Getting A Deal On The Debt Is The “Greatest Economic Challenge We Face”

Twice-a-year meetings of the International Monetary Fund and the World Bank bring to Washington, DC the world’s Finance Ministers and Central Bank Governors, followed by many other current and former high-level economic and financial policy makers. Preceding the Fund-Bank meetings are a number of other official meetings, along with conferences, press briefings, and cocktail parties. Last Thursday we were invited to participate in a Bertelsmann Foundation conference, “Back to Work: Innovation, Investment and International Open Markets.” Here are a few takeaways from that event.

The lead-off speaker, US Treasury Secretary Timothy Geithner, addressed what he characterised as “the greatest economic challenge we face”: getting agreement on a multi-year roadmap for the US budget. Geithner struck a positive note, assuring the participants that “we can do it.” It is significant that both sides embrace the target of achieving $4 trillion in budget cuts.  They differ fundamentally on how to get there. Reaching agreement will be difficult, but the alternative is unacceptable.  Geithner noted that, despite all the headwinds, the US economy is recovering, with strength apparent across the board (except in the housing sector) and people and firms willing to invest. Other speakers, including Congressman Henry Waxman, cautioned, and we share this view, that differences in the multi-year budget issue will be taken to the 2012 elections.

Geithner’s optimism about reaching an early agreement on raising the US government’s debt ceiling does seem well-founded, on the other hand. Leaders on both sides of the House and the Senate recognise that it is unthinkable to let the US government default on its debt. After a lot of political noise, agreement will be reached.  There is a risk; however, that the debate will carry the issue too close to the edge, leading some investors to lose the faith they now demonstrate that the US will in the end manage its fiscal problems.  It is prudent not to assume that Congress will do the sensible thing.

The French Finance Minister, Christine Lagarde, stated that she has “huge trust in the US … at the end of the day, responsible decisions will be taken.”  Other international speakers expressed similar confidence. Turning to the Eurozone, Lagarde said that “Portugual will be the firebreak” against any further contagion. She expressed pride in what the Eurozone countries have accomplished in less than a year: creating a financial stability fund, agreeing to tougher fiscal rules and a degree of automaticity for delinquent countries, and taking actions directed at improving international competiveness. She stressed that they need to continue to demonstrate that they have the means to deal with problems that may arise at the periphery of the zone and also need to be very vigorous with the next round of stress tests for Eurozone banks.

Stanley Fisher, Governor of the Bank of Israel, expressed concern about global inflation, as they do not know whether the recent surge in food and energy is a one-off shock or part of a long-run higher inflation trend. Israel has to focus on headline inflation, as that measure is used for the indexation that is widespread in the Israeli economy. Daniel Tarullo, member of the Board of Governors of the US Federal Reserve, responded that the Fed looks at core inflation and, so far, has not seen any signs that headline inflation is getting into core inflation. He also noted that he sees no need to end QE2 prematurely or to extend it.

Lawrence Summers, until recently Director of the National Economic Council in the Obama White House, discussed the continuing problem of imbalances in the global economy, which also was the leading issue before the official meetings last week.  Summers stressed it will take time to resolve those imbalances and will require the US to increase its savings rate, mainly through addressing the government budget problem. He also urged China to reduce its savings rate by decreasing the need to save through strengthening its social safety and also improving the functioning of its capital markets.  He called for cooperative or coordinated action by the G20 grouping of the leading economies. Lagarde also praised the work of the G20 thus far, saying the process is difficult and looks messy at times, but real progress is being made.

The G20 did reach another milestone in its meeting last Friday, by agreeing on criteria they will use to determine whether or not a G20 country should receive special scrutiny by the International Monetary Fund. This is seen as a necessary step in agreeing on a multilateral process to identify actual or developing imbalances and the difficult policy decisions needed to resolve them. There is a lot further to go for this initiative, but we find this small step in international cooperation encouraging in the present difficult environment.