In the face of a collapse in world trade even faster than that in the 1930s, countries needed no persuasion of the necessity of policy stimulus. But it has proved much harder to form a consensus on how to tackle the underlying problems. So, three years later, the imbalances in demand remain. Around the world, short-run stimulus packages of various kinds, and unsustainably low interest rates, have bought time. So far that time has not been used to deal with the underlying imbalances, or the weaknesses in bank and sovereign balance sheets. Four years after the financial crisis began, the foreign exchange reserve holdings of China are substantially larger than at the onset of the crisis. Markets now realise that before the crisis banks were seriously undercapitalised and so react in a volatile way to any news about the health of the banking system. And the indebtedness of governments around the world is certainly greater. Time is running out. So what is to be done? One way or another, domestic spending must be raised in the surplus countries and lowered in the deficit countries, relative to current trends. In the past, marketdetermined exchange rates have played an important role in rebalancing world demand and trade. Exchange rates are the natural safety valve, which can limit the extent of imbalances in demand across countries.
Governments in the G7 agreed that intervention in the currency markets should be undertaken only when there was a collective view that exchange rates had become out of line with their longer run fundamental values. That reticence served us well. But over the past two decades, some governments, particularly in Asia and the euro area, have tried to fix exchange rates without putting in place mechanisms to ensure that competitiveness could be rebalanced by other means. That has contributed significantly to the problems facing us. It is crucial to the health of the world economy that we find ways of allowing competitiveness to adjust so that trade imbalances, and hence the present scale of indebtedness, can be reduced. Neither liquidity nor austerity are answers to the question of how to restore a loss of competitiveness. Dealing with these structural issues will take time. Meanwhile, how do we resolve the immediate crisis of confidence in some banks and sovereigns? Since the summer, there have been renewed concerns about the adequacy of the capital of banks in the euro area to absorb likely future losses, thus jeopardising their ability to raise funds. Wholesale funding dried up for many banks over the summer, and share prices of European banks are around 35% lower today than at the start of July. A transparent recognition of losses and a substantial injection of additional capital are necessary to restore market confidence.