis - increased further as a result of labour unemployment and continued payment of managerial super-bonuses awarded mostly to those responsible for the financial debacle not by markets but by a semi-feudal process of self-serving decisions by a managerial caste.

The current generalized advocacy of strict fiscal discipline, demanded by international financial institutions and often enshrined in national constitutions as a balanced budget obligation, is particularly anti-keynesian, and is bound to be counter-productive in the middle of a recession.

First, a balanced budget is neither sufficient nor necessary to the sustainability of government debt, because a primary surplus (net of interest payments) may or may not be necessary to debt sustainability - depending on whether the economy grows at a rate slower or faster than the average interest paid on government debt.

Second, the keynesian lesson has been forgotten or ignored, that the balance of government expenditures minus revenues, plus the balance of private investment minus savings, plus the external balance of exports minus imports, must necessarily add up to zero as a matter not of theory but of accounting consistency. Therefore the budget balance cannot be a policy instrument, but only a target that may or may not be achievable depending heavily also on the behavior of national economic agents and of global trade partners (including the elimination or large reduction of Germany’s trade surplus vis-à-vis the rest of Europe, and China’s gigantic trade surplus). Generalized efforts by all governments to balance their budgets simultaneously might actually result in a perverse combination of budgetary (and trade) imbalances as well as a lower level of employment and income worldwide than would be the case without such efforts.

By the same token, generalized efforts to promote employment and growth via higher international competitiveness - whether achieved by external devaluations or by domestic deflation of wages and prices - can also be competitively self-defeating: another clear keynesian lesson is that lower wages can raise employment through higher exports in one country, but cannot resolve unemployment as a world problem. Nor can world unemployment necessarily be reduced by a generalized reduction of employment tenure and other labour welfare provisions, or the replacement of collective bargaining by firm-level bargaining: the only certain effect of such policies, also very popular in anti-crisis policy packages under the pretext of “structural reforms” (e.g. see the European Central Bank’s guidelines to the Italian government in their letter of 5 August 2011) is the deterioration of the quality of work and labour incentives.

Often it is believed that the impelling necessity of environmental improvements, required by the reduction of global warming and of general pollution, and the forthcoming exhaustion of natural resources, will create a new important opportunity for investment and growth. However - apart from the observably controversial nature of global warming - these are all opportunities for public or public-funded investment, desirable in itself (not absolutely but up to some point) but competing with alternative uses of scarce public funds whose expenditure today is supposed to be kept under control in the interests of fiscal sustainability.

The chances of world leaders suddenly learning keynesian lessons, and implementing them with the speed and on a scale adequate to propel the global economy out of stagnation are remote, indeed would amount to a miracle. Even those who would like to do it are prevented by the electoral challenge of populist competitors (as is Barack Obama by his Tea-Party Republican challengers). By comparison the prospect of Wealth Sovereign Funds coming to the rescue of highly indebted governments might seem a more normal occurrence, but this would be the true miracle and is simply not going to happen: it worked in 2008 to the advantage of financial stabilization, but now WSFs have run out of trust.

The fact that the US can always “print” the dollars it owns to pay its creditors does not make the US debt indefinitely sustainable: at some point the resulting dollar inflation will make dollar bonds unpalatable at less than crippling interest rates so high that they would necessarily involve eventual insolvency. Other countries face even stricter debt sustainability conditions, without the same initial room for manoeuvre. Where private wealth largely exceeds the difference between current debt and its sustainable level, it is always possible to apply a once-and-for-all or recurring wealth surcharge to achieve solvency. Italy, for instance, has a public debt of euro 1,900 bn, but in 2008 it had a household wealth of euro 8,600 bn, 45% of which was concentrated in the top 10% of households; but wealth taxation is unpopular and the political will to introduce it is scarce. Privatization of public assets is often considered as a way to reduce sovereign debt, but the potential revenue obtainable from this source is usually overstated with respect to the depressed values realizable during a crisis, when it is infelicitously timed.

An insolvent country, like Greece, has only three alternative options: 1) instant orderly default with significant “hair-cuts” negotiated with creditors; or 2) instant dis-orderly default; or 3) delayed default, whether orderly or dis-orderly, preceded by roll-over of debt with the assistance of international financial organizations (like the IMF, or the European Financial Stability Fund soon to become the European Stability Mechanism, or the European Central Bank with its controversial purchases of government bonds in secondary markets) followed eventually by actual default, as in all schemes of pyramid banking, to which such rollover of uncovered debt has been likened.

The three default options are ranked above in order of increasing cost. However it should be remembered that non-default by insolvent debtors is also very expensive, as witnessed for instance in the large scale fall (of the order of 25%-30% in just one quarter in mid-2011) in the capitalization value of stock exchanges in temporarily solvent Euro-zone countries with uncertain longer-term solvency.

Partly the probability of default, assessed by Rating Agencies (like the oligopolistic three: Standard and Poor’s, Moody’s, Fitch), reflected in the interest spreads with respect of bonds regarded as totally secure (like German Bunds) and in the price of insuring bonds against default by buying Credit Default Swaps, expresses political as well as economic judgments (as in the recent case of Italy, handicapped by a corrupt, disreputable and divided government short on credibility).

Of course Rating Agencies have proven to be highly fallible and often biased, for they have their own agendas to drive forward, have positions of conflict of interests (“issuer pays” instead of “buyer pays”) and opportunities for insider trading. Alternative, public Rating Agencies have been advocated, for instance in Europe, but such institutions could not be regarded as independent and therefore their credibility would be low. Better still, “the use of ratings in financial regulations should be significantly reduced over time” (as was suggested in the de Larosière Report of 2009 under Recommendation 3, but never acted upon by European authorities).

In order to contain the unavoidable disruption and turmoil involved by a country’s default, it would be essential to anticipate its adverse effects and counteract them beforehand, by re-capitalizing commercial banks exposed to the cross-effects of default, including central banks and above all the European Central Bank that has been acting (probably exceeding its mandate) as Lender of Last Resort to the governments of “peripheral” (meaning “high spread”) countries. An experience of default is bound to depress the price of, and thus raise yields on, old and new government bonds for the whole area; therefore contagion would worsen the sustainability conditions of debt, and therefore slow down the speed of subsequent recovery.

Furthermore, a post-crisis global economy should have renewed efforts to establish some form of global governance rather than have in place the many and inadequate ad hoc institutions cobbled together to, at present, provide some semblance of governance. But in order to be established global government now would have to be universally accepted not only in its initial form, but also in all its rules for the continuous adjustment to future, unforeseen and unforeseeable, circumstances: such acceptance now is probably out of the question. Besides, the demotion of the nation state is not necessarily desirable. For the nation state provides a layer of authority that can protect citizens from global corporations as well as from a necessarily monopolistic global governance authority that could easily misbehave out of democratic control, and without any remaining territory to which one could run for cover.

Eventually the post-crisis economy - sooner or later - will begin to recover, thanks to the profitability of production and investment being raised by depressed wages (due to mass unemployment), the accumulation of new profitable technical inventions and opportunities, the progressive depletion of existing inventories and production capacity. Once started, recovery would tend to be amplified by indirect effects, such as the usual interaction between multiplier and accelerator, until potential capacity constraints are met again and some cyclical mechanism is set in motion again in reverse. Such is the inexorable logic of the market economy. But reliance simply on market self-regulation will most probably lead to recovery much later than possible with government intervention and jump-starting. It is unfortunate that the inadequate policy responses of 2008 and their premature withdrawal should have grossly diluted their effectiveness thus making the implementation of growth policies harder today.

Changes must also be attempted in order to prevent the operation of factors that facilitated the last global crisis, or to better cope with them. The increase in banks’ capitalization, envisaged by the Basel-3 new rules, will have an initial adverse effect on the volume of lending but longer term benefits for financial stability. A new composite currency is bound to emerge, in place of the US dollar or the euro.

Regulations on the separation of credit and investment operations of banks (à la Glass-Steagall Act) are bound to be reintroduced, as already proposed in the UK by the Vickers Commission. The Over The Counter derivatives trade might be subjected to stricter regulations, such as the requirement of an underlying “insurable” interest for taking up a position in that market, or the prohibition of short-selling, temporarily introduced in the European Union on shares and government bonds. The traditional principle of Central Bank independence in the exclusive pursuit of inflation targeting - based on the now discredited theory of rational expectations and the consequent de-coupling of inflation and unemployment - is bound to change into the even more independent pursuit of multiple targets including employment and competitiveness. We might witness attempts to protect domestic industries and stop immigration - largely unsuccessful in view of the irresistible force of underlying trends.

Currently, by and large, the economic system emerging from the crisis is bound to be substantially very similar to the pre-crisis one, improved in some respects, but worsened by large scale cuts in welfare expenditure made necessary by the (debatable) purpose of achieving fiscal balance. The post-crisis system will be more conflictual and insecure, more unequal and less cohesive, less rather than more “green” - basically a more unpleasant world in which to live. It need not be so.

Transition economies: a worse nosedive than anticipated

“At the start of this year, the global economic crisis was hitting central and eastern Europe with unimaginable force. Any illusion that this region was somehow immune from the “western” credit crunch and the subsequent financial squeeze was definitively quashed. Output was declining at startling rates that would only become apparent much later in the Spring.”
“But the danger signs were everywhere. There was real risk of a genuine emerging market crisis – that financial systems in a number of countries would collapse entirely, that currencies would run out of control, that there could be sovereign defaults.” (Anthony Williams, EBRD Head of Media Relations, The road to a fragile recovery, 16 October 2009)

Now they tell us

I don’t remember the EBRD ever signaling any such danger. Slowdown, yes, in their forecasts for 2009 and 2010, that from optimistic growth expected in May 2008 got progressively worse to insignificant growth in January 2009 and an average 5.2% contraction for the 29 countries of EBRD operation in May 2009. I suppose it is part of the institutional duties of the EBRD not to encourage pessimistic expectations that may become self-fulfilling, but then we should note this for future reference and remember that, when the EBRD forecasts a significant slowdown, what they really mean is an impending disaster.

How was the disaster averted? “That this horror scenario didn’t happen – Anthony Williams continues – was a result partly of unprecedented international support, with the EU and organizations like the IMF providing huge macroeconomic packages that were flexible and tailored to specific country needs [to Latvia, as well as Hungary, Ukraine, Romania and other CEE]. Other IFIs, including the EBRD, stepped in to provide micro support to banking groups and corporates with little or no access to liquidity. Crucially western banks, a dominant force in financial sectors in many countries in central and eastern Europe, did not retrench as feared. The authorities in eastern Europe responded with policies aimed at dealing promptly and effectively with the crisis, even though those responses were in some cases immensely painful and politically unpopular.”

At least in Latvia, it is not at all clear that a systemic crisis has been averted. And evidence that western banks “did not retrench as feared” has not been provided by the EBRD; perhaps they will in due course, in their Transition Report 2009 due in November 2009 or elsewhere. Did western banks really not retrench at all, or on average? Did they retrench less than feared, and how much were they feared to retrench and by whom? Certainly not by the EBRD. And recently Swedbank, the largest Swedish lender in the Baltic region, “has threatened to scale back its presence in crisis-hit Latvia if the country goes ahead with controversial plans to limit the amount lenders can collect from mortgage-holders” (Stefan Wagstyl, 28 September 2009).

Otherwise, is everything fine now in transition economies? It might be in the Czech economy, which has been taken off the list of EBRD countries of operation because it no longer needs its credit – the first to deserve this upgrade – and, most annoyingly, off EBRD statistics. Not fine at all in the 28 EBRD remaining client countries (including Turkey since last year), where the average nosedive now expected for 2009 turns out to be more pronounced than the Bank anticipated in May 2009: a contraction of 6.3% instead of 5.2%, with Estonia, Latvia, Lithuania, Armenia and Ukraine expected to decline by well over 10%.

“Signs of positive growth in the third quarter of 2009 suggest that the recession is now bottoming out in many countries of the EBRD region. However, any upturn in 2010 is likely to be fragile and patchy.” (EBRD press report, 15 October 2009) For 2010 the EBRD now forecasts an average growth for the region of about 2.5%, which is 1% higher than it forecast in May 2009, but since it starts from a level which is now 1.1% lower than it was expected then, the higher growth forecast for 2010 actually masks a lower absolute level of GDP than previously anticipated. And “There are likely to be significant cross-country differences in output growth in 2010”, with Latvia, Lithuania, Hungary and Bulgaria expected to continue to contract until 2011. “It is also clear that the social costs of the global economic crisis are only likely to be felt in earnest next year, when corporate bankruptcies and unemployment will continue to rise”, said EBRD Chief Economist Erik Berglof (Ibidem)
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The same factors that transmitted the global crisis to transition economies – the contraction in world trade and tight credit conditions – are now causing its continuation. “The Institute for International Finance, a bankers’ group, estimates that in 2007 $382bn – more than 40 per cent of the financial flows into all emerging markets – went into CEE. The IIF forecast in June that even with all the extra support the IMF, the EU and the EBRD are putting into the region, this year’s figure would be about zero” (Stefan Wagstyl, FT, 28 September 2009).

Heterogeneity

Transition countries with a fixed exchange rate regime – excluding euro-zone members but including Bulgaria, Latvia or Lithuania – are facing a slower and more painful adjustment, the burden of which falls on wages and prices and therefore ultimately demand and employment. Other factors explaining country heterogeneity are the differences in their fiscal positions, the weakness of banking systems, and dependence on commodity exports. The full set of the EBRD October forecasts is reproduced below, or can be downloaded from the EBRD website ).

“Russia’s economy is expected to shrink by 8.5 per cent on a year-on-year basis in 2009, followed by a rebound in late 2009 and growth of about 3 per cent in 2010 year-on-year. Kazakhstan will suffer a much milder output decline this year (of about 1.5 per cent) but the recovery is expected to be weak, in the order of +1.5 per cent.”

“Relatively faster 2010 growth, in the order of between about 2 and 5 per cent is expected in some internationally competitive countries with relatively sound pre-crisis banking systems, such as Albania, Poland, Slovakia, and Slovenia.”

“Some commodity rich countries including Azerbaijan, Mongolia, Turkmenistan, and Uzbekistan, whose financial systems were smaller and less affected by the crisis, and whose growth is mostly driven by commodities, are also expected to grow faster in 2010, in the order of 5 per cent or more.”

“In Hungary, which was hit particularly hard at the start of the crisis, the crisis has been contained thanks to strong international support as well as sound domestic policies. However, its growth is expected to remain slow in 2010 due to necessary fiscal adjustment and a continued credit crunch. It is expected to show slightly negative growth next year, driven by a weak economy in late 2009 and early 2010” (EBRD press report, 15 October 2009, cited above).

Divergence?

The crisis spells – at least temporarily – a reversal in the convergence process that had accompanied EU enlargement. In 1999-2008 income per head in the EU (15) grew at an average yearly rate of 1.41%, and in the Euro-zone at 1.47%, while in the new member states it grew at 2.00% (Poland) or more (from 2.29% in Hungary to 4.17 in Romania). “Growth over the medium term in the EBRD region is also likely to be below the trend experienced over the last decade” (Erik Berglof, quoted). The crisis is reinforcing the heterogeneity of national performances among transition economies and within the EU.

It is true that some of the factors making for vulnerability to external shocks – such as trade openness, economic and financial integration – are also factors that will reinforce recovery trends in an upturn. But there are other vulnerability factors – such as weak banking systems, fiscal over-stretching, or high private and public indebtedness made worse by mismatching of assets and liabilities – that need tackling before the global upturn can be expected to pull national economies out of recession or stagnation. And membership of a single currency area can make countries more resilient to a downturn but cannot be a cure after the event: a rush to a precipitous euro-zone enlargement today – necessarily preceded by a devaluation – apart from being against the Maastricht rules would not make any sense.

EBRD capital increase

Before the crisis the EBRD was confronted with demands from the US, its largest shareholder, to reduce the scale of its activities in transition economies. Now, as anticipated last May, the Bank is seeking a 50 per cent capital increase, an extra €10bn, from its shareholders – some 60 governments, including European Union members, the US and Japan – to compensate for the decline and reversal of capital inflows into the area. Thomas Mirow, the EBRD president, in a letter to shareholders warns that working with its current €20bn capital, the Bank would have to limit its annual lending to about €8bn in 2009-10 and reduce it to €6bn thereafter. “Activity would shrink while the recovery is still precarious,” while “raising the capital by €10bn to allow the bank [would] commit €9bn-€10bn annually, or €20bn in total extra funding in 2010-15. By mobilizing extra capital from private investors, the total additional funds raised could reach €60bn” (Stefan Wagstyl, FT, 28 September 2009). A final decision will be taken at the EBRD’s next annual meeting in Zagreb, in May 2010.

Mr Mirow states that “The region will need to change its growth model – away from reliance on easy finance and commodities, and towards the development of domestic financial markets, strong institutions and a diversified production base.” If conditions improve “further and faster than is currently expected”, the extra capital might not be needed and could be returned after a review in 2015. Not a chance, regardless.

It is wrong to push the old into a quicksand

Francesco Giavazzi – the distinguished economist from Bocconi University, Milan, a frequent visitor to MIT – made two gaffes around September last year: about Lehman Brothers, and about derivatives markets. Then he lay low for about a year, to re-emerge now with two more gaffes: one on targeting the aged in order to cover the cost of fiscal stimulus, and one on a wishful drive towards global recovery. This just goes to show that the judgment of engineers who turn to economics should be seen as that of engineers.

Lehman Brothers

On 16 September 2008, the day after Lehman Brothers went bankrupt, Francesco Giavazzi expressed great enthusiasm for the US authorities’ decision not to bail it out. “Yesterday has been a good day for capitalism” (sic!), he wrote on LaVoce.info, adding that “Now the liquidity cushion needed by AIG will also be provided by the market”. First he had to add a postscript to his piece, acknowledging that the US government had bailout AIG only a couple of hours later. Then he had to recognize – in a joint book with Alberto Alesina on the global economic crisis – that “ex-post, the failure to save Lehman Brothers probably was a mistake” (La crisi. Può la politica salvare il mondo? 2008, p. 49), rather than the “victory of the market” he had hailed earlier. Compare with Chris Giles, in the FT of 13 September 2009: “The collapse of Lehman Brothers transformed an expected global slowdown into the worst recession since the second world war. Though the direct losses from the Lehman bankruptcy caused little trouble, the ensuing panic that engulfed financial markets, banks and companies hit the global economy harder than the Opec oil crises of the mid-1970s, the loss of control over inflation in the late 1970s or the dotcom crash at the turn of the millennium”.

Derivatives markets

Expressed enthusiasm for the inordinate growth of the derivatives market, on the ground that derivative products allow Indian farmers to reduce the risks surrounding their crops, and enable the homeless to buy their homes, was another economic error. According to the Basel-based Bank of International Settlements, the global outstanding derivatives – bets on the value of assets, and bets on those bets – have been growing exponentially and at their peak earlier in 2009, when their total began to decline slowly, they had reached 1.14 quadrillion dollars (more precisely: $548 trillion in Exchange Traded Derivatives plus $596 trillion in notional Over-The-Counter derivatives). By comparison, the Gross Domestic Product of all the countries in the world is only 60 trillion dollars. What was supposed to be an instrument to distribute risk turned into a multiplication of risk. Or else those Indian farmers and US homeless have been exercising a lot of leverage.

But clearly the statute of limitations leaves errors unpunished in economics. Giavazzi has now reappeared to fire two more shots, though his aim has not improved over last year.

Targeting the aged

In a post on Vox.eu asking “What’s the proper exit strategy from the crisis?”, Giavazzi argues that the exit will take a long time, probably a matter of years, and the real co-ordination necessary is not across countries, but between monetary and fiscal policy. What should be rescinded first, exceptional monetary accommodation or the fiscal deficit?

Jean Pisani-Ferry argued recently that first should come structural reforms, then the gradual withdrawal of fiscal stimulus, then monetary policy could be reined in. He feared that Central Banks would not accept a secondary role, and was right: on 11 September, at a Bank of Italy Conference in Rome, ECB Board member Lorenzo Bini Smaghi said: “The more delayed the fiscal exit, ceteris paribus, the more the monetary policy exit might have to be brought forward. Indeed, given the level of the debt accumulated in most advanced economies, any delay in the fiscal exit is likely to have an effect on inflation expectations, and may even disanchor them.
This is a risk that monetary policy cannot take, as it would undermine its overall strategy.” (Bini Smaghi 2009 “An ocean apart? Comparing transatlantic responses to the financial crisis”; I was there and could not believe my failing ears).

Now, this does not sound like co-ordination, more like blackmail. Giavazzi likens the strategies of Central Banks and fiscal authorities to a game of chicken, whereby two car drivers on a collision course may both refuse to give way and crash – a patently inferior solution to a cooperative one. Giavazzi instead recommends that Euro-zone governments should commit themselves irrevocably to future spending cuts, in order to stabilize expectations and allow central banks to wait longer before they remove monetary accommodation. This would avoid the demand contraction that earlier fiscal cuts would cause.

True, but Giavazzi singles out for future cuts the ageing-related spending over the next 15 years. According to The 2009 Ageing Report issued by the European Commission (2008), ageing related spending amounts to 7% of GDP per year in Holland, 5% in Spain, 3.5% in Germany, and 3.3% in the EU27. Thus the budgetary effects of ageing are several orders of magnitude larger than the fiscal cost of the crisis. In terms of present value of total age-related expenditure (note: over 15 years), the present value of fiscal stimulus (temporary, over only 2 years) naturally is much lower, comparatively negligible (see Giavazzi’s Fig. 1, from IMF data).

Figure 1. The fiscal costs of the crisis compared to age-related spending

Source: IMF

The trouble is that all these figures are utterly misleading. The incidence of pension expenditure, on GDP or on total government expenditure, is not comparable across countries because of different statistical conventions (for instance in the treatment of golden handshakes and of payments to invalids), and even less comparable across countries with different incidence of so called distributive, Pay As You Go (PAYG) systems, versus capitalized, fully funded pension systems. Necessarily countries with a dominant PAYG system look as if they were more generous towards the aged than they actually are, because pension contributions should, but usually are not, counted as government revenue against pension expenditure. Conversely, an entirely funded system will appear as making no claim on government expenditure at all, because pension contributions are credited to the pension funds financing pension expenditure: but there is no reason why PAYG pension expenditure and revenue should be accounted for any differently. Only for uniform statistical conventions and for a comparable incidence of redistributive/funded pension systems will government expenditure on pension indicate – as the IMF figure produced by Giavazzi suggests – governments’ relative generosity towards old-age pensioners. Reflect on the fact that in 2006 the Italian pension system actually showed a surplus of 0.8% of GDP which therefore made a positive, significant contribution to the funding of public deficit (See R.F. Pizzuti, Rapporto sullo Stato Sociale, 2008, p.21), rather than wrecking social accounts from now to Kindom Come. See also three earlier posts on this Blog, of 13 June, 23 June, and 30 June, as well as the theoretical backing of Nick Barr and Peter Diamond, Reforming Pensions: Principles and Policy Choices, Oxford UP, 2008, and Pension Reform: A short Guide, Oxford UP (2009).

The same considerations apply to the additional expenditure due to population ageing, although its funding is not spelled out in the data quoted by Giavazzi. It is simply wicked to compare two item of expenditure in terms of their present value – two years in one case, 15 years in another. Besides, you cannot single out ageing as a specific source of expenditure, that can be cut at will regardless of the means provided by the recipients to finance the pension system as a whole. You might as well resort to the method – probably apocryphal but telling – that Federico Caffè used to quote when he discussed pensions: in some primitive society apparently the young brandish long pointed poles to decisively push into quicksand the aged no longer able to look after themselves. At the time of the Italian pension reform of 1995 the satirical magazine Cuore published a poster saying: “Your Government Needs YOU: Kill an Old-Age Pensioner”. Is this the Giavazzi solution? After all, it appears to be seriously considered by the IMF (2009).

The drive towards global recovery

In the September issue of the latest IMF publication, Development and Finance, there is a piece on “Growth after the Crisis”. If the world economy is to recover, a replacement must be found for the newly frugal U.S. consumer. Giavazzi calculates a consumption shortfall of about 3% of US GDP (i.e. a 4% increase in the saving rate from zero, of over 70% GDP being disposable income, = 2.8%), that cannot be compensated by the growth of China India and Brasil. China in particular will need to improve the provision of finance to the private sector, introduce a public safety net and risk-sharing financial products (this time we are talking about health and life insurance, and pensions, not derivatives…) before the Chinese saving rate is reduced. Europe – and particularly an export-led Germany, cannot or is not willing to do much (especially after the German elections).

So, Giavazzi argues, “the only way to maintain full employment is through higher investment.” This cannot be higher public investment, given the limited opportunities especially in the United States (where it is about 3% of GDP) and the “high probability that some of it will be wasted rather than contributing to raising the productive level of the capital stock”. Private investment (which is close to 20% in the USA) then must be the answer. But what would induce firms to raise investment spending in the middle of a sharp recession, and without any prospect of a likely technological breakthrough?

Elementary: “the realization that the crisis will change the composition of world demand for the long term. To address such a change, the structure of world output would have to adjust, which requires industrial restructuring and, as a consequence, new investment.” Because the crisis has brought about “a change in the composition of world consumption”, which “cannot happen without substantial restructuring, and, therefore, substantial investment.” What would prompt firms to invest is “the anticipation of a change in both the geographic allocation and the composition of consumption—relatively more consumption in China, relatively less in the United States; higher demand for such things as basic appliances and relatively lower demand for high-end automobiles.”

At this point the production of a long list of instruments of industrial policy, powerful enough to promote this kind of investment in restructuring, might be expected. But no, Giavazzi candidly relies on the incentive that “Those countries that do the restructuring—and get it right, including the portion that happens through public investment—will come out of the crisis richer.” Thus Giavazzi's pronouncements on the crisis range from applauding the Lehman disaster to misunderstanding the size role and danger of derivative markets; from the targeting of social welfare provisions for the old to the rosiest, starriest-eyed version of economic planning, not via public investment because of its presumed inefficiency, but presumably through the resurrection of French-type indicative planning that never worked and never will. Since when, in this century, do western governments take national investment decisions as they appear to do in Giavazzi’s world? Are private enterprises really enlightened and optimistic to the extent of selflessly investing in the hope of collectively implementing a balanced plan, starting from a large scale, tangible imbalance?

Giavazzi’s article appears in a prestigious official IMF publication; are his views shared by Dominique Strauss-Khan and/or Olivier Blanchard? The mind boggles.