A Comprehensive Plan for the Shadow Banking System

When the G20 meets in Toronto on June 23rd and 24th, it will say some predictable things. It will affirm the importance of fiscal consolidation. It will underscore its commitment to strengthening financial regulation. It will reiterate the importance of avoiding protectionism and narrowing global imbalances.

Here is a plea that it also say some surprising things. First, G20 members should explain that they are committed to pursuing fiscal consolidation in ways that avoid damaging growth potential. This means limiting cuts to public investment. It means not gutting education, public support for R&D, and infrastructure spending,. Governments with serious budgetary problems have repeatedly warned that no category of spending is exempt from cuts. Well, some categories should be protected precisely to avoid damaging long‐term growth potential.
Having explained how they will support the continued expansion of aggregate supply, G20 leaders should next describe the support they will provide to aggregate demand. This means taking a differentiated approach to fiscal consolidation. Those who absolutely must should proceed with consolidation now, while the others, starting with the U.S., Germany, China and Japan, should commit to consolidating later. Someone has to provide demand for the products being churned out by the world economy. The U.S., Germany, China and Japan can do so because they possess fiscal space and account for half of global demand.

To reassure investors, these countries will of course have to make credible commitments to medium‐term fiscal consolidation. So how can G20 members show that they mean it? A start would be to commit to laying out an explicit medium‐term fiscal strategy using a standard template. It has already been agreed that the IMF will help the G20 with its so‐called “peer review process.” G20 members can delegate to the Fund the task of providing the assumptions about productivity, investment and labor force growth that governments feed into their spreadsheets when they show us how they plan to narrow their deficits. This will prevent them from offering up unrealistically rosy scenarios. The Fund can then collate the submissions and tell us whether the individual national plans add up to a coherent scenario for the world economy. And if national plans are unrealistic or mutually inconsistent, it can send governments back to the drawing board. If the G20 really seeks credibility, it can use Toronto to describe exactly how this process will work.

Toronto would also be a fine time for some leadership from the G20 on the uncertainties that are roiling financial markets. Spain and Germany, we are told, have finally agreed to release the details of their bank stress tests. While this is a positive step, it is not enough. What about other countries, France and Austria for example, where there is similar anxiety about the condition of the banking system? Why not have G20 members all commit to releasing this information on a regular cycle, since there is no knowing where anxiety about the condition of banking systems will pop up next, and since we know that uncertainties about one country’s banks can infect the entire system?

Finally, the governments assembled in Toronto need to explain what they will do to maintain political support for a difficult process of fiscal consolidation and structural reform. If the public turns against it, politicians will too, or else those politicians will be replaced. And if this leads governments to backtrack on their commitments, the next crisis will be worse. The result could then be a lost decade of no growth and high unemployment.

A lost decade would be a breeding ground for populism. This has happened before, notably in the 1930s. But it is not something that happened everywhere. In my own country, the Father Coughlins and Huey Longs never carried the political day. Credit for the fact is owed to a set of targeted federal programs: the Works Progress Administration to provide low‐wage employment, and the extension of basic social support through
the provision of unemployment insurance and social security. These measures helped those least able to help themselves and provided the public with reassurance in a period of high uncertainty. They prevented extremists on both the left and right from carrying the day.
The equivalent today would be tax incentives for hiring young workers, youth unemployment in many G20 countries having reached frightening proportions. It would be programs enhancing access to quality health care, not least for the unemployed, something that is a source of considerable anxiety not just in the U.S. but also in Europe.

It is hard to argue for new social programs, even modest, targeted programs, in a period of enforced fiscal austerity. But governments have to show that they care about those who are bearing the brunt. Otherwise the political center will not hold. The G20, in its communiqué, should signal that it understands.