European Central Bank Executive Board. Jürgen Stark is on left side, to the left of ECB president, Jean Claude-Trichet

The lessons from the current crisis and previous crises suggest that failure to address long overdue reform challenges promptly might result in a “lost decade” for the global economy, Jürgen Stark, the chief economist of the European Central Bank (ECB) said on Monday.

Stark, who is a member of the ECB's executive board, told the National Association of Business Economists (NABE) Conference in Arlington, Virginia, that it is natural to assume that there will be a more permanent retrenchment by consumers in countries which experienced debt-fuelled consumption booms. Households in the United States, and also in a number of other countries, are unlikely to return to their past spending patterns. Massive losses in the value of financial and real estate assets mean that current debt levels are not sustainable and will require higher personal saving rates, which will depress consumption in the years to come. Retrenchment by consumers has already begun, but the wealth destroyed over the last few years may take a long time to rebuild.

On the supply side, economic growth may be dampened in future as the financial crisis is likely to reduce the level and growth rate of potential output. This may occur through depressed capital accumulation, with investment held back by a higher cost of capital and credit restrictions. The financial crisis may also adversely impact productivity and labour markets. Differing growth patterns are likely to lead to structural shifts in the global economy, both from “West” to “East” and at the national level. A major risk is that structural frictions might impede the necessary adjustments and lead to higher unemployment in the longer run.

The economist said if history is any guide, we should also take note of IMF studies which have found that, in advanced economies, recessions associated with financial crises tend to be unusually severe and long lasting, with output taking, on average, three years to recover to its pre-crisis peak. Globally synchronised recessions are often long and deep and are generally followed by weak recoveries.

He warned that the risk of global stagflation should not be underestimated. The emergence of a multi-speed recovery, with developing economies leading the way, might put upward pressure on commodity prices at a time when labour markets are weak and the recovery still fragile.

Stark said reform challenges include:

• achieving a balanced global growth trajectory;
• implementing stability-oriented macroeconomic policies;
• carrying out structural reforms;
• putting in place more flexible exchange rate arrangements;
• appropriate financial sector regulation and oversight.

US Economy

The US federal budget deficit is on a trajectory that poses “significant economic risks” and will become unsustainable, Douglas Elmendorf, director of the Congressional Budget Office, said on Monday at the NABE conference.

“US fiscal policy is on an unsustainable path that can’t be resolved through minor tinkering,”he said. “The problem posed by the federal budget deficit not at its current level but on this trajectory… poses a growing risk to the recovery.”

Elmendorf said that if current tax policy is extended, including the extension of the tax cuts enacted by President George W. Bush in 2001 and 2003 beyond their 2010 expiration, the deficit will swell from the $6 trillion baseline forecast by 2020 to just under $10 trillion.

In addition, the debt held by the public with current tax policies extended would soar to 90% of GDP by 2020, Mr. Elmendorf said, making the US public debt load one of the world’s highest.

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“The US is entering unfamiliar territory in its level of public debt,”said Elmendorf. “It will be larger over the next decade than it’s been in half a century… and also unfamiliar by the standards of other developed countries.” The choice is not whether to change course from current policy, he noted, but “how quickly and in what way.” Last month President Obama declared a spending freeze on discretionary, nonessential outlays, but that only amounts to roughly 17% of total spending. Much of the rest of federal spending is for entitlement programs including Social Security, Medicare and Medicaid, defense spending and interest payments on the federal debt.

The size of US entitlement programs has expanded sharply since 1970, from 3.8% of GDP to 8.2% as of 2007, and is expected to hit 11.1% of GDP by 2020 due to an aging population and fewer workers in the system to help pay for their benefits.

Elmendorf said one reason entitlements have grown over recent decades without being matched by an obvious increase in taxes or reduction in government spending is because defense spending, has fallen by half during the same period of time, to 4% of GDP in 2007.

That same pattern can’t be repeated in coming years, Elmendorf said. “We’ll have to pay for future growth in Social Security, Medicare and Medicaid through a visible increase in the tax burden, a visible reduction in other programs or a visible reduction in these (entitlement) programs themselves,” he said.