Long-Term Policy Implications

The new fiscal landscape generated by the crisis raises several concerns. The risks associated with rising government debt burdens could be further aggravated by lower potential output growth and higher interest rates. The effects of this reduced potential output might then have more serious fiscal implications if associated with a permanent decline in employment. Further, the risks associated with rising interest rates will be higher, and the consequences more serious, for those countries where debt burdens are already very high. These risks could become even higher for those countries tempted to inflate away debt.

The possibility of a vicious circle—rising debt restraining growth and pushing interest rates up—developing over the medium term cannot be ruled out. Once the recession is behind us the global economy could well face a prolonged period of lower growth and rising (or at least not declining) debt. In some cases debt burdens could become unsustainable, opening the way to possible defaults and/or rising inflation. A potential scenario such as this calls for a serious discussion of the adequacy of the entire global policy framework, not simply the measures taken in direct response to the crisis. While addressing such a discussion goes well beyond the scope of this paper I can, nonetheless, suggest that a new global policy environment should be based on three pillars: (i) an integrated approach targeted at reinforcing and possibly increasing potential growth by better connecting macroeconomic, structural, and regulatory policies, (ii) strong institutional frameworks to ensure fiscal sustainability, and (iii) enhanced international cooperation in formulating and implementing macroeconomic, structural, and regulatory policies targeted at preventing unsustainable payment imbalances from developing.

Implementation of these three pillars would take on different characteristics within different countries and regions (which would nevertheless not prevent overall coherence from obtaining in international governance). Below are elaborations on how these three pillars could be translated into concrete action in the case of Europe.

Pillar (i) would call for reinforced and renewed impetus behind the Lisbon Agenda for Growth and Jobs as well as for the Single Market initiative. Low potential growth has been a long standing problem for Europe, commencing well in advance of the outburst of the crisis. The crisis offers the opportunity to accelerate the reform process, without which Europe could witness a new version of the “Eurosclerosis” scenario prevailing in the 1980s.

Pillar (ii) would call for a renewed and strengthened fiscal framework. The Stability and Growth Pact needs to be put back on track taking into account the new fiscal landscape. In evaluating countries' fiscal positions and their sustainability, more attention should be devoted to the quality and composition of fiscal measures. At the same time, more attention should be paid to the debt dynamics (in addition to the deficits). Also, more effective coordination of national fiscal policies (if only in terms of the timing and implementation of national budget processes) would enhance their impact on economic performance while strengthening sustainability.

Pillar (iii) would require, among other things, a more effective single European voice in international institutions such as the IMF and in international informal groupings. This would facilitate the management of global policy coordination and adjustments, for example the management of payment imbalances, while allowing for more space and responsibility for the emerging economies (Padoan 2008).

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