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Pauline Neville-Jones: Government's must tackle economic crisis

A couple of years ago - even a year and a half ago - I don't think I would have been asked to speak about security and the economy. 

The backdrop is, of course, the banking crisis; a crisis which shows how quickly things can change - how quickly, in this interconnected world, a crisis can spread to all countries and affect all areas of life.

When ordinary people think about the crisis, they quite understandably consider the direct implications for themselves and their families - the implications for their savings, for their pensions, for their job security.  Quite suddenly, after a sustained period of economic expansion and increased prosperity, which apparently had no end in sight, they are faced with an abrupt change of fortune and experience a strong sense of personal insecurity.   Very often what matters is not the absolute level of hardship itself but the gap between it and disappointed expectations. We can be better off but still be disaffected and insecure.

Across the world, governments are trying to address this sense of personal insecurity among their electorates by putting in place financial stability packages to safeguard the banking system and provide vital liquidity to markets on which normal economic activity depends. The political pressures are local and so are significant aspects of the solutions. But effective global coordination is needed for the solutions to endure and there may be tensions between them with which political leaders will have to grapple.

We are today tackling a systemic risk of global significance. Sovereign default cannot be ruled out. The financial crisis has led on to a major worldwide economic downturn which puts in jeopardy the gains in global wealth creation. According to the World Bank, from 1981 to 2001, the number of people living on less than $1 a day went down from 1.5 billion to 1 billion.  Improvements in global literacy went hand-in-hand with this.  This favourable trend could now go into reverse. Just one indicator of what is at stake.

The irony is that globalisation has been the brainchild of the financial institutions which now threaten it.  The very word was first used about the emergence of banks operating round the world on a twenty four/seven basis, the businesses being managed through the wonders of the internet which largely overcame the constraints of time difference.  Technology has magnified both the possibility and the effects of poor business practice. Let us look at some of the effects.

International investment flows. It is difficult to find a total figure for annual global private sector investment flows which globalisation brought into being.  But consider the following indicative examples:

In 2007, net private capital flows to emerging economies were $898 billion;

Global trade rose by 9.4 per cent in 2006 and 7.2 per cent in 2007;

Between 2001 and 2007, private equity transactions were valued at $2.7 trillion - approximately $0.45 trillion each year.

Compare this with the outlook for the next few years. The Institute of International Finance estimates that net private capital flows to emerging and developing countries will be just $165 billion in 2009 - a decline of 82 per cent from 2007. Private sector FDI is bound to take a hit.  The IIF also estimates that global trade flows will grow by just 2.1 per cent in 2009, the slowest rate since 2001.  I hope that does not prove optimistic.

These are dramatic changes which are bound to have political consequences. Government  injections of capital - now necessary because private sector financed growth turns out to have been based to a dangerous degree on highly leveraged loan finance and riskier sorts of assets in sectors like housing - have not so far matched previous levels of global private sector investment flows. 

Nor are they likely to even if the saver economies like China spend and invest at higher rates than before. It will nevertheless be important that they do since this can contribute significantly to lessening the severity of the downturn and the shortening of its length.

Some of the regulatory measures for banking that are now being talked about - especially those involving increased capital ratios and insistence on more conservative banking practice, both of which may well be necessary, are bound nevertheless to reduce still further the finance available for active use and slow down economic recovery.

With the upturn, we shall not go back to the status quo ante.  There is talk of the need for structural rebalancing of our economies for a variety of reasons, including climate change.  But this new world will take time to emerge and not every place or person will be a winner.

So what might be the implications of this shortage of liquidity for the geopolitical landscape, our strategic relationships, and the security of supply of essential commodities like energy and food?

I want to look at briefly at these issues. Necessarily some of what I say will be speculative.  Much will depend on how long the economic crisis lasts. Which in turn depends on the quality of the responses to the crisis.  We are in an interactive situation.  I will nevertheless try to explore some of the drivers, drivers that we, as politicians and officials, should consider when developing financial and economic policy as well as national security policy.

<h2>Domestic Security and the Dangers of Protectionism</h2>

The United States intelligence community has looked at some of these issues. Its current Threat Assessment observes that 'roughly a quarter of the countries in the world have already experienced low-level instability such as government changes because of the current slowdown.  Europe and the former Soviet Union have experienced the bulk of the anti-state demonstrations'.  In other words, have already been and will continue to be a rise in social unrest directly attributable to the economic downturn.  No doubt not all of it will be peaceful.

The  US Threat Assessment goes on to say that 'although two-thirds of countries in the world have sufficient financial or other means to limit the impact for the moment, much of Latin America, former Soviet Union states and sub-Saharan Africa lack sufficient cash reserves, access to international aid or credit, or other coping mechanism.  Statistical modeling shows that economic crises increase the risk of regime-threatening instability if they persist over a one to two year period'.

In simple language, some parts of the world have less resilience than others and if the crisis goes on for more than a couple of years or so some governments are likely to be toppled.  The political insecurity of governments can itself be a potent driver of both repression and economic nationalism which they may see as shortcuts to greater security.  In reality such actions are likely both to exacerbate political tension and prolong the global downturn. 

Even in free trading UK we have seen calls from government for 'British jobs for British workers'.  The French President proposes to give aid to French car manufacturers provided the money is spent only in France - in clear breach of the free trade rules of the European Union. To an audience of this kind, I need hardly spell out the risk of rising trade protectionism and the damage which beggar my neighbour economic policies of all kinds can do.  The Doha round becomes the more urgent and necessary the harder it becomes to secure.  Here, it is not just the developed world that has to make an effort but also developing economies like India.

Alongside the menace of increased social unrest potentially leading to political upheaval, there are possible consequences of the downturn for the international terrorist threat we all face.   Crowd violence can be manipulated for political as well as economic ends.  In addition, we know that a number of factors contribute to the vulnerability of individuals to extremist messages of any kind, including poor education, unemployment, poor local services, isolation and lack of effective political rights or a combination of all of these. 

The economic crisis is likely to exacerbate such factors, sharpen the effects of underlying conflicts and potentially increase the appeal of the terrorist message.  I personally am not inclined to exaggerate the likely direct effects of the downturn on the terrorist threat, but we should all be monitoring it carefully.  And the longer the downturn, the more the enemies of stability and ordered government will have opportunities to gain ground.

<h2>Security of Commodities</h2>

There will be leaders in this hall for whom the details of how to regulate the banking sector whether domestically or internationally is less immediately important that how to ensure that all their citizens have enough to eat.  Hunger drives disease.  It also drives revolution.  I want to turn briefly to the security of food supplies and to the security of the indispensable commodity that powers the daily lives of most inhabitants of this planet: energy.
One of the features of globalisation has been the increasing chase after basic commodities and, as a result, massive price rises in some of them.  Supply, once abundant, has been decreasingly able to meet demand and the cost of accessing new sources has gone up.  Some might argue that the downturn will ease the pressure and make life easier.  In the case of energy, this may be true over the very short term but not for long.  In the case of food, I do not think it is true at all.

In relation to food, the World Bank has made two pertinent estimates: one of immediate insecurity, and one of long-term demand. 

On immediate insecurity, the World Bank says that food prices, which have risen in the first decade of this century, have already increased the number of undernourished people by 100 million.  The civil unrest in countries like Egypt, Haiti and Lebanon, the Philippines and others are partly attributable to this.  High food prices also pose a challenge to the provision of aid that seeks to address the problem: the World Food Programme can feed less than a tenth of the world's undernourished population, and its budget no longer covers even current deliveries.

Over the medium and long term, the World Bank predicts that, by 2030, demand for food will increase by fifty per cent- largely the effect of population increase. But how will suppliers meet it, when things like climate change and poor weather conditions can reduce crop output? Will improved husbandry be enough?

Current responses could also make solutions more difficult than they need be.

Over thirty countries have reduced exports, introduced export restrictions or stockpiled food.  Food protectionism is a bad start.  And countries like Saudi Arabia and China have responded to the prospect of increased costs and the possibility of shortages by seeking long-term food purchase agreements, buying land leases or, indeed, buying tracts of agricultural land outright in places like Africa.  That makes other countries' problems greater as the tracts of land are not being secured for trading purposes, but for the direct shipment of products to their own populations.  Food prices are likely to be driven up by autarky.

So what are we to do?  Just as there are calls for reform of the structure of the international financial system, so there have been proposals for international reforms to ensure food security. 

One proposal is to change the structure of international agricultural trade, one of the most distorted and protected in the world- not least I may say the EU's Common Agricultural Policy which should have been dismantled long ago and still awaits reform.  Another possibility is to alter the allocation of existing foreign aid budgets - only 3 per cent is currently allocated to agriculture - and to get host governments also to spend more of their budgets on agriculture.  The African Union, for example, set a target of 10 per cent by 2008, but this has not been met. 

A third proposal is to put in place an 'IEA for food' or, at least, a global system of food reserves.  The International Energy Agency was established following an oil crisis to coordinate collective action in future crises, particularly through an emergency response system of strategic oil reserves.  Storage of grains in particular is well established - and there is little in store at present. Perhaps we need a more internationally organized system of storage for certain basic food stuffs?

Finally, let me look at energy security.  Others at this forum have spoken - and will speak - about this, so I shall be brief. 

The recent price of oil and gas has seen huge one time transfers of wealth from consumer to producer countries - so great and so destabilising as themselves to be an important factor in the downturn and in the consequent drop in demand.

But energy prices at current levels are not likely to last indefinitely if only because of steadily reducing supply from existing reserves. The US Energy Information Administration estimates that there will be an average of two percent annual growth in global oil demand over the years ahead along with, conservatively, a three percent natural decline in production from existing reserves. 

So markets will sometime get tighter. More turbulence in the world also increases the likelihood of supply crises arising from political tensions leading to economically disruptive price spikes and indeed blackouts. To smooth the relationship between supply and demand of energy we need new investment now. But the downturn may get in the way of this.

The drop in oil prices has at least two economic effects.  First, it makes investment in alternative energy technologies less immediately cost effective and reduces incentives to  diversify away from non hydrocarbon sources of power, which the world needs if only for climate change reasons.

We shall however continue to need oil and gas for a long time to come.  But - my second point- the downturn will slow down investment in new reserves, increasing quantities of which are in inhospitable parts of the world requiring big chunks of finance and sophisticated extraction technologies. One might think that this does not necessarily have security implications.  But it does.  Supply shortages lead to oligopalistic behaviour and tempts suppliers to exploit their market dominance.

Consider, as an example, ongoing efforts made in some quarters to cartelise the gas market on the model of oil.  In October we learnt that Russia wanted to form a so called gas Troika with Iran and Qatar.  Between them, these three countries hold 60% of known gas reserves.  Russia for one has used petro power as a political weapon. Further cartelisation of the energy market would be an unwelcome development with potentially significant security implications for consuming nations.

For the immediate future, in a recession, the best way to ensure that countries do not move towards autarky is to resolve together to move firmly in the opposite direction.

<h2>The need for international cooperation</h2>

There are broad choices for the international community in responding to the downturn:  a resort to autarky and protectionism as a way of safeguarding jobs, or a push to keep an open global system by recapitalising and regulating international banking, maintaining investment flows and free trade.

The first is the apparently easy way which will look after the short term in the immediate locality but will not prevent crises elsewhere which could in any case have repercussions locally.  Nor is protectionism likely to deal effectively with systemic risk. Indeed in a world geared to international free trade to an extent unprecedented in history it is likely to do great damage and cause great hardship.  My protected market is your closed factory and angry workforce.

The second route - maintaining the open system - requires possibly unpopular decisions about keeping markets open and thus putting some local jobs at risk and is a much bigger immediate challenge to political leaderships.   But it is the route more likely to bring long run sustainable security.  But while governments can be protectionist on their own, they have to cooperate to keep markets open.

As a proponent of liberal capitalism, I want to see it heal itself and continue to be the motor of international economic development and welfare.  To achieve this, we need to use global mechanisms.  The G7 is no longer inclusive enough and it is right that the G20, despite being somewhat unwieldy as a steering mechanism, is at last - some might say rather late - taking primacy.  The forthcoming meeting in London in a month's time will be important.

Within this framework, a key relationship is of course that between China and America - both for trade and investment reasons.  Each has a very large stake in the continued economic prosperity of the other, and one thing we must seek to avoid is a destructive and impoverishing trial of strength between the two forms of capitalism they represent. 

We are gathered today in the continent where strategic relationships are most obviously in transition.  The spread of wealth means an increment in power. It also means assuming greater responsibility for international governance. It is time the international financial institutions were reformed and along with them the UN Security Council enlarged. The United States remains the single biggest economic and political player- but it requires all of us to cooperate to get out of the present mess.

<h2>Conclusion: risk assessment is part of national security</h2>

Let me conclude.

We have already we have seen social unrest worldwide as a result of the economic downturn which, on the best of scenarios, is going to continue for sometime. 

The measures taken by governments at home and internationally will materially affect not just the world economy but its political stability too and the security of our societies. Beggar my neighbour economics can boomerang in the form of lower security.  We must work hard to keep an open and global economic system.

What else do we need to learn?  From the national security point of view, I feel we should have been more alert to the emerging crisis before it finally broke. Not all economic problems have security implications but when systemic risk is involved which can bring down the global economy there are bound to be repercussions for security.  I have today set out some of them.

We need to ensure in future that our governmental machinery is geared to watching for such risks - horizon scanning as the experts term it - and  that we are able to act effectively further upstream.  The private sector already knows how hard assessing and managing risk can be.  Government is considerably behind the private sector in this but being on top of risk is a part of the business of governing that it can no longer afford to neglect.

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