Vítor Constâncio: The future of economic governance in Europe in a
global perspective
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
European Conference organised by the Gulbenkian Foundation, Paris, 7 December 2010.
* * *
1. Introduction
I am grateful to the Gulbenkian Foundation for inviting me here tonight. It is a great pleasure
for me to be able to address you on the future of economic governance in Europe in a global
perspective. Economic governance is a highly topical issue that is being worked on at this
very moment in both policy and academic circles.
European and global governance are of course interconnected, and the financial and
economic turmoil sweeping over the world economy since 2007 is having fundamental
effects on both. Accordingly, I will start by highlighting the lessons of the financial crisis for
standard economic policy and theory, which will have a substantial impact on our
methodologies for understanding the workings of markets and economies. I will refer to the
changing paradigms of global governance, including the shift-away from the so-called
"Washington consensus" towards a more inclusive, development-orientated "Seoul
consensus" emerging from the November G20 summit. Turning to Europe, I will then address
the challenges for economic governance as regards economic growth as well as
macroeconomic imbalances. I will conclude, after also referring to the ongoing reform of
financial regulation, with some observations on the role of Europe in global governance and
what it means to be European at this point in time.
2. Lessons from the crisis for economic policy and theory
It is difficult in the time I have available to convey my understanding of the reach and depth
of the crisis we have been experiencing. Let me, however, provide with you with some key
figures.
The costs of the crisis, as estimated by Andrew Haldane of the Bank of England, in terms
only of permanent loss of output, could amount to between one and five times the total value
of present annual world output.1 The direct support given by governments and central banks
to the financial sector have been quantified by the same author as equivalent to 25% of world
GDP, with very heterogeneous percentages in different parts of the world: 30% in the euro
area, 50% in the United States and a staggering 75% in the United Kingdom.2 Last week, the
Federal Reserve disclosed that it lent USD 3.3 trillion to various financial institutions, and
even hedge funds received USD 71 billion. Without this massive state intervention, the
financial system would have collapsed with an accompanying depression in the real
economy.
Among the various causes of the crisis, two main ones stand out.

First, the excessive growth of a loosely regulated financial sector in search of risky
high yields and profits from rent seeking.

Second, the development of sizeable global macro imbalances, with the high
savings of many emerging countries flooding the financial markets of advanced
economies, especially the United States, and contributing to lower interest rates and
asset bubbles.
The crisis taught us some important lessons that economic policy cannot now ignore:
1. the financial sector is not self-regulating and self-equilibrating and can generate very
large economic crises;
2. excessive credit growth and leverage almost always ends in a crisis generated by a
collapse in demand and an unavoidable deleveraging of balance sheets; and,
3. maintaining price stability in the market for goods and services, i.e. controlling
inflation, is not enough to avoid overshooting and bubbles in the price of assets -
from housing to the financial markets.
Humanity has been taught these lessons several times, but always seems to forget them.
When this happens, regulation and supervision become loose and the financial system can
then come off the rails on its own. This time in particular, this effect happened as a result of a
"cognitive capture" of regulators by the dominant economic theories, which have much to
answer with respect to the crisis.
The prevailing macroeconomic theory saw the economy as a simple system determined by
fully rational individuals that could anticipate a future perturbed only by some random shocks
with well-behaved distributions and by quickly self-equilibrating markets. The main macro
model did not have a financial sector, as it was supposed to work efficiently and smoothly
without creating turmoil or bankruptcies.
On the other hand, the so-called modern finance theory maintained the "efficient market
hypothesis" (EMH), according to which financial markets process all relevant information for
the proper valuation of assets. In consequence, market prices are always right, as they
reflect fundamentals, thus precluding the possibility of bubbles and other irrational
phenomena like herd behaviour or long periods of mispricing.
Another feature of modern finance theory is that only individual investors exist in the market
and determine asset prices through their rational decisions. In the models, there are no
financial intermediaries with their own interests, creating significant principal-agent problems
and extracting rent through instruments of financial innovation that in some cases only
redistribute value from taxpayers and non-financial clients, contributing ultimately to financial
disasters with high costs for the general welfare. In the United States, for example, the
weight of financial sector profits in total profits increased from 12% in the early 1980s to
about 40% in 2007.3
These points were forcefully made by Lord Turner, Chairman of the UK Financial Services
Authority, and Paul Woolley in a recent book published by the London School of Economics
called "The Future of Finance". Turner writes that "It is possible for financial activity to extract
rents from the real economy rather than to deliver economic value". While recognising that
"financial innovation ... may in some ways and under some circumstances foster economic
value creation", he insists that this "cannot be asserted a priori". Ben Bernanke, Chairman of
the Federal Reserve Board, in his testimony to the US Congress Financial Crisis Inquiry
Commission, made the similar remark that "some innovations amplify risk" and others "are
used primarily to take unfair advantage rather than create a more efficient market".
The crisis has indeed struck a blow to standard economy theory. Many economic concepts
and models will have to go through significant changes. Both in macroeconomic theory and
finance theory, important revisions are underway to take better account of less-than-efficient
markets, to replace rational robots with economic agents endowed with insights from
behavioural economics, to go beyond the representative single economic agent and populate
new models with heterogeneous agents, to acknowledge financial instability as a trigger of
economic crises and the possibility of bankruptcies, and much more. For years to come, the
crisis will generate new theories and models in the same way that the Great Depression led
to the creation of macroeconomic theory by John Maynard Keynes.
Recently, Ben Bernanke described some of the changes that are necessary, stating that
"more work is needed on the behaviour of economic agents in times of profound uncertainty;
on asset price bubbles and the determinants of market liquidity; and on the implications of
financial factors, including financial instability, for macroeconomics and monetary policy".4
3. The changing paradigms of global governance
Besides economics, other paradigms are also changing as a consequence of the crisis.
Globalisation entered a new phase with an acceleration of the shift in global power towards
emerging market economies that began in the last decade, giving these countries a seat at
the leading table of world governance, most notably in the G20. So far, the potential for
tensions and challenges within this new framework of governance, including between
advanced economies, has by and large been contained by the urgency of the tasks ahead.
As countries emerge from the economic and financial crisis, however, incentives for
cooperation in the future may be reduced.
Another historic shift concerns the role of the State and its interplay with the market. The
crisis made clear that the State is irreplaceable as risk manager of last resort and as
regulator of irretrievable imperfect markets. On the other hand, instead of a continuing
expansion of free markets we see in various parts of the world the progress of a kind of state
capitalism with the accrued importance of state firms and sovereign wealth funds. "The
Washington consensus is dead!" proclaimed the UK Prime Minister at the G20 London
Summit in April last year, marking an end to the reign of principles unequivocally advocating
free markets, privatisation, deregulation, smaller government and free capital movement.
In fact, the laissez-faire regime of the "Washington consensus" is giving way to a quite different
system: the new G20 "Seoul consensus". At the risk of over-generalisation, the one-size-fits-all
approach to economic management stemming from the belief in an optimal model is being
replaced with an acknowledgment of the merits of policy diversity and tailoring to countries'
circumstances. The over-reliance on the ability of markets to self-equilibrate and optimally
allocate resources has foundered on the reality of asset prices decoupled from fundamentals,
unsustainable credit growth, and precarious balance sheets. Instead, states have moved in to
stabilise markets, manage national resources and provide growth impetus. The doctrine of
unrestricted capital flows, which the IMF very nearly mandated for all its members in 1998, has
been revisited and countries are experimenting with various controls - with IMF endorsement -
to protect themselves from flows of potentially destabilising magnitude or volatility.
Amid all these historic changes, governance at the world level is facing three fundamental
challenges:
1. The reform of the international financial regulation in order to tame a sector prone to
excesses, whilst respecting the need to maintain the level playing field that is
essential from the point of view of globalisation.
2. The reform of the international monetary framework to correct growing global macro
imbalances and to stabilise the exchange rate system.
3. The creation of cooperative conditions to ensure sustainable international growth.
Much progress has been achieved since last year on the first two challenges, while the third
seems to be a more difficult endeavour. Concerning financial regulation reform, under the
aegis of the G20, a remarkable amount of work has been done by the Financial Stability
Board and the Basel Committee. A major component of this reform was the adoption of the
new Basel III framework with the aim of strengthening the capital base of banks and
introducing stricter liquidity risk requirements and a minimum leverage ratio. This in itself will
substantially reduce the probability of future banking crises, thereby improving long-term
economic and social welfare.
All of these new measures, which will be introduced over a long transition period, should not
have any unduly severe implications for the ongoing economic recovery. Although the
agreement on Basel III constitutes a robust conceptual framework, much remains to be done.
The potential implications of the leverage ratio and the liquidity risk framework still need to be
assessed. Furthermore, since the leverage ratio is largely based on accounting information,
the accounting standard-setters should strengthen their efforts to eliminate existing
accounting differences. This is essential in order to ensure a level playing field.
The Basel Committee has also decided that systemically important financial institutions,
commonly designated as "too big to fail", will be required to have a higher loss absorbency
capacity than other institutions that are subject to Basel III. The ways and means of
achieving this are going to be deliberated next year.
In relation to the second challenge of reforming the international monetary framework, a
good start was achieved with the governance overhaul of the IMF, endorsed at the G20
Seoul Summit. The IMF's move to better reflect the systemic importance of emerging market
economies should lead to greater legitimacy. This could also have positive economic effects,
such as a mitigation of precautionary reserve accumulation, which can otherwise contribute
to the build-up of global imbalances. Exercises aimed at analysing spillovers from major
countries and regions to the other partners will also gain new legitimacy. More generally,
however, I do not see a major reform of the international monetary system on the horizon, as
there is no real substitute for the US Dollar in medium term. The special drawing right (SDR)
is not a promising option, and the insufficiently deep and liquid financial markets of emerging
market economies will limit the role that their currencies can play in the foreseeable future. A
more cooperative system of exchange rate regimes is essential but does not depend on
unachievable radical reforms.
Concerning the third challenge, creating the conditions for growth, the G20 have approved
the Framework for Strong, Sustained and Balanced Growth which, alongside a set of
structural reforms, has at its core fiscal consolidation, which could lead to 1) internal
rebalancing in advanced economies by substituting public stimuli for increased private
demand; and 2) external rebalancing by promoting domestic demand in surplus countries
and increasing external demand in deficit countries.
Such needs for rebalancing are sometimes presented in overly simplistic terms, namely that
surplus countries should reduce savings and deficit countries should increase them, mainly
through consolidation of public finances. The attempt to translate this into target ranges for
current account deficits or surpluses failed at the Seoul Summit. The question is a complex
one because it is not sufficient to change savings' behaviour. The solution also has to involve
movements in the exchange rate, as explained by John Williamson when he denied the
possibility of an "immaculate transfer".5 In fact, the reduction of domestic savings implies a
positive change in the capital balance, which requires a necessary negative development in
the current account. The appreciation of the currency is what helps this to happen. This is
why, at the G20 Toronto Summit, members with significant external surpluses committed
themselves to strengthening their domestic sources of growth, as well as allowing greater
flexibility in their exchange rate policies. At the Seoul Summit the G20 then pledged to
"pursue the full range of policies conducive to reducing excessive imbalances", the "timely
identification" of which will be facilitated by "indicative guidelines" to be agreed by finance
ministers and central bank governors in the first half of 2011. The Summit also approved the
Seoul Development Consensus for Shared Growth that sets out a commitment to work in
partnership with other developing countries to help them maximise their growth potential.
There is, therefore, some progress in international cooperation but we are still far from the
solution to the major question of correcting global imbalances and promoting the
mechanisms of international adjustment that must be at the centre of a proper functioning
international monetary system.
However, the challenges that the advanced economies face to achieve adequate future
economic growth go far beyond solving these international problems. The crisis has reduced
the growth potential of these countries and has challenged the more recent growth model
based on the creation of demand through credit and indebtedness, which relies on expansion
in construction, car production or financial services. The delocalisation of significant sectors
of industry to emerging economies like China and India, increasingly of a non-traditional type,
makes productivity growth in advanced economies more difficult, as productivity grows less
in the services sector. This difficulty reflects the new phase of globalisation that we have
entered.
In 2004 Paul Samuelson wrote an article that, in his own words, "deals some weighty blows
against
economists' oversimple complacencies about globalization".6 He demonstrated
again, as he had already done in his 1972 Nobel Prize lecture, that it is "dead wrong" to
consider that the gains of those who benefit from trade are always and necessarily higher
than the losses of those who are hurt by trade. This statement has nothing to do with the
fact, which he also underlined, that the theories about free trade only apply in situations of
full employment. It relates instead to the possibility that the less developed country will make
a sudden jump in productivity (by imitation or other means) in sectors where the developed
country previously had a comparative advantage. Samuelson uses the examples of the
United States and China for his demonstration and concludes that: "this invention abroad that
gives to China some of the comparative advantage that had belonged to the United States
can induce for the United States permanent lost per capita real income .... And, mind well,
this would not be a short run impact effect. Ceteris paribus it can be a permanent hurt."
These statements do not mean that Samuelson has abandoned his position in favour of
liberalised trade, as he understands the dangerous consequences of any protectionist drive
in the present circumstances. In a spirited answer to some of his critics, he explained that his
point was just a lucid reminder of good theory, saying: "The result is not a Spenglerian
"Decline of the West", but rather a trend toward (but not necessarily all the way) to
geographical equalization. Bet for the future half century to be a repetition of what took place
historically in the first half: continued growth in the advanced world but arguably at a lower
rate ceteris paribus due partly to competing imitative inventions abroad."7 In the same text,
he warns that trade theory points to the need for actual redistribution to compensate the
losers, a trend he considers to be heading "...politically downward in our present-day
democracies."
Among other factors, this has certainly contributed to the spreading of income inequality in
our societies, a development that has led to increasing recourse to indebtedness by
households. Raghuram Rajan, former IMF Chief Economist, in his new book describing the
policies that resulted in this development (which won the 2010 Financial Times and Goldman
Sachs Business Book of the Year Award), includes a chapter entitled "Let them eat credit", a
pun on the infamous Marie Antoinette quote.8
The impossibility of continuing down the same route, now that all economic agents are
deleveraging, generates enormous difficulties to improve growth prospects for all advanced
economies. They may face the threat of a protracted period of low growth. Only two things
could prevent this: 1) the resolution of the global imbalances conundrum with increased
demand by emerging countries; or 2) a wave of technological innovations which create new
needs and new markets.
The possibility of a long period of mediocre economic growth, raises the prospect of
momentous social problems that will test our institutions. In the present post-modern culture
where "higher values" tend to be depreciated, legitimacy comes primarily from performance
in terms of offering permanent hope of higher living standards. As Benjamin Friedman
indicated in his recent book, our democracies depend as much on economic growth as on
the level of prosperity already attained.9 In a recent study10 that uses a dataset comprising
16 OECD countries for the period 1970-2002, the authors found a significant relation
between variations in growth and support for extremist parties, mostly of the right. A one
percentage point drop in growth results in an increase of just under one percentage point in
votes for extreme right parties. The authors conclude that: "In most economies this is unlikely
to have any lasting impact on the political outcomes", but we should remind ourselves of the
1930s and how events can sometimes evolve very quickly.
4. Challenges for economic governance in Europe
It is time to turn to Europe and discuss what all these developments and challenges mean for
the future of governance in Europe. I intend to answer this in two ways.
First, I will address some of the challenges for economic governance in Europe, as revealed
by the financial crisis. These are challenges that are linked to fundamental shifts in the
international economy brought on by globalisation. The crisis has served to "unmask" them
and bring them into clearer perspective, and now governance solutions are urgently called
for. I see three areas that are critical for Europe:
i. establishing a growth model to address adverse demographic trends and declining
productivity in Europe, which imply weak potential growth in the future;
ii. addressing macroeconomic imbalances in the euro area and establishing
procedures that ensure macroeconomic stability and competitiveness; and
iii. setting-up an effective system of financial supervision, which is commensurate with
the realities of financial integration in Europe.
Second, I will address how the new developments in global governance accelerated by the
financial crisis will affect European governance, and the role Europe can play in this new
constellation.
4.1 Growth and demographics
The move to a new phase of globalisation that I described above, and the profound shifts in
global production and financial intermediation that are associated with it, have shone a light
on some of Europe's deep underlying challenges. It is now clear that, in hindsight, the good
times witnessed in Europe the years before 2007 did not mark a shift to a new, higher,
growth trend, but rather reflected a system off-balance, where markets were insufficiently
regulated by the public sector and where unsustainable growth policies were insufficiently
disciplined by markets. As the system rebalances, Europe's challenges related to long-term
economic growth are being revealed once more, in particular its adverse demographics, and
there is an urgent need to address them.
According to a recent growth projection by the European Commission, potential output
growth in Europe would amount to 11⁄2% per annum on average in the period 2011-20
- significantly below the rates observed in the EU in last 20 years and much below those
recorded in the United States.11 The projected potential growth for euro area over this period
is worse still, amounting to 11⁄4% per annum on average.
These weak growth prospects are the consequence of two interrelated phenomena.

First, population ageing is expected to result in a contraction of labour supply and to
increase the fiscal burden of age-related expenditure.

Second, in a no policy change scenario, productivity growth in Europe is expected to
continue on the disappointing trend observed in the years before the financial crisis.
According to the latest Ageing Report (2009), which is produced jointly by the European
Commission and the Economic Policy Committee (EPC), the number of elderly people in the
euro area aged 65 and above will increase from about 59 million today to about 98 million in
2060. At the same time, the working-age population, which is defined as people aged
between 15 and 64 years, will decline after 2010 and dropping by about 13.4% by 2060.
Another set of projections made by the U.S. Census Bureau shows that by 2030 the total
population in Europe will stagnate and the working-age segment will decrease by 12 million,
in spite of the assumption made that Europe will take in 20 million immigrants over the next
20 years. By contrast, the US population is projected to increase by over 60 million with an
expansion of the active population by a growth rate of 0.5 million annually. Of the other major
countries in the world, China, Japan and Russia will have developments similar to or worse
than Europe. Only India will follow the same pattern as the U.S. In the euro area, the
so-called old-age dependency ratio, i.e. the ratio of people aged 65 or above relative to the
working-age population aged between 15-64 years, is expected to increase from 28% in
2010 to 54% in 2060. As a consequence, euro area public expenditure on pensions, health
and long-term care is expected to increase by 5.6 percentage points of GDP by 2060. About
half of this rise is projected to come from governments' spending on pensions (around
2.8 percentage points of GDP), and the other half will come from spending on both health
care and long-term care (each around 1.4 percentage points of GDP).
Establishing a comprehensive strategy for growth
To arrest and reverse these trends requires an ambitious and comprehensive strategy in
each Member State. In June of this year, the Commission presented the "Europe 2020
strategy", which is aimed at boosting the competitiveness and growth potential of the EU
economies. The strategy provides a coherent policy framework for Member States to
implement structural reforms and for mobilising EU policies and instruments. The strategy's
overall goals have been translated into five headline EU-level targets. By 2020, the EU
should increase its employment rate among 20 to 64 year olds to 75%, from about 69% in
2009. Equally, to promote new sources of growth in the future, overall investment in R&D
should reach 3% of GDP each year. Further targets under the strategy are aimed at limiting
climate change in line with previously agreed targets, increasing educational attainment and
reducing poverty.
In its Autumn 2010 economic forecast, the Commission simulated the effects of closing the
performance gap in the EU vis-à-vis the three best performing economies by one third on a
number of relevant policy variables, such as enhancing competition in product markets,
reducing the administrative burden, shifting tax burdens from labour to VAT, reducing benefit
replacement rates and promoting R&D. The simulation results showed that by 2020 a
comprehensive package of policy measures, encompassing both product market and labour
market reforms, could lead to a 2.2% increase in GDP, compared to the base line scenario.
Employment levels could rise by about 1.5% over the same horizon. Such an outcome would
also greatly support the ongoing fiscal consolidation process. Importantly, it would also seem
that a swift implementation of such reforms would lead to immediate sizeable welfare gains
already in the period up to 2015.12
If Europeans are to reap these potential benefits, it is clear that reform efforts by national
governments have to be reinforced. It is therefore welcome that the EU-level targets under
the Europe 2020 strategy are being translated into precise country-specific targets to guide
policy-making at the national level. Moreover, the simultaneous review of Member States'
fiscal and structural reform policies in European fora prior to national decision making - the
so-called European Semester - to be introduced as of 2011 is likely to lead to stronger and
more effective follow-up and peer pressure.
An ambitious EU-level programme under the Europe 2020 umbrella will complement actions
at the national level. This includes:
1. completion of the single market starting in 2012, twenty years after the 1992
deadline for establishing the internal market;
2. mobilisation of all available financial resources under the EU budget; and,
3. development of a new trade and external policy aimed at improving global market
access for EU companies.
Finally, the Commission is currently rolling out seven so-called "flagship initiatives" targeting
key policy areas of the strategy (including innovation, education and competitiveness) to
complement national reform initiatives.
4.2 Macroeconomic imbalances
These processes of globalisation and financial integration in Europe have facilitated
increased leverage and more advanced financial engineering, which has made it possible to
advance future consumption and maintain citizens' standards of living in the face of shifts in
global production and increased income inequality. Regrettably, the latter phenomenon has
not facilitated a smooth transition to a new equilibrium, but rather fed distorted expectations
of growth among private agents, leading to excessive debt and risk taking, masking the need
for economic adjustment to adapt to these global changes. The large scale deleveraging that
began in 2007 reversed this trend and laid bare large fiscal and broader macroeconomic
imbalances that had built up across Europe in this period. It is these imbalances which
subsequently fuelled the disorderly market developments we are seeing today.
The challenge for European governance is how to manage these macroeconomic
imbalances, how to prevent them from arising again, and how to deal with their effects in a
more orderly manner.
Imbalances should not be seen as a problem per se, as they may reflect natural economic
adjustment related to "catching-up" phenomena and be self-correcting. Whilst some of
developments in the euro area over its first decade reflected real economic convergence, in
general they do not fall into this category. The symptoms of unsustainable positions were
apparent in most indicators. Growing current account deficits were predominantly linked to
an increase in net private borrowing requirements, related credit growth and the build-up of
private sector debt. In some (but not all) of these countries, there were also sharp increases
in domestic asset prices, particularly house prices. While house prices declined in Germany
between 1999 and 2008, there was an average annual increase of more than 10% in Spain
and Ireland. These factors also fed into a sustained loss of competitiveness in a number of
countries, with unit labour costs in Ireland increasing by 30% more than those in Germany
between 2000 and 2008. Fiscal policy was also expansionary, reinforcing these nominal
developments. Indeed, hardly any euro area country managed to observe a budget position
close to balance or in surplus on a structural basis between 1999 and 2008, despite
government debt ratios above 60% of GDP in many countries.
Eliminating imbalances
Countries that have accumulated these imbalances face a long process of adjustment to
more warranted levels of spending and debt in both the public and the private sectors. A
process of de-leveraging and balance sheet repair will have to take place in several cases.
These adjustments will inevitably entail a period of low growth in domestic demand. This, in
turn, will necessitate corrective adjustments in relative prices and wages in order to foster net
exports and rebalance the economies in question.
To make this process as short and effective as possible, decisive policy action is required on
the part of governments.
First, convincing fiscal consolidation to redress the fiscal imbalances is essential. In the
present situation, the scale of the fiscal challenges faced by many European countries puts
them in "uncharted waters". In this context, adjustment is taking place in a number of euro
area countries. According to the European Commission, the euro area average deficit ratio is
projected to decrease to 4.6% of GDP in 2011 and 3.9% of GDP in 2012 under the
customary no-policy-change assumption. This represents a sizeable improvement compared
with the spring forecast, which stems mainly from expenditure measures announced or set
out in more detail since then, in particular in the 2011 budgets.
Second, structural reforms should be introduced to increase wage flexibility and the
adjustment of wages to appropriate levels. This could be achieved through measures to
improve the functioning of labour markets, which would also facilitate the necessary transfer
of workers from the non-traded to the traded sectors. In fact, we have already seen
wagesetting developments in some European countries that many observers would have believed
impossible just a few years ago. The adoption of measures to increase productivity growth is
also essential.
Third, repairing the balance sheets of banks and making banks more resilient are crucial
prerequisites for the resumption of growth and for financing the reallocation of resources
from the non-tradable to the tradable sectors. Many policy initiatives have already been taken
in this respect, ranging from the establ