Watershed in Busan

In this article, Bruegel director Jean Pisani-Ferry looks at the shift in gear during the G20 talks in Busan from budgetary stimulus to retrenchment.  He analyses what this change will mean for Europe, with many countries in the continent dealing with a dismal budgetary situation that will call for adjustments not undertaken since the second world war.  The consequences will also be seen across the Atlantic- with the US having to confront retrenchment at some pint. What does all this mean for the divergences that will emerge between the North and South G20 partners? The author looks at four possible consequences.

The meeting of the G20 finance ministers on 5 June in Busan, Korea, will go down in history as the moment when major players in the world economy changed gear from budgetary stimulus to retrenchment.
Only two days before, in a letter to his colleagues, US Secretary Tim Geithner, warning against “a generalized, undifferentiated, move to pull forward consolidation plans” was emphasizing the need to “proceed in step with the strengthening of the private sector recovery”. But the ministers in Busan did not echo Geithner’s warnings. Instead, they emphasized the “importance of sustainable public finances” and the need for “measures to deliver fiscal sustainability”. Gone is the stress on cautious, gradually phased‐in exit strategies and the search for a rebalancing is almost unnoticeable in the communiqué.
The change affects first and foremost Europe. Shortly before Busan the countries of southern Europe had already announced major consolidation efforts in the hope of restoring calm in debt markets. Only a few days after, British Prime Minister David Cameron announced “years of pain ahead” and German chancellor Angela Merkel outlined a $100bn budgetary retrenchment plan. France is more reluctant but will no doubt follow.
It is only the start. The advanced countries face a dismal budgetary situation, with an average deficit of 9% of GDP in 2009 and the prospect of the public debt ratio rising from some 70% of GDP prior to the crisis to more than 100% of GDP in 2015. According to IMF calculations, to reach a 60% debt ratio in 2030 would on average require a budgetary adjustment of almost nine percentage points of GDP between 2010 and 2020. While some countries in the past undertook adjustments of similar magnitude, a generalized consolidation of this sort is without precedent since World War 2.
How painful will the adjustment be? There is hope sometimes that it will not hurt. True, some countries in the past enjoyed tearless consolidation because the launch of the retrenchment program was accompanied by a drop in long term interest rates, a decline in private savings, or a surge in exports provoked by a depreciation of the exchange rate (or all of these at the same time). But since initial conditions are characterized by low interest rates and high private debt, this is unlikely to happen this time, except possibly for exchange rate effects. Indeed depreciation has already started for Europe where many observers consider that the fall of the euro from 1.5 dollars in late 2009 to 1.2 dollars in recent days is large enough to offset at least in large part the growth effects of the consolidation.
But this can only work as long as the US does not follow suit and keeps on playing the role of the consumer of last resort. This may not last for very long. Even if the US keeps on postponing retrenchment, US congress is unlikely to see with equanimity an appreciation of the US dollar that makes European exporters more competitive and shifts the burden of sustaining the recovery onto the US consumer. More importantly, increasingly nervous bond markets will at some point start questioning the sustainability of US public finances. The US budgetary situation is not at all better than those of major European countries like Germany, France or the UK, it is in fact worse. It is only because the EU is fragmented, because markets started off by questioning the solvency of the weakest countries within it, and because Europe does not benefit from a safe haven effect that it has been the first to suffer the pressure.
Fortunately the public finances situation is entirely different in the emerging and developing world, which has been hit by the collapse of world trade in some case by capital flow reversals, but does not face an internal adjustment challenge. While domestic credit booms may be a threat for the future, banks have this far remained immune from the fallout of the financial crisis and domestic non‐financial sectors do not face the same deleveraging perspectives. More importantly, the fiscal challenge is of much lower magnitude than in the advanced world – in fact it barely exists. The starting points are a 40% debt ratio and an average budget deficit four percentage points lower than in the advanced world which, against the background of much faster potential growth, means that only a minor effort is needed to keep the debt ratio around the 40% level.
So the question will soon be, what if Europe and the US both enter a phase of prolonged budgetary adjustment while the emerging world stays on course? What if divergence between
the ‘North’ and ‘South’ G20 partners widens further? Four consequences are already predictable.
First, there will be a significant drag on world growth. Whatever the emerging world does to sustain domestic demand and reorient exports from advanced countries to other emerging countries, the European and US elephants (not to mention Japan) are just too big for their illness to be without effect. Growth in Europe and the US will suffer and initially at least there will be a drag on world growth.
Second, the growth differential between emerging and advanced countries will widen further, which will in turn intensify flows of capital and skilled labor towards the emerging world.
Third, the advanced countries will need monetary support, which implies low policy rates for the years to come, while the monetary needs will be radically different in the emerging and developing countries. This will inevitably make fixed exchange rate links crack under pressure as the same monetary policy will not possibly be appropriate for both regions.
Fourth, differences within the G20 will widen. Instead of managing common challenges as in 2009, the group will need to manage divergence within it. This will be a major test of resilience for an institution that demonstrated effectiveness in the crisis but still has to past the test of the new global economic phase. The summit in Toronto will provide a first opportunity to assess the G20’s ability to adapt to new conditions.

A version of this op-ed was published by Caixin.