The Global Economy and Financial Turmoil: Finding our FootingSpeech by First Deputy Managing Director John Lipsky,
International Monetary Fund,
At the Center for Strategic and International Studies
Washington D.C., September 18, 2008
As Prepared for Delivery
Financial market developments over the past few days have been dramatic: The bankruptcy of a major U.S. investment bank, the acquisition of another by a large commercial bank, the federal government's intervention to shore up the GSEs, followed by the Federal Reserve's provision of a massive emergency loan to stave off a disorderly bankruptcy of the world's largest insurance firm, are the latest searing manifestations of a financial crisis that has expanded suddenly to historic proportions.
There is now almost universal consensus that the global economy is set to weaken, with the debate shifting from whether emerging economies would decouple from the advanced economies to whether the slowdown will be shallow and somewhat protracted or deep and very long. While the events of the past week underscore the seriousness of the situation, my message is today straightforward: this storm can be weathered without a damaging global recession, but attaining such an outcome will require clear and coherent policy responses from public authorities and institutions around the world, together with the restoration of private market functionality and an end to investors' spiraling crisis of confidence.
It is obvious that the challenges at hand are daunting. The confluence without historic precedence of three shocks-to commodity prices, to housing markets, and to the financial sector-represents the source of the sharp strains sweeping across financial markets.. The contours of the challenges are shifting, however. With energy and commodity prices well down from their earlier, all-time highs, inflation pressures should begin to recede in most advanced economies, opening the prospect of a gradual restoration of consumers' purchasing power. At least in the battered US housing market, the prospect is emerging of an eventual bottoming out in the steep drop in activity, and we expect prices to begin to stabilize in the course of the coming year.
According to IMF analysis, the most likely outcome is that the financial turmoil still underway in many advanced economy markets will not by itself prevent a gradual recovery in economic activity in 2009. Nonetheless, the turmoil is one reason why we expect the recovery to be only gradual. At the same time, the moderate growth we expect will not be sufficiently powerful to quickly end the deleveraging and sector shrinkage afflicting financial institutions in many key markets. Furthermore, the dangers created by the financial crisis still represent the principal risk to near-term growth prospects.
There is no doubt about the ability of flexible market economies to rebound from adverse shocks. Moreover, non-financial corporate sectors in many key economies — in particular in the United States - have entered this period of financial turbulence in a relatively strong position of high profits and profit margins, solid productivity gains and low leverage. Nonetheless, a decisive public policy response to the current challenges also represents a necessary element for resisting the potentially significant damage from the financial turmoil.
A bit more than six months ago, I spoke about the various macroeconomic, financial, and crisis management policies that were available to policymakers, urging them to "think the unthinkable".1 The unprecedented policy responses of the past few days — principally but not exclusively in the United States — have demonstrated that monetary and fiscal authorities in advanced economies have been willing to implement innovative and unorthodox measures when they appeared to be warranted. Some of the options that I outlined in those earlier remarks — most notably use of the public balance sheet to support specific institutions and markets — have been exercised. However, the essentially reactive and inevitably case-specific nature of many of these measures raises the question whether broader and more proactive approaches have become warranted.
Outside the United States, and looking beyond the market turbulence that has followed in the wake of last weekend's events, there is no doubt that the macroeconomic picture is evolving in a worrisome direction. Advanced economies that appeared resilient earlier on are now faltering. As housing markets in the United Kingdom, Ireland, and Spain turn down, concerns about feedback to the financial sector are mounting. Some key mortgage lenders in the United Kingdom are facing increasing losses, and policymakers have helped this week to arrange the sale of the country's fifth largest bank. In the emerging economies, the balance of risks in many countries is shifting as inflation risks have begun to recede and downside risks to growth have intensified.
The IMF's flagship analyses of global economic and financial developments — the World Economic Outlook and the Global Financial Stability Report — will soon be released to the public and will provide our full analysis of current conditions and challenges. In anticipation of these documents' release, I will provide today the Fund's broad take on the current state of the global economy, explain in a bit more detail why we are cautiously optimistic about the underlying resilience of the global economy, and describe the key policy options that will need to be considered in order to stave off the very real risks to the global outlook.
State of Play: The Global Economy on Two Tracks
I will begin with the current situation.
First of all, economic performance is becoming bifurcated. Advanced and emerging economies are moving in the same direction-that is, growth everywhere is slowing, decisively ending any hopes of a growth decoupling — but they are facing two different sets of problems.
Nearing the end of the year's third quarter, most advanced economies are either virtually stagnant or on the verge of recession, while underlying inflation risks are becoming increasingly well contained.
The growth slowdown that originated in the United States has spread, as evidenced by declines in activity in the second quarter in both the euro area and Japan. Advanced economies, in general, face a spell of growth well below potential, as they grapple with ongoing strains from the financial crisis that began a year ago, as well as the lingering effects of high oil prices and weaker external demand.
For these economies, headline inflation reached 4½ percent in July-a rate not seen since the early 1990s. This acceleration was driven mainly by energy and commodity price increases. At the same time, underlying inflation has remained subdued, hovering around 2 percent. We expect headline inflation to moderate significantly in the advanced economies, reflecting the impact of retreating energy and commodity prices and the emergence of increasing margins of unused capacity.
As for emerging economies, their aggregate growth rates continue to diverge-but not decouple-from the advanced economies. Put simply, emerging economies can not defy gravity in an increasingly multipolar world. Still, they can exhibit some important degree of resiliance. Activity gains in these economies is decelerating, but growth still is expected to remain near trend. Growth has moderated from an annual pace of 8¼ percent in the middle quarters of 2007 to 7¼ percent in the past three quarters, largely reflecting slower export growth as a result of weaker demand from advanced economies. More recently, there are signs that capital is beginning to flow out of many emerging economies, reflecting both declining risk appetite and moderating growth prospects. In response, many of these countries have experienced sharp exchange rate depreciations. In some cases, this is a welcome development, as previous appreciation pressure associated with capital inflows was leading to exchange rate overshooting. However, these new outflows also are creating risks for these economies that warrant close attention.
The implication of these developments is that the balance of risks is shifting for many emerging economies. To be clear, inflation is still a key problem for some emerging economies and tighter policies are still required in some cases so as to ensure that hard-won gains in monetary policy credibility are not eroded. But for many other emerging economies, downside risks to growth are increasing, while risks to inflation appear more subdued. As the balance of risks shifts, so should policymakers' responses.
A Confluence of Shocks
Against this backdrop, the three major challenges-high commodity prices, the housing downturn in the United States and some other advanced economies, and the financial turmoil -- still remain. On their own, any of these three shocks could be dealt with through standard policies. However, the interplay of the three shocks has made policymaking much more difficult-as I will discuss shortly.
Before doing so, I would like to elaborate on how each of these three shocks appears to be evolving.
First, the energy and commodity price shock has introduced a serious constraint on the ability of policymakers to conduct countercyclical monetary policy, particularly in the advanced economies. The good news from this perspective is that this shock appears to be unwinding-at least to some degree. In particular, oil prices have fallen sharply in recent weeks. In our view, both the run-up in prices earlier in the summer and the subsequent decline in prices primarily reflect shifts in fundamentals - especially changes in expected demand and supply trends. With both supply and short-term demand for oil highly inelastic, small shifts in the supply-demand balance can lead to large price swings in cash markets. With demand still running strong early in the summer, and with perceived margins of excess capacity very tight - or even non-existent-prices rose dramatically. More recently, as oil demand has declined and supply has increased, prices have retreated from earlier highs. If these trends are sustained - that is, looking beyond the short-term disturbances created by the US hurricane season and by financial uncertainties-this would help create new space for countercyclical monetary and in some cases, budgetary policies.
Second, the housing downturn-the epicenter of the slowdown in the United States-is still unfolding. House prices-on a national basis-continue to fall and inventories of unsold homes remain high. As prices fall, the collateral value of housing is declining, which is squeezing already limited access to credit. Despite this collateral effect, consumption has held up better than might have been expected, in part because the moderate drop in total employment has not prevented a modest ongoing gain in disposable income, including the impact of the income tax rebates that were distributed at the end of the second quarter. As I will discuss shortly, we see some prospective light at the end of the U.S. housing tunnel in the course of 2009. At the same time, house price declines and sharp drops in residential construction also are underway in some economies outside the United States. This is creating challenges for the authorities, as these weakening trends could still have some way to go before they are likely to be halted and eventually reversed.
Finally, the strains in financial markets have intensified recently more than a year after the turmoil erupted, and we do not expect the turbulence to fully subside for some time to come.
Stepping back from the events of the past week, the broader issue facing the financial sector is that many firms are facing the prospect of a much-reduced revenue stream compared to both recent experience and earlier expectations. At the same time, they face a prospective shortage of capital if price declines force new writeoffs. For sure, banks in the United States and Europe have raised substantial amounts of capital in the past year. But these infusions are still some $150 billion less than the writedowns, and further capital raising will become much more expensive, if not impossible.
Given the scale of the financial distress, a protracted process of deleveraging and restructuring is unavoidable. In short, it has become obvious that the financial sector in the United States and elsewhere is in the midst of a historic reordering that will alter market and institutional structures. At this point, anticipating the outcome is highly speculative, but a return to rapid credit growth appears to be a long way off.
The Global Outlook: A Gradual Recovery
Given these challenges, one could reasonably expect that we would be pessimistic about the global outlook and the scope for recovery. For sure, the further tightening of financial conditions in light of recent events will have some negative implications for global economic activity, not least because it is likely to diminish the scope for a rapid recovery of credit creation. However, several factors provide a degree of reassurance that a severe downturn can be avoided.
First, as noted earlier, oil prices have come down sharply in recent weeks. This should reverse a significant portion of the adverse terms-of-trade effects arising from the more than 60 percent increase in oil prices during 2008 and the erosion in purchasing power and real wages being felt by most advanced economies. In the United States, if oil prices remain at current levels, the implied boost to real disposable income will rival the value of the income tax rebates. Indeed, in our projections, we expect a modest rebound in consumption in both the United States and euro area over the course of 2009.
Second, it is plausible to anticipate that the U.S. housing market will find a bottom in 2009. Already, the inventory overhang is diminishing, while affordability measures are returning to levels that appear much more consistent with past experience. The recent US Treasury support for the GSEs was intended to allow these agencies to expand their balance sheets through 2009, while direct Treasury purchases of the GSEs mortgages securities should help to keep mortgage costs down. As a consequence, we expect residential investment to find a floor. This will reduce the considerable drag-amounting to ¾ percent of GDP over the past two years-of the housing sector on economic activity. At the same time, the eventual stabilization of house prices should help restrain mortgage-related losses and contribute to restoring financial institutions to health.
Third, while financial conditions have tightened in both the United States and in Europe, it does not mean that an economic recovery is thereby excluded. In the United States, for example, corporate finances in general remain relatively healthy. Productivity gains have helped to sustain profits. Time-limited investment tax credits will encourage corporate capital expenditures in the coming months. Moreover, recent IMF analysis suggests that a slowdown in credit intermediation does not necessarily impede economic recovery.
Finally, relatively robust emerging market growth, led by strong domestic demand in several of these economies, has helped boost U.S. exports. Going forward, we expect net exports to support growth in the United States as the effects of the earlier declines in the value of the dollar take hold with a lag. Of course, the dollar has strengthened in recent months.Nonetheless, Fund analysis indicates that the US currency is still somewhat on the strong side relative to medium-term fundamentals. At the same time, the limited adjustment in the currencies of several economies with pegged exchange rate regimes and large current account surpluses has not been adequately supportive of global adjustment while preserving growth.
Against this background, we project global growth to come in around 4 percent in 2008 and somewhat under 4 percent in 2009 on an annual average basis. However, the dynamics are portrayed more clearly when growth rates are examined on a fourth quarter over fourth quarter basis. Using this metric, global growth would slow from 4¾ percent in 2007 to near 3 percent in 2008 before recovering to around 4 percent in 2009.
The challenges facing the global economy and financial system are clear, and downside risks to the outlook have increased notably. The overarching risk revolves around the feedback loop between continuing strains in financial markets and slowing economic activity. Despite aggressive policy actions aimed at alleviating liquidity strains and preventing systemic events, markets remain under severe stress. There is a clear risk that financial conditions could deteriorate further and more aggressive attempts by financial institutions to deleverage balance sheets could imply severe problems of credit availability. There also is a clear risk that emerging market economies, that have so far been relatively insulated from the financial turmoil, could be subject to large reversals of capital flows, with serious implications for economic activity.
But the critical issue is how we deal with these challenges and risks. The remainder of my remarks will focus on policies to address the challenges that I have just outlined. Let me emphasize, however, that the confluence of shocks has made policymaking more difficult and resolving the current turmoil on a durable basis will require creative solutions across a range of policy instruments.
Policies: Finding our Footing
Monetary and budget policies are critical, but these provide only a first and second line of defense against the deleterious impact of a financial crisis. The use of public funds to safeguard the financial system that we have labelled the third line of defense may become imperative. It is appropriate that this option be considered in a broad, coherent and proactive manner.
The first line of defense lies with monetary authorities, both in terms of liquidity provision to the financial sector and in setting policy interest rates. Monetary policy can play a critical role in helping individual economies find their footing, but the scope for policy easing ultimately will depend on each country's cyclical position.
In advanced economies, we expect the slowdown in activity to help contain inflation going forward. Weakening domestic demand, increasing output gaps and sluggish labor markets should limit pressures on underlying inflation. Moreover, the recent sharp decline in oil prices should help alleviate short-term pressures on headline inflation. Hence, we see monetary policy as broadly appropriate at this time across most advanced economies. Outside the United States, given the downside risks to growth and the ongoing strains of the financial crisis, there could be scope to lower rates in the euro area and the United Kingdom if activity slows and inflation moderates as we expect.
In many emerging economies, with the shifting balance of risks between inflation and growth, there is greater scope for countries with moderating inflation and policy credibility to take a wait and see approach. That said, serious inflation risks persist in countries where growth remains strong and where, given lags in pass-through, food and energy price increases are still in the pipeline. For these countries, monetary policy should have a tightening bias.
Fiscal policy-the second line of defense-has played a role in the United States already and automatic stabilizers are appropriately providing support as growth slows in other advanced economies. In many emerging economies, budgetary policy will have to play a supportive role to monetary policy in helping to bring down inflation.
Fiscal policy is broadly appropriate across the advanced economies, but room for maneuver is limited given the need for medium-term fiscal consolidation in many of these countries. However, support for the financial sector inevitably will involve budgetary costs that must be taken into account in considering policy alternatives.
In emerging economies where inflation remains a problem, fiscal policy should play a more supportive role in restraining demand growth and easing inflation pressures. In particular, greater restraint on spending growth would be helpful as a complement to tighter monetary policy.
Direct intervention-the third line of defense-has and must be considered so long as there are systemic risks to the financial system. And we must keep in mind that, although the situation is far from ideal, there are also a variety of other policy options that can be used, including further direct support to housing markets.
In this regard, the Fund welcomed the recent actions by the U.S. authorities to support Fannie Mae and Freddie Mac. These actions represented a significant step-and a key lesson from past financial crises (notably in Japan and Scandinavia) is that direct public intervention should be of a large scale, as piecemeal efforts of this nature often are not effective.
The measures taken should bolster the GSE's balance sheets and stabilize the funding of mortgages. They should also substantially reduce downside risks to the U.S. growth outlook related to shortages of housing finance, although by themselves are unlikely to turn around the U.S. housing market. Over the longer term, a deep restructuring of the GSEs remains essential to restore market discipline, minimize fiscal costs, and limit systemic risks for the future. Ultimately the conflict of private ownership and public policy objectives within the GSEs' former business model must be resolved.
Even after the dramatic events of this past week, it would not be surprising if some additional financial institutions will not survive in their present form. Nor will market structures or instruments remain unaltered. In fact, it seems clear that the overall size of the financial sector will shrink in many markets. There is no inevitability to any over-expanding sector, at least not in relative terms. In these circumstances, the key is to strike the right balance between limiting moral hazard and safeguarding the financial system's effectiveness. This task is by no means an easy one, but the consequences-either in the short- or longer-term-would be severe if the pendulum swings too far in either direction.
Notwithstanding the recent use of innovative and unconventional measures, more may be needed. The implication is that a more systematic approach may be required to deal with such basic issues as the disposition of distressed assets, the degree of protection offered to depositors, and the scale and scope of liquidity support that is offered to institutions and markets.
The fact of globalized financial markets means that policy interventions need to be globally coherent and consistent in order to be effective. Although I am cautiously optimistic that the global economy will continue to be resilient in the face of significant headwinds, this does not imply that the policy challenges and tradeoffs are not daunting. At the IMF, we stand ready to assist our members in confronting these exceptional challenges, in understanding the critical policy tradeoffs, and in navigating successfully through the turbulent waters ahead.
1 See Lipsky, John, "Dealing with the Financial Turmoil: Contingent Risks, Policy Challenges, and the Role of the IMF", Speech at the Peterson Institute for International Economics, March 12, 2008.