Lorenzo Bini Smaghi: Western democracy and its discontents -
economic and political challenges
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Aspen Transatlantic Dialogue: "Western Democracies under Pressure", Rome,
14 October 2010.
* * *
The theme of this conference, especially this first session, which concerns the ability of
democratic systems to cope with the challenges of economic and financial crisis, has been
addressed in the past by distinguished scholars such as Ralf Dahrendorf. He observed that:
"To stay competitive in a growing world economy [the OECD countries] are
obliged to adopt measures which may inflict irreparable damage on the
cohesion of the respective civil societies. If they are unprepared to take
these measures, they must recur to restrictions of civil liberties and of
political participation bearing all the hallmarks of a new authoritarianism...
The task for the first world in the next decade is to square the circle
between growth, social cohesion and political freedom."1
This comment was written in the mid-1990s, but the current crisis makes it even more
pertinent. It's an expression of doubt about the ability of (so-called) advanced countries to be
able to take unpopular but necessary measures to overcome the crisis that is prompting
financial markets to disinvest, or even bet on those countries' bankruptcy, resulting in an
outflow of capital that prolongs the crisis.
What lessons can we draw from this crisis in respect of the functioning of democratic
systems, and in particular their ability to meet the challenges of the global economy? Let me
try to provide some answers, starting with three thoughts on the current crisis.
The first one concerns the causes of the crisis. Reams of commentary have been produced
on the factors that unleashed it. Some commentators have focused on the shortcomings of
the financial regulations, or on the ineffective supervision of markets and market participants.
Others have pointed to the excessive monetary expansion in some countries. Others still
have remarked that the lack of international coordination has generated large global
imbalances. There is a grain of truth in each of these analyses. But if we stay at this level of
detail we risk missing the essence of the problem and not finding a remedy for it. We have to
ask why the regulations were inadequate, why monetary policies were so loose, why
international cooperation was insufficient. Were they simple human errors, or errors caused
by factors more deeply rooted in our societies - ones which touch on the subject of today's
discussion?
Few have embarked on this kind of reflection - an essential one if we are to understand the
crisis and how to get out of it. Raghu Rajan, for example, takes as a starting point the
increase in inequality that has occurred in recent years in advanced societies. It has resulted
in a stagnation of the incomes of the middle classes.2 Technological change in recent years
has increased the productivity gap in various sectors of the economy and led to sharp
differences in income. Another contributing factor has been, in my view, the rapid change in
the comparative advantage of advanced economies associated with the globalisation
process, which has hurt the less well-educated members of the population.
Technological change and economic integration have been taking place for centuries and
have driven economic systems towards new equilibria in which well-being has generally
increased for all. There is no reason why these processes should come to an end now. But
they involve periods of transition during which a significant dislocation of resources may take
place and some segments of the population may incur a relative impoverishment. Economic
growth may even slow down and make the inequalities worse. The transition may also
persist if the factors that triggered the changes are systemic in nature and scale, as is the
shift by hundreds of millions of people to the market economy which started in the late
1980s.
It is during the transition that financial engineering comes into play. Finance makes it
possible to bring the future forward. Those who expect an increase in income can, thanks to
new financial instruments, i.e. debt, immediately increase their consumption and move on to
a higher standard of living. They can, say, purchase a house, send their children to college
and buy a powerful car. Financial engineering meets the needs of those who are not yet able
to afford them, increases the revenue of financial institutions - and thus of the shareholders
and managers - and raises government revenues too. Financial engineering helps to solve
the transition problems of advanced societies facing changes arising from technological
innovation and globalisation, especially for the poorer segments of the population. Financial
innovation is thus favoured and encouraged by all the political forces, as Rajan notes. This
explains the "affordable housing" measures taken by the Clinton administration and the
"ownership society" of the Bush administration. Financial innovation has also been facilitated
by the interest rates kept low for an extended period of time.
The problem arises - and arose - when the transition to the new equilibrium is very long,
longer than expected. If the transition is longer than expected, financial engineering is no
longer a solution and can become a problem. The debt burden becomes unsustainable and
cannot be repaid, starting by the less well-off, whose incomes do not keep pace with property
values inflated by low interest rates. The sub-prime crisis was created by excessive debt,
taken on not by the wealthy, as happened on other occasions in the past, but by the less
well-off, whose relative position in society was slipping. Debt had given them the illusion of
being able to live for a few years beyond their means.
The gist of this first thought is that the crisis sprang from an unsuccessful attempt to square
Dahrendorf's circle. The failure involved not recognising that technological and global
processes bring about a longer and more difficult than expected transition for one part of the
population. It consisted of deluding oneself that such a transition can be facilitated by easy
debt and low interest rates. Recognising this failure is the first step towards not failing again.
The second thought comes from the way in which our societies have responded to the crisis.
Without making a value judgement, but considering only the efficiency and timeliness of
actions that have been implemented to tackle the crisis and counter its negative effects,
there is no denying that in most cases the reaction has been slow. This slowness has added
to the cost of the crisis itself and to the scale of the adjustment required. Let me offer a
couple of examples. If Lehman Brothers' bankruptcy had been avoided in September 2008,
through an effective and timely intervention, there would probably not have been the collapse
of confidence that in the months thereafter affected the global economy. The rescue package
- TARP - would very probably have been much less than the USD 700 billion needed to
restore calm to the markets. In Europe - to take another example - if the Greek government
had decided to intervene with corrective action as early as autumn 2009, having just
discovered the budget hole left by its predecessor, it could have avoided the sovereign debt
crisis and the drastic adjustment programme which it then had to put in place under pressure
from the markets. If the European countries had agreed in early February to provide financial
support for Greece's adjustment programme, they would probably have avoided the
escalation of tensions in the markets last spring and the associated crisis of confidence.
They would have avoided paying out the enormous sums which became necessary when
Greece lost access to the financial markets.
These examples show that in developed countries the economic policy measures necessary
to maintain the confidence of the markets tend to be taken only when markets are on the
brink or in the middle of a crisis. Only under pressure from the markets do governments
seem to find the strength and the consensus to adopt the necessary measures to ensure
financial stability. This increases the scale of the adjustment required and consequently the
negative repercussions for the economy. The doubts about the ability of governments to take
the necessary measures in turn increases the distrust of financial markets and tends to
intensify the crisis.
How does this vicious circle come about? Let me try to identify some factors that
characterise the problems that our societies face in reaching a consensus on decisive action
in a crisis.
The first factor concerns how the financial crisis is perceived by the public and sometimes
even by economic policy-makers. In our affluent societies, accustomed to economic growth
and well-being, most people do not understand the risks to financial stability. Moreover, there
were few, even in the inner circle of decision-makers, who understood the gravity of the
situation in which the markets found themselves in early May this year.
The second factor is that, in the face of systemic crises, such as the one through which we
have passed, those who govern must sometimes take decisions that infringe long-term rules.
The most striking case is the rescue of a bank or a country. In theory this should not occur
because taxpayers' money should not be used to save those who have misbehaved or failed
to comply with the rules. But in some cases it is necessary in order to avoid a systemic crisis
that can have even more devastating effects. In a democratic system it is very difficult to
convince voters, especially if they do not perceive any imminent danger, that in some cases
a discretionary interpretation of the rule is needed to avoid the worst. This was shown clearly
in Europe when it came to deciding on the support package for Greece. In the U.S., the
administration was unable to go against the widely held sentiment, which was opposed to the
use of public funds to save a bank, and decided to let Lehman Brothers fail. The subsequent
rescue of AIG to avoid panic and financial ruin then turned out to be much more expensive
for taxpayers. Fortunately we avoided this in Europe.
Let me move on to my third and last thought. It concerns the post-crisis period. The
industrialised countries are emerging from the crisis poorer, more indebted and with lower
prospects for growth. The process of fiscal consolidation must remain the cornerstone of
economic policy and form the basis for a radical overhaul of the economies in order to create
more growth. But in the current environment I see two risks facing our democracies in the
coming years.
The first one is the illusion that this crisis is cyclical rather than structural, that it has no
impact on the long-term growth potential of our economies. We may, in this case, be
deluding ourselves that traditional macroeconomic policies (monetary and fiscal) are per se
able to restore growth to pre-crisis levels. Thus there is a risk of triggering again
unsustainable policies which in turn create new imbalances that sooner or later implode.
The second risk is an attitude of resignation, of being resigned to not having the capacity and
strength to untie the knots that restrict our growth potential, or of being resigned to economic
stagnation. This state of mind is associated with the politician's dilemma neatly articulated by
the President of the Eurogroup, Jean-Claude Juncker: "We all know what to do, but we don't
know how to get re-elected once we have done it ". This type of reasoning occasionally leads
some people to argue that democratic systems are not up to making our societies swallow
the medicine needed in order to grow again. Structural reforms in fact involve a redistribution
of income to the detriment of the less efficient sectors, which are characterised by
monopolistic rents and are strongly opposed to change. The idea is often floated that some
emerging countries are better able to manage the current crisis because they have "stronger"
regimes, which do not need to justify their actions vis-à-vis their electorates very often.
These are dangerous positions in my view and are not justified by empirical evidence.
Juncker's provocative remark is not in fact substantiated by the facts. He himself is one of
Europe's veteran political leaders, who has brought rigour and development to his country
and was re-elected three times in a row. An analysis of the correlation between economic
variables and political popularity in Europe reveals that, contrary to what many believe,
budgetary austerity and reforms do not penalise governments. Indeed, in recent years in
Europe there has been a positive correlation between political popularity and budgetary
rigour (see Chart 1). The correlation is much stronger than the one between political
popularity and economic growth (see Chart 2), which indicates that, for a given level of
growth, healthy public finances reward governments. This suggests that political leaders who
have the courage and the ability to reconcile balanced public finances with the economic
growth are rewarded over time.
Democratic systems should not to be blamed if advanced economies risk stagnation and do
not grow. They are in danger only if people succumb to the illusion or become resigned to
thinking that democracies do not allow change. Centuries of history demonstrate just the
opposite: that without democracy there is no change, and sooner or later there is decline.
Thank you for your attention.
Chart 1
Trust in national government vs. government
balance (average 2005-2009) - EU
Chart 2
Trust in national government vs. growth
per capita (average 2005-2009) - EU
Sources: Eurobarometer, EC and ECB calculations.
Note: "Tend to trust government" is the proportion of respondents to the May 2010
Eurobarometer survey who reported trusting their national government.