Marek Dabrowski Prospects of Economic Recovery: Potential Traps and Uncertainties

1. Marek Dabrowski Prospects of Economic Recovery: Potential Traps and Uncertainties Presentation for the International Conference on “The New Reform Agenda of the New EU Member States”, Open Society Institute, Sofia, October 19, 2009

2. Plan of presentation • Global risks and uncertainties • monetary policies • fiscal policies • financial sector rehabilitation • free trade/ globalization • growth potential • Regional vulnerabilities • sources of rapid growth in post-EU-accession period • EU core and peripheries and vulnerabilities of the latter • uncertain perspectives of EMU accession www.case-research.eu

3. Expectation of recovery – how well founded? • Has crisis reached the bottom? Have the previous bubbles been corrected enough? • Risk of overcoming crisis too quickly (lesson of 2001 dotcom recession) • Timing of “exit” strategy • Potential growth in post-crisis period www.case-research.eu

4. Monetary policy dilemmas • Monetary stimulus helped to avoid deflationary spiral (lesson of the Great Depression) but at high price • central banks interest rates close to zero; • huge expansion of reserve money (quantitative easing) • compromising central bank independence (quasi-fiscal activities) • Timing of exit strategy: risk of deflation vs. risk of high inflation/stagflation and building new bubbles (e.g. in commodity market) • More likely: too late exit (political factors plus CB responsibility for financial stability) www.case-research.eu

5. Fiscal challenges • Effectiveness of fiscal stimulus – highly questionable • High costs of fiscal stimulus: • growing public debt (“Japanese path”)  crowding out credit to private sector and emerging markets, higher interest rates • blow to fiscal discipline (including the SGP) • beggar-thy-neighbor effects • Temptation to inflate out part of public debt (in developed countries) and its potential costs • Adjustment in social expenditures badly needed (also against the consequences of population ageing) www.case-research.eu

6. Financial sector rehabilitation • Crisis triggered by collapse of systemically important financial institutions in US and Europe; its length depends on speed of their rehabilitation • So far mostly rescue recapitalization • New regulations (national and international) only discussed; dilemmas around BASEL-2 • Costs of new regulations: more expensive financing www.case-research.eu

7. Globalization and trade • Longer recession/ stagnation, more temptation to protectionist measures • Unclear prospects of WTO Doha round • Lack of global financial supervision • Lack of efficient mechanism of global macroeconomic policy coordination in spite of some ad hoc initiatives of G8/ G20 www.case-research.eu

8. Growth prospects • 2003-2007 growth rates over the potential in all regions • After-crisis growth slow or moderate • Necessity to increase growth potential in all regions/ countries what requires • structural and institutional reforms on national level; • progress in global and regional trade integration; • progress in global and regional (EU) macroeconomic and financial sector governance www.case-research.eu

9. CEE: sources of high growth rate before 2008 • Global economic boom and over-liquidity • High level of trade and financial openness (it works in both directions) • Opening a full access to SEM (one-off factor) • Overestimation of EU “insurance umbrella” and expectation of fast EMU entry www.case-research.eu

10. Vulnerabilities of CEE • Costs of overexpansion (especially financial and real estate markets) • Currency and time mismatches in corporate and household sector (unavoidable in small open economies) • High trade and financial dependence on Western Europe (general vulnerability of EU periphery) • Remaining outside the EMU by most of NMS; limited credibility of domestic currencies (high level of actual dollarization/ euroization) • Limited sovereignty in economic policy sphere • Lax fiscal policy in good times • Halting structural and institutional reforms in good times • Poor business climate/ corruption in many countries • Possible further turbulences (banking crisis, sovereign default) www.case-research.eu

11. Prospects of EMU enlargement • Maastricht criteria outdated but cannot be changed • Deterioration of fiscal situation (some candidates also de-converge on other criteria) • Reluctant attitude of incumbents • Negative consequences of delayed EMU entry • continuing macroeconomic fragility of candidates • second-class EU membership www.case-research.eu