Some reflections on the financial and economic

crises

Luc Soete UNU-MERIT, University of MaastrichtThe Netherlands

Maastricht University alumni meeting, Brussels 03-06-2009

Outline

A historical day… tomorrow European elections in the midst of the worst economic crisis since the 2nd World War.

A unique crisis… major macro-economic challenges. Very different scenarios of what the crisis will bring us.

Specific focus on the impact of the financial crisis on knowledge investments

European and global long term challenges

1. The financial crisis

A double squeeze: a financial crisis having affected the real economy with a mutual reinforcing double squeeze on the economy.

Practically all large international operating banks were technically bankrupt, slow but still difficult improvement.

An economic recession which cannot be addressed using traditional financial tools, banks no longer being in a position to carry out that function.

Large financial banks have become “dead bodies”: black holes in our economy, absorbing public money but no longer emitting any economic dynamism.

As a result a declining financial sector in most (small) countries in coming years with large public funding involvement.

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McKInsey Analysis Why this crisis is unique and very different

Systemic failures of credit markets

High leverage levels

Globally interconnected

High uncertainty

A number of credit markets have come to a stand still at the same time

High leverage levels in combination with asset write downs result in a credit contraction that slows GDP as no cash for investments is available

Almost all economies and markets across the globe are hit, limiting the possibility of recovery through strong demand or capital injection from other regions

Two mutually reinforcing forces (the financial crisis and a recession) are having impact on the economy which makes potential outcomes very hard to predict and potentially very negative

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Mutually reinforcing effects

Source:Morgan Stanley; Federal Reserve; BEA; The Economist; McKinsey analysis

Sell assets to restore capital ratio

Lowers asset prices

Further asset write-downs

Banks try to restore solvency

Commercial paper collapses (counter-party risk)

Companies who can turn to bank credit lines

Adverse selection further depresses market

Commercial paper markets collapse

Economy contracts

Increase in non-performing loans

Banks further tighten lending standards

Economic contraction

Cheap Credit

Financial Innovation

Asset Price Rise

Over the past 8 years, leverage has reached unprecedented levels

Markets are trying to adjust to the changed conditions, but it is unclear what the end-state will be and how long it will take to get there

US Subprime

crisis Lehman Failure

A simple way to think about policy measures in a downturn (McKinsey Global Institute)

Economic activity

Time

1. Limit the slide down

2. Accelerate the recovery

rate

3. Create stronger end state

Working through the cycle to a stronger end point• Combine short term correction with longer term

strengthening• Mix financial recovery with economic recovery• Differentiate a mix of measures for three recession

scenario’s (moderate, strong and “deep freeze”)

‘End state’

Example measuresExample interventions

Protecting business in distress

Stimulate demand/

economy

Strengthen/

maintain fundamentals

“Limit the depth” “Accelerate recovery” “Shoot higher”

Support work time reduction Support specific companies/

sectors (e.g., construction) Improve bankruptcy

legislation (tax claims, ch.11) Creating bank rescue funds Create company refunding

fund Reduce tier-1 ratio’s in banks Create credit guarantees Move forward large

investment projects Reduce taxes/ defer tax

payments Stimulate car purchases

Show commitment to foreign companies risking to move

Improve bankruptcy legislation (Ch.11, tax)

Stimulate entrepreneurship Support adult training in

down-time Purposeful government

buying

Stimulate investment in education

Reduce corporate tax (to attract and improve business)

Stimulate higher efficiency/ renewable technologies

Purposeful government buying

Focused attraction of foreign business

Protecting investments in R&D

ILLUSTRATIVE

Protect investments in new technologies/Research

Countries response so far focuses largely on short term

Germany € 62 bn 2.6% GDP

France € 26 bn 1.4 % GDP

UK € 23 bn 1.5% GDP

“Limit the depth” “Accelerate recovery” “Shoot higher”

Investment in infrastructure Reduce tax for low incomes Cuts in social security cost Credit guaranties for SME € 500 bn bank rescue fund € 100 bn credit fund Recycle premium for old cars

Investment in infrastructure Support car industry Support for construction,

energy, transport sectors Investment in social

residences Faster returns of VAT Credit support for SME € 350 bn bank rescue fund

Reduce VAT 17.5 to 15% Delay increase in corp tax. Allow deferred tax payment Exempt foreign dividends Forward investment in roads Loan guarantees for SME 400 bln bank rescue fund

Recycle premium for old cars

Forward investment in education and defense

Increased funding for energy efficiency of houses

Forward investment in schools and home insulation

Subsidy for hiring new employees

75.000 training places for unemployed

Funding jobless to set-up business

Increase subsidies for energy efficient cars

Not clear

Not clear

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Severe Moderate

Capital Markets Crisis

EarlyRecovery

Continued Slowdown

Economic Global Recession

Regeneration of globalization Recession 3-4 quarters, then strong growth New, effective regulatory regime Recovery is broad-based Credit markets recover, safe leverage ratios, cost of

capital to historic norms Global trade recovers rapidly

Battered, but resilient

Recession 2-5 years, then strong growth New, effective regulatory regime Recovery led by regions (eg. US, China) Credit Markets recover, safe leverage ratios,

cost of capital to historic norms Slow recovery of global trade

Stalled GobalizationRecession 1-2 years

Recovery is based on national markets and national industrial policies.

Financial and credit markets renationalize and downsize.

Recovery growth quickly runs into foreign energy dependence so that global trade recovers only slowly

DisruptionRecession > 10 years (“Japan-style”) Major disruptions bringing about new

national regulatory policy experiments Credit markets rely on government input,

cost of capital and energy high Global trade drops, knowledge as well

highly skilled labour mobility increases

Alternative crisis scenarios

Source:McKinsey Global Institute

10

Severe Moderate

Capital Markets Crisis

EarlyRecovery

Continued Slowdown

Economic Global Recession

No change

At first rapid recovery Limits to unsustainable growth (oil price, raw materials,

agriculture increases) expressed in re-occurrence of crises in new areas (water, health, environmentally induced migration, …)

Rising inequality and exclusive growth, resulting in unsustainable social exclusion, increased security costs

Slow but balanced growth Redirection of global financial flows in a more

balanced way Growth in US and UK savings, reduction in

reserves in China and S-E Asia – new role for IMF

Stronger representation of emerging countries in international financial organizations

Growing international trade conflicts

Financial nationalism

Focus on protecting national savings, going for national and international “trust” investments (local banks and global “community” banks)

Regional disparities with growing labour migration pressures

Financial global imbalances limit national growth opportunities

Knowledge globalization Dramatic slowdown in trade of goods, with

severe structural unemployment & new specialization patterns emerging

Long disruption period with globalization governed by green concerns: priority on global implementation of environmental technologies

High skill labour mobility

Global developments

Adapted from McKinsey Global Institute

2. Impact of crisis on research Traditionally, one would view private research investments as evolving in an anti-

cyclical way: The negative impact of the recession on profitability forces firms to focus on the most

productive segments of their output: the opportuntiy costs of achieving productivity growth is lower in recessions, providing incentives to undertake research activities in downturns (Aghion and Saint-Paul, 1998; Canton and Uhlig 1999);

R&D-personnel will be subject to “labour hoarding”; the most qualified scientists and engineers will be kept at the expense of lower skilled personnel.

However, with respect to innovation, the cyclical view appears the most common: Innovation or the implementation of new ideas, wil be postponed in a recession till the boom

period (Shleiffer, 1986 and Francois and Lloyd-Ellis, 2003); The so-called innovation acceleration hypothesis of Gerhard Mensch (1975) whereby radical

innovation would be favoured in depressions out of despair remains subject to debate (Clark, Freeman and Soete, 1981).

Well illustrated in the case of ASML, the Dutch litographic machine maker: R&D intensity increased significantly over the period 2001-2003 following the dramatic

dowturn in IT sales in 2001; innovation peaked with the introduction of a new generation of machines over the boom

period from 2005 onwards.

Slide 12 |

ASML’s R&DASML’s R&D budget = total revenues of one of its competitors

Second largest, non-government R&D investor in the Netherlands

Source: ASML

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’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07

R&D investment M€

Total sales M€

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Knowledge investments not part of recovery plans? As a result traditionally macro-economists will not consider supporting research,

higher education and innovation a priority in addressing the economic crisis: Prioirty goes to short term, demand led economic recovery plans as opposed to more long

term structural reform plans such as R&D and human caoital investment support; Given the counter-cyclical nature of research and productivity investments, the deeper the

economic crisis, the quicker the structural transformation towards a knowledge economy. Thanks to the economic crisis, the EU might actually come nearer to its Lisbon and Barcelona targets in 2010!

While innovation will lag behind, there is little one can do about it... successful innovation is ultimately crucially dependent on entrepreneurial market expectations: it is endogenous to the business cycle.

The central assumption behind this view: firms will consider their R&D investments as costs “of last resort”: essential long term investments for the future of the company. However, this

Depends on the nature of the recession The nature of funding of research and innovation (Barlevy, 2007).

Nature of the crisis A rather unique crisis originating from within the financial sector and affecting the real

economy under the form of a dramatic change in “risk aversiveness”. Private financial institutions which normally play the role of central agents in any counter-cyclical recovery policy have become by and large “dead bodies”, in some countries even “black holes”.

Spreading of lack of trust in future risks with private investors as a result of the huge write-offs over the last year and growing distrust in society: a fertile ground for growing financial nationalism;

The current dominant philosophy of “Cash is king” has a direct negative impact on knowledge investments:

Within stock listed companies, the CFO’s pressure to distribute as much of the limited profits as dividends – in a recession a crucial differentiating factor signalling solvability and managemnet reputation– is likely to prevail over long term R&D investment commitment.

Within SMEs as credit is becoming difficult to get, the focus will shift to organisational and easy to implement process innovations reducing costs and inventories. New product innovations and renewal investments will be postponed.

Finally high-tech starters will postpone the introduction of new product innovations. As a result seed money providers are having difficulties in finding sufficient worthwhile investment proposals. The venture capital market collapses.

Policy responses

On the supply side: structural policy reforms in research: Broadening of existing R&D support schemes for the private sector but

also closer private-public interaction: Need for complementary policies within broader trend of increased

(global) specialisation of private R&D within large firms with a growing trend towards “outsourcing” in the direction of small firms.

Use opportunities for increased “outsourcing” of a number of specific R&D-activities in the direction of public sector (universities and other public research institutions);

New role, with partly public (local) funding support for some of the large private R&D labs as “open” systemic innovation infrastructure;

Arguments similar to support for systemic banks but with one major difference: not aimed at stabilisation but at enhancing growth dynamics. Example of dismantling of Bell Labs in the 80’s and impact on private R&D in US of many of those underutilized R&D managers.

Long term growth opportunities

On the demand side focus on sustainability: Fasten the development of various possible “lead markets” using technology

procurement following the US example with respect to DARPA, NASA, NIH, etc.; involve the private sector more actively in technology development and innovation in so-called societal innovation programmes (health, education, mobility and logistics, security);

Thanks to internal EU rules, such national “innovation procurement” will not result too easily in hidden support for the own national industry.;

Use the immediate local growth and employment opportunities associated with the application and diffusion of green technologies to the full. E.g. “green” construction represents a long term productive investment both for the public and private sector, including house owners;

Focus the recognition of “grand challenges” on sustainable development. Use this new “mission” focus so as to bring about a brake in the current lack of trust with private investors and starters in future risk taking;

Make investments in sustainable investment shares and bonds fiscally more attractive.

A less flat research area in Europe after the crisis? Historically there have been continuous shifts in public versus private funding of research and

innovation, sometimes in favour of public funding (2nd World War and post-war period), sometimes in favour of private funding (80s and 90s).

Today given the risk aversiveness on the financial side, there is a need for stronger role of public funding; Crucial for the effectiveness of research and innovation is not so much the funding origin but the

performance location. EU countries with high R&D investments (Finland, Sweden, Germany) typically embrace the view

that the financial crisis offers opportunities for domestic structural reforms strengthening R&D and innovation, including the deployment of “green” technologies and eco-innovation; countries with low private R&D investments appear to only marginally refer to research and innovation stimulation measures within their domestic recovery plans;

In the long term these different policy responses are likely to signal a further growing divide between EU countries: a forced crisis knowledge specialisation

technologically leading countries which have the policy room for investing more public resources in knowledge taking a further lead

and a group of falling behind countries adjusting their specialisation towards less technologically advanced goods and services.

The public resources for knowledge and innovation investments are up to now nowhere under pressure (even not in Island). Most planned expansionary R&D and innovation investments appear to be continued; the real test though will only come when countries will see their budgetary deficits increase rapidly over 2009 and 2010.

3. Globalisation and the crisis: a historical return to normal? What remains striking from ahistorical perspective is how the two largest countries in the world:

China and India, saw their share of world population and their share of world GDP more or less continuously fall over the period 1820 till 1973. Actually, I would hypothesize that in 1973, the imbalance between the world’s concentration of GDP and the world’s concentration of population was the highest the industrialized world ever winessed.

This extreme geographical inequality in world GDP has formed the basis of the unilateral focus of both social scientists and policy makers on domestic competitiveness and in particular on technological competitiveness as the essential feature for a country’s future economic growth.

As Ulrich Beck put it: “The consequences of globalization for sociology have been spelt out most clearly in the English-speaking countries, but above all Britain, where it has been forcefully argued that conventional social and political science remains caught up in a national-territorial concept of society. Critics of ‘methodological nationalism’ have attacked its explicit or implicit premise that the national state is the ‘container’ of social processes and that the national framework is still the one best suited to measure and analyse major social, economic and political changes. The social sciences are thus found guilty of ‘embedded statism’ and thought is given to a reorganization of the interdisciplinary field”.

China and India’s late industrialisation However, the recent rapid industrialisation of China and India appear e.g. from the

available Cambridge world economic model simulations (Izurieta and Singh, 2008) non-sustainable. It will ultimately lead to financial imbalances with a huge current account deficits for the U.S. economy but also other resource constraints.

Furthermore from an environmental perspective at current levels of technology, growth rates of 3% per annum in the advanced G7 countries and rapid sustained growth in emerging economies are unsustainable in terms of agriculture production, access to water and climate impact.

At the same time, fast economic growth in India and China appears a social necessity because of the need to shift hundred of millions of people from farms to industry. In the Indian case there is an additional compulsion of providing jobs for a labour force which is growing at 2% per annum.

The advent of the ICT revolution in the 90’s has radically challenged the national-territorial bias in research and policy making. The cluster of ICT represents from a global perspective a historically unique process of technological, organisational and above all social transformation in terms of speed and world-wide impact. A level playing field in aspirations: in consumption, income and quality of life.

G-5 share of population and GDPPercentage share of world population

Year China India Brazil South Africa Mexico Total1820 36.6 19.9 0.4 0.1 0.6 57.61870 28.1 17.0 0.8 0.2 0.7 46.81913 24.4 14.2 1.3 0.3 0.8 41.01950 21.7 14.8 2.1 0.5 1.1 40.21973 22.5 14.8 2.6 0.6 1.5 42.02001 20.7 16.5 2.9 0.7 1.7 42.52006 20.2 16.9 2.9 0.7 1.7 42.3

Percentage share of world income

Year China India Brazil South Africa Mexico Total1820 32.9 16.0 0.4 0.1 0.7 50.11870 17.1 12.1 0.6 0.2 0.6 30.61913 8.8 7.5 0.7 0.4 0.9 18.31950 4.5 4.2 1.7 0.6 1.3 12.31973 4.6 3.1 2.5 0.6 1.7 12.52001 12.3 5.4 2.7 0.5 1.9 22.82006 16.8 6.1 2.4 0.5 1.8 27.4

Source: Deepak Nayyar (2008) based on data from Maddison (2003); Maddison(forthcoming)

The 21st Century and some EU international implications The advent of the ICT revolution in the 80’s and 90’s has radically challenged the

national-territorial bias in research and policy making. The cluster of ICT represents from a global perspective a historically unique process of technological, organisational and above all social transformation in terms of speed and world-wide impact.

In a certain way this means that compared to GDP as in the past, population is likely to become the indicator of future market opportunities.

For countries like the EU ones, it means that their future global role will decline, first because decline of share in world population, given the demographic structure of EU population with the ageing of the baby boomers, and second because likely relative lower labour based GDP growth compared to emerging economies.

Migration and/or enlargement should from this perspective be seen as an important future additional growth factor for the EU.

As Gijs Beets illustrated of the 15 most populated countries in 2025 (countries with more than 100 million), not a single one will be a European country. In short, the EU is primarily composed of small countries, and thus also small markets. Only if the EU-27 would act as a singly country, as in the case of WTO, will the EU still play an important international role.

The global knowledge challenge

Conclusions Crisis is unlikely to disappear with partial recovery of stock markets, interaction between real and

financial sector works both ways. Negative influence today and probably in the coming year from the real economy to the financial sector.

Limited public sector room for further interventions… It will be essential for the Ministries of Finance to get the surplus value on their financial participations. Danger of being governed by strict but overly negative accounting rules.

Long term challenges to European knowledge investment. E.g. the European Barcelona 3% R&D/GDP target arose from concerns that Europe’s industrial R&D appeared to lag too far behind that of the other technologically leading countries such as the US and Japan. The assumption was that more R&D carried out in Europe would be a crucial factor behind Europe’s attempt at becoming the most competitive region in the world. It was always obvious that R&D as an investment cost target is somewhat of an odd policy target. More important is the question what the results are…

iT is time to think of a new Lund green R&D investment/GDP target whereby the focus would not just be on research but also include knowledge diffusion and application. This new Lund target would ultimately also have to focus on implementation outside of Europe. European competitiveness will ultimately be most dramatically strengthened if doing so directly contributes to the global grand challenges.

As European citizens we are ultimately dependent on the speed of (green) knowledge diffusion in both our countries as well as those in the rest of the world.