Transcript of OECD lecture "Problems of Today - World of Tomorrow"
3 February 2009
It is a pleasure to be addressing such a distinguished audience today and in one of the world's great cities. One pervasive feature about the current environment is uncertainty. Uncertainty about the fallout of the financial crisis on the real economy. Uncertainty about the appropriate response to the financial crisis. Even uncertainty about the economic governance of the world of tomorrow.
To a large extent, these uncertainties stem from the fragilities that the financial crisis has revealed throughout the world. Contrary to past financial and economic crises, this one is truly global. Its origin was in the United States, with the collapse of the subprime market. However, this was really only the canary in the coalmine. We failed to listen to its song. It was a song of regulatory, market and policy failures. That song, we now know swiftly resonated into other financial markets and to other countries, creating the worst financial crisis since the Great Depression.
Today, I would like to share my thoughts on the likely economic consequences for the global economy, the required policy responses and how this episode may reshape the capitalist system.
Economic implications of the crisis
Turning first to the economic consequences of the crisis. We all know the global economy is in recession. But what is the likely depth and duration of the economic downturn? Answers to these questions inevitably depend on a conditional forecast. Conditional, not least, on assumptions about the magnitude and the time required to achieve full normalisation of financial markets.
A reasonable assumption would be to assume that the extreme financial stress since mid-September is short-lived and is followed by an extended period of financial headwinds through to late 2009, with a gradual normalisation thereafter. That was the basis for the forecasts we published in November 2008. That, now already too optimistic, outlook pointed to negative growth in two thirds of our member economies in 2009 and a drop in OECD area GDP of 0.4 per cent in 2009.For Australia, the decline of growth is anticipated to be less pronounced than in other OECD countries in 2009. These projections are the result of the combined effects of tighter financial conditions, subdued income growth, and negative wealth effects from lower equity and house prices. It implies an 8 million increase in the number of unemployed in the OECD area by the end of the decade. At the same time, inflation will ease considerably, due to lower commodity prices and widespread spare capacity.
Regarding the duration of the recession, we believe it will be lengthy, as it always takes time for financial institutions and other sectors to deleverage. Most OECD regions, therefore, will experience a U-shape growth pattern. The downturn will be particularly pronounced in the United States and Europe, where imbalances in property markets are pronounced and financial institutions' balance sheets are encumbered by non-performing loans.
However, not least because of the closer integration of financial markets, the economic fallout from the crisis is global. In Japan, for instance, where the banking sector is relatively sound, industrial production is plunging, exports are falling and large-scale layoffs loom. Emerging Asia appears to be in a slightly better situation. China and India have been growing at a fast clip over the last few years. However, here too, incoming data point to a marked deceleration in these countries, in line with the collapse in global trade. In short, the global economic outlook is already looking considerably bleaker than just two months ago.
Lets turn to Australia: Australia has a resilient economy, and is for several reasons well-armed to withstand the shock. Firstly, and above all, because financial markets and economic fundamentals are sound. The excellent state of the Commonwealth's public finances is clearly a trump card. Australia's general government cyclically-adjusted balance was estimated to be around 1.5 per cent of GDP in our November projections, as compared to -2.8 per cent for the OECD. Large budgetary surpluses have allowed the government the room to introduce a substantial fiscal package last October amounting to 0.9 per cent of GDP - one of the first countries to introduce discretionary fiscal stimulus - without compromising its medium term fiscal sustainability. Policy interest rates have also been significantly and promptly cut by a total of 3 percentage points since September 2008. Today further cuts were announced. This corresponds to a much stronger policy easing than in the euro area or in the United States. Finally, Emerging Asia will continue to be an export outlet for Australia. Although economic activity in the South East Asia region will decelerate, it will do so from very high GDP growth rates.
However, Australia could be potentially one of the hardest hit economies. Not only does Australia suffer from the reverberations of the global economic downturn, it is also hit by a negative terms-of-trade shock, due to the steep falls in the prices of its commodity exports. Moreover, Australia's dependence on foreign markets to finance its external deficit represents potential economic fault line. If global banks scale back lending to Australia, as recent information seems to suggest, it could result in a large gap in credit available to Australian businesses and intensify the depth of the downturn in the Australian economy.
The response to the crisis should be global
This gloomy outlook calls for concerted policy reactions to cushion the downturn. Even though the appropriate policy response needs to be country specific, the efficiency of the policy response can be strengthened through a number of measures. First, it is crucial to ensure consistency between short-term stabilisation policies and long-term sustainability objectives. In the immediate period ahead, fiscal measures, which are timely, targeted and temporary, should be used to sustain demand. At the same time, setting up or strengthening fiscal frameworks is necessary to reassure markets and enhance the credibility of fiscal policy.
Second, international cooperation boosts the effectiveness of stabilization policies aimed at restoring confidence in financial markets. It is important, for example, to avoid distortions that can trigger runs on financial institutions not covered by support schemes. It is also crucial that our efforts avoid actions that in effect shift a problem to other countries. One example of this was the way in which the Irish deposit insurance guarantee system was extended.
There are other areas where international coordination is helpful. Fiscal policy is one of them. A coordinated approach to fiscal policy is desirable, because it bolsters policy effectiveness, especially in economies where trade and financial flows are closely integrated. A coordinated approach also helps in terms of consistency in the timing and the direction of the fiscal stimulus across countries. Fiscal co-ordination, however, does not mean aiming for similar magnitudes of stimulus in each economy. The degree of stimulus needs to be country specific and calibrated to avoid putting the long-term sustainability of public finances in danger.
The 'exit' strategy is another area where international coordination is important. The extraordinary emergency measures taken to stabilise financial markets over the last two months, will if maintained encourage excessive risk-taking. This is what economists call 'moral hazard'. While all efforts are currently focused and rightly so on containing the crisis and supporting economic activity, the exceptional measures introduced over the past four months will need to be withdrawn as soon as the economic recovery is entrenched. Individual countries may find this difficult, acting on their own, pointing to the need for co-operation.
Ensuring the efficiency of policy action is necessary, but not sufficient. There is also a need for an economic and social balance. The severity of the economic downturn means that unemployment and poverty will escalate sharply in the months to come. Vulnerable workers are likely to be the most strongly hit. Helping them will require action on multiple fronts, including assisting youth in their transition from school to work; providing income support to the unemployed and linked to effective job search; and more generally reinforcing the use of the mutual obligation strategy, whereby effective re-employment services are combined with strong job-search incentives. To assist governments in meeting these challenges, the OECD Jobs Strategy, which is the result of intense studies and discussions on employment policies in the 1980s and 1990s, could be a useful reference point. The 2006 restated OECD Jobs Strategy recognises that there are ways other than cutting out-of-work benefits to encourage people to work. These approaches rely on activation - policies to help overcome barriers to work - and mutual obligations - the requirement to work once employment obstacles have been removed. By combining these policies with relatively generous unemployment benefits, strong incentives for the unemployed to find jobs are maintained.
I would also like to stress that the immediacy of the economic crisis should not be an excuse for relaxing our efforts to address structural weaknesses in our economies. Such challenges include population ageing and soaring health care spending. These need to be tackled and underscore the need for sustainable public finances in the medium to long term.
Responses to the crisis also have to be coherent with long-term aims of reducing GHG emissions, even though both issues will need to be tackled through different instruments. For instance, lowering fuel taxes would not be consistent with emissions reductions. By contrast, focusing on energy- or carbon-saving investment tax credits might be an option. An example of this could be a tax credit or offset for households that install more energy efficient or energy conserving devices in their homes. It is encouraging to see major OECD governments placing "green" investments at the heart of their own crisis-response strategies for 2009.
Nor should the economic crisis be a pretext for scaling down our foreign aid commitments. During the last major recession in 1991-92, ODA fell by 22 per cent and took until 2003 to regain the same level in real terms. To counter a repeat of such a development, donors signed an Aid Pledge last November. It reaffirms earlier commitments to increase the volume of aid and to maintain aid flows at levels consistent with those commitments. It is important that this aid pledge is honoured. A reduction in foreign aid would compound other shocks hitting developing countries, resulting in sharp contractions in economic activity, and add to fragility in vulnerable states.
Finally, governments must resist the pressure for inward looking, protectionist policies. That would repeat one of the mistakes of the early 1930s and exacerbate the size of the economic downturn. Open and competitive markets have proven to be fundamental to boosting growth and enhancing the resilience of our economies to absorb and to withstand shocks. Indeed, like the canary, that is the song of the Doha bird which is calling for a successful conclusion to the multilateral trade talks. We cannot afford not to listen to it.
How should Australia and South-East Asia countries respond to the crisis?
Apart from these general considerations, how more specifically should Australia and countries in South-East Asia react to the crisis?
First of all, it should be said that unprecedented actions already taken have averted a total collapse of the banking sector, which obviously would have had disastrous economic consequences. But financial markets remain tense and credit is not flowing to firms. This could be a question of time, as the full effect of the financial rescue packages come on stream. But the bleak outlook described above suggests that additional action is needed.
The choice of the policy instruments should be made carefully. Pressures to increase subsidies to non-viable sectors should be resisted. Rather, actions in three areas could help sustain demand while also boosting the supply side of the economy in the long-term. First, the schedule of already planned investments in infrastructure could be put forward. Second, reforms could improve the functioning of certain markets, for instance professional services, education or health by harmonizing regulations across states. Third, the crisis is an opportunity to make progress in climate change and water policies. Overall, it should be reminded that given the current very large uncertainties on the effect of policies on the economy, a strategy relying on a portfolio of measures appears to be appropriate.South-East Asia economies also need to implement measures that ensure consistency between cushioning the downturn and enhancing the long-term potential of their economies, while keeping or putting their public finances on a sustainable footing. In Japan and Korea, reforms that cope with the increasing dualism of labour markets would meet this criterion.
Towards truly global solutions
Furthermore, in order to harness the power of truly global solutions in addressing the problems of today, the OECD has initiated a process of enlargement and enhanced engagement with 10 new countries that account for nearly half the world's population (15% of global exports, and a combined GDP of 5.8 trillion dollars. These include Chile, Estonia, Israel, the Russian Federation, Slovenia, Brazil, China, India, Indonesia, and South Africa).
A concrete example of enhanced engagement the first-ever OECD Economic Assessment reports for Indonesia and South Africa launched by the Secretary-General in July 2008. China and India have already each had one OECD Economic Survey (2005 and 2007 respectively). Work is now underway on Surveys for Brazil and China which will be published in 2009, while the Indian government has asked for OECD participation in a review of key economic policies, and discussions are underway to establish the date for a second Survey. All EE countries have been invited to participate in committee meetings in the last quarter of 2008 and, for the first time, all Enhanced Engagement (EE) countries will be featured in the Economic Outlook 84, to be published in late 2008.
The OECD has also strong engagement with China and India in the area of investment policy co-operation. China has completed Investment Policy Reviews in 2003, 2006 and 2008. The first full Investment Policy Review will discussed with a high-level Indian government delegation in 2009. And the Secretariat is currently discussing with Indonesia and South Africa arrangements for the first OECD investment policy reviews of both countries to be conducted in 2009-2010.
With respect to taxation, China will host significant events on tax and environment and tax and financial markets in 2009 and we would strive to build upon our earlier successful cooperation with India in the fields of tax reform and international succession, subject to resource constraints. Amongst the five EE partners Indonesia has had the most limited involvement with the OECD and is arguably the farthest from OECD norms in many areas. In this respect, the Secretary-General's official visit to the country in July 2008 has resulted in the expression of great deal of interest in Enhanced Engagement, including the prospect of possible membership, and strong high level political support (from the President, Ministers of Foreign Affairs, Finance...) to develop Indonesia's participation in the substance of OECD work.
The OECD is, thus, gradually turning into a vector of convergence between developing and developed economies. The immediacy of the crisis is not preventing us from continuing this important work. On the contrary, it is one of the ways to face the challenges of the turmoil and go back on the path of sustainable growth and prosperity.
To conclude, let me stress that we are only at the start of the reform process that will put our economies back on a strong economic growth path and strengthen the global financial architecture. The reform agenda is comprehensive, and given the complexity of the many issues involved, it will take time and effort to implement. We must remain focused on the reform objectives needed to rebuild the world of tomorrow. I am confident that together we can rise to this challenge, drawing the lessons from the problems of today to build a better world of tomorrow.
Thank you for your attention.
Contact: Sarah Stock
Phone: 0419 278 715