Lorenzo Bini Smaghi: Developments and prospects for the European
economy in 2009
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Conference "Altagamma: Scenari 2009", Milan, 30 March 2009.
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I would like first of all to thank the President of Altagamma, Leonardo Ferragamo, for the
invitation to participate to this conference.
The issue I was asked to address - "Developments and Prospects for the European
Economy in 2009" - is certainly not an easy one. Never has it been so hard to make a
forecast, not only about the future but also about the present and even the recent past
(although it might sound paradoxical). The forecasts of major international organisations are
being systematically revised downwards, not only with respect to the next few months, but
mainly due to what happened over the past months, which turns out to be much worse than
expected. The last ECB forecast, from early March, was worse than the one published a few
weeks earlier by the European Commission mainly because it was able to include
preliminary data for the last quarter of 2008, showing a GDP fall of 1.5%.
In the last few days other forecasts have come out, based on more recent data, which are
even more pessimistic. The difficulty in making forecasts in these circumstances derives from
the fact that available economic models are not calibrated to take into account shocks of a
size similar to the one we are experiencing, nor are they capable of understanding the nature
and mechanisms of the transmission process.
Rather than elaborating a new scenario, which risks becoming obsolete quite rapidly, I would
like to share with you some reflections on the current crisis and on possible developments. In
this respect, I would like to remind that, given that the Governing Council will meet on this
coming Thursday, we are in the so-called Purdah period in which we abstain from making
comments on monetary policy. What I will say should thus in no way be associated to
possible monetary policy decisions, and I would appreciate if the media reporting on this
event could acknowledge it.
The starting point of this reflection is that before the start of the crisis the world economy was
not in a balanced position. On the contrary, it was characterized by several imbalances,
within individual economies and across countries.
At the global level, the world economy experienced wide and growing current account
imbalances. On the one side, the US ran continuous deficits since the 1980s, with the
exception of a couple of years, and growing over time, reaching 6% of GDP in 2006. On the
other hand several Asian countries, notably China, recorded growing current account
surpluses (which in the case of China reached over 10% of GDP in 2007). The financing of
the US deficit took place largely through the purchase of dollar denominated Government
bonds by the rest of the world, resulting in the accumulation of huge liquid reserves, in
particular in China, Japan and oil exporting countries.
Another international imbalance derived from the growing pressure that world demand
exercised on the scarce resources of the planet, in particular primary commodities, such as
oil, generating a sharp price rise until mid 2008. Primary commodity price developments
have put into question the convenience of several durable products with high energy
intensity, thus reducing their demand.
Imbalances have emerged also within countries, generating excessive growth in some
sectors, such as finance and housing, and large financial flows, especially household debt. In
the US all these imbalances have developed at the same time. Just to give an example, in
the five years before the crisis the share of profits made in the financial sector profits rose to
40% of overall corporate profits, the double with respect to the average of the previous thirty
years.
From 2002 to 2007 the world economy grew at a yearly average of 4.3%, pulled by
international trade growing by 7.3% per year. This has been the most intense period of
postwar growth. It has also been the most fragile, as a result of domestic and global imbalances.
This suggests that won't be possible to exit from this crisis and return on a sustainable
growth unless the imbalances which have accumulated until a couple of years ago are
reabsorbed. It implies in particular that some sectors of economic activity which grew in an
unbalanced way in the past might be substantially downsized, not only in the short term but
also over the medium term, when the world economy will start growing again.
One of the sectors that is likely to be downsized, at least for some time, is finance, given that
risk aversion is likely to remain elevated for some years, reducing the scope for innovation.
Financial regulation will tend to reduce the scope for non regulated sectors. The whole
financial system will have less leverage, lower margins and thus less employment than in the
so-called "golden years". Another example is housing, where prices are unlikely to return
soon to the pre-crisis levels, especially in some countries. Also in this sector profit margins
are likely to be lower and so will investments and employment. Excess supply and debt might
require years before being absorbed again, as shown in the early 2000s after the burst of the
high-tech bubble. Other sectors which could be downsized in a permanent way are those in
which technology turned out to be out of pace with medium term trends in energy prices.
Another grave side of the current crisis - which was also largely unpredicted - is the collapse
of international trade, which has brought the process of economic integration backwards,
some sort of de-globalization. This has hit exports and imports of all countries, in a rather
brutal way, with multiplier effects on investment, consumption and employment. The sectors
which have been more seriously hit are those that were more exposed to international
competition, which had grown strongly over the recent years thanks to the global integration
of production processes. Those countries which relied most on exports and manufacturing
production have been hit hardly by a crisis which had originated in the financial sector.
According to some estimates, around 90% of world trade was partially or totally supported by
financial instruments, which in the past years had also experienced a rapid process of
innovation. The crisis of confidence which burst after the failure of Lehman brothers, stopped
financial flows, especially those between agents located in different countries which are less
acquainted with each other and base their transactions on market-based liquid and
sophisticated credit instruments, which are however also riskier. The reflow of capital
towards the major financial centres and the de-leveraging process, which started in the
second half of September 2008, has induced banks to reduce their non-core activities.
Export credit, which consists in financing not only the export company but also the foreign
importer which buys from the exporter, entails higher risks than domestic activities. Credit
lines with foreign counterparties, which require a greater use of capital, tend to be reduced,
especially for small and medium size enterprises and towards emerging markets. We are
observing recently that trade finance is going back to simpler instruments, such as
documentary credit and confirmed letters of credit, which substantially reduce risk.
The link between financial integration and trade integration has been the transmission
mechanism through which the loss of confidence in the financial system has spread to the
real economy, and from the country where the crisis started to the rest of the world. This
implies that restarting the trade integration process will depend confidence coming back in all
the components of the global financial system. The overall solidity of the global system
depends on its weakest part. During the last few months enormous resources have been put
in place, on both sides of the Atlantic, to support the commitment made by the policy
authorities not to let any systemically important financial institution fail. The effects of these
measures are starting to be appreciated.
Once the financial system is stabilised, time will be needed to rebuild a financial
infrastructure for international trade comparable to the one prevailing before the crisis. This
means that the pace of exports and imports growth during the recovery could be slower than
before the crisis.
Another risk factor for the rebound of world trade, over the medium term, relates to the
fragmented network of production, distributed across borders, which contributed to maximize
efficiency. This network has been hardly hit. For instance, trade in euro area intermediate
products fell in January 2009 by 20%, compared to the previous year. The protectionist
pressures and the slowdown in foreign direct investments might lead to a restructuring of
production, which might take time and turn out to be less flexible and efficient.
For those countries more open to international trade, which will be hit by the contraction of
exports and imports, re-directing idle resources towards domestic demand might be slower
and more difficult than expected.
To sum up, a thorough analysis of the causes of this crisis suggest that it is due not only to
cyclical factors but also structural ones, associated to the downsizing of sectors which had
grown too quickly and excessively in the past. This is not a novelty. During al recessions
some sectors suffer more than others. Think about the burst of the high tech bubble in 2000.
However, never before was the over-indebtedness so spread out and intertwined with the
real economy. This explains why it is so difficult to understand how intense and lasting the
downward adjustment of economic activity will be and how much dynamism there can be
after the through.
This reflection suggests that the cyclical pick-up will hardly bring back economic activity to a
level comparable with the one prevailing before the crisis, but rather to a lower level. This
means that at the steady state, after the economy has stabilised and gone back to a growth
path, production potential is likely to be significantly lower than before the crisis. This means
that the so-called output gap, which measures the distance between the level of production
and its potential, and which is generally used to estimate the path of economic recovery,
could be substantially lower than the one estimated with traditional statistical methodology. In
other words, this crisis might have affected the structure of the "world production function", as
a result of the downsizing of some productive sectors, such as finance, and the permanent
change in relative prices.
This is particularly relevant not only for economic analysis put also for the conduct of
macroeconomic policies. These policies, in particular fiscal and monetary policies, contribute
to cyclical stabilization by bringing forward resources in the low phase of the cycle and
delaying payment to the favourable phase. For instance, an increase in public expenditures
financed through debt delays payment to the cyclical upturn. Monetary policy also acts
through incentives aimed at shifting consumption and savings over time. The sustainability of
these policies crucially depends on the pace of economic growth and income level achieved
over the medium term, after the crisis is over.
Given the uncertainty on the structural and cyclical components of the current crisis, there is
the risk of a divergent assessment of the sustainability of economic policies, between
financial markets on the one side and policy authorities on the other. The latter might have
the tendency, or the temptation, to calibrate the policy response on an income target as high
as the pre-crisis one, as if the crisis was entirely of a cyclical nature rather than structural,
while financial markets might consider lower levels of potential income over the next few
years, as a consequence of the structural effects of the crisis. Such a divergence might
impair the effectiveness of macroeconomic policies.
It might be useful in this respect to recall the experienced of the 1970s, after the first oil
crisis, when economic policies did not take into account that the higher oil price had reduced
potential growth in advanced economies and calibrated their policy response to an unrealistic
target.
What can be drawn from the above considerations is that the exit from the current crisis does
not depend on macroeconomic policies only, but also on structural factors, such as the
functioning of goods and labour markets. As I already mentioned, the contraction of sectors
that had grown excessively before the crisis is likely to have a structural component, lasting
over the medium term. This means that not all the employment lost in these sectors during
the slowdown might be reabsorbed during the recovery. Some labour will have to be
reallocated to other sectors, to avoid weighing on growth and on public finances, and on
social conditions. This raises the need for accompanying short term macroeconomic policies
with measures aimed at reallocating idle resources, for instance by enhancing training,
human capital, market flexibility and income stabilizers.
Measures aimed at improving competitiveness are also required, especially in those sectors
exposed to international competition and in those countries which experienced poor
performance even prior to the crisis, due to low productivity growth. Furthermore, the global
dimension of the current crisis shows the need to support trade finance, in particular through
traditional instruments of risk insurance.
Experience shows that measures aimed at postponing the problems, such as early
retirement, should be avoided, as they aggravate public finances and slow down production
potential. Differently from previous crisis, the current one takes place in a phase of
demographic stagnation, in which life expectancy increases while birth rates are falling. In a
situation similar to that of Italy, an increase in the overall number of retired would
dramatically worsen the working environment for the younger generation, which would have
to pay for the higher contributions to finance the pension system. Under such circumstances
all should be done to maintain a high participation rate in the labour market.
The highest risk, in this uncertain environment, is to limit policy action to the short term
horizon, relying on stimulating the cycle without addressing the necessary structural reforms
which would foster a better allocation of resources during the recovery. We would loose
precious time and would find ourselves down the road with problems even greater than we
can imagine. It would be a grave mistake. Thank you for your attention.