Crisis Lessons For The IMFSpeech by John Lipsky, First Deputy Managing Director, International Monetary Fund
At the Council on Foreign Relations
New York, December 17, 2008
As prepared for Delivery
Good morning and thank you for coming out so early on one of the shortest - and hence, darkest - days of the year. Today's limited sunlight unfortunately provides an appropriate setting for discussing the current situation in financial markets and in the global economy. Attempts to improve financial markets and the economy undoubtedly would benefit from both more light and more heat. Hopefully, the coming months will eventually begin to supply both.
Although I will begin with a brief review of the near-term outlook, the principal theme of my remarks today is the current and prospective role of the International Monetary Fund (IMF). You will not be surprised that my primary thesis is that the IMF can contribute significantly -- and perhaps uniquely -- to dealing with both the current and likely future challenges.
In the broadest sense, the IMF's principal tasks are to help reduce the global economy's systemic instabilities and to promote effective counter-cyclical policy action. In other words, the Fund has been mandated by its members - today totaling 185 countries -- to play both a structural and a cyclical (or better put, a counter-cyclical) role. I also believe that this role fits neatly and inevitably into the emerging consensus about governance of the post-crisis global economy and of financial markets. I will discuss the Fund's role and its governance implications in a bit more detail at the end of my remarks.
The Near-Term Outlook
Regarding immediate prospects, my principal message is that additional - and vigorous -- policy action will be needed in order to avoid a serious global downturn. Officials should concentrate their efforts on achieving such an outcome, as the emergence of substantial output gaps in economies around the world would leave a legacy of reduced output, lost opportunities and sacrificed well-being. The measures needed to avoid this encompass both renewed efforts at stabilizing financial systems, as well as monetary and budget measures to support final demand.
For now, global financial markets appear to have stepped back from the brink in response to aggressive policy support measures. Nonetheless, the danger of renewed deterioration remains high in several markets, while funding and liquidity markets are still severely strained. These negative developments reflect deep shocks that have undermined confidence in financial market counterparties, persistent concerns over future losses and funding needs, and large losses in bank and other institutions' capital.
Thus, financial market deleveraging is still underway, underpinning our base case expectation of a substantial and sustained slowdown in credit growth through the coming year. Moreover, financial stresses have spread to emerging markets, where equity market downturns by now have equaled or outstripped those in advanced economy markets, and where outflows from debt markets threaten to reverse the structural progress that has been one of the most striking recent financial market developments.
Against the background of weak financial markets, last month we revised lower our forecast for global growth. Based on current policies, global economic growth is projected to decelerate to only 2-1/4% in 2009, down from about 5% last year, and we also scaled back our projection for the recovery in 2010. While we believe that efforts to stabilize financial conditions and strengthen demand support measures could still enable a gradual recovery beginning in the second half of 2009, it seems likely that we will reduce again our growth forecast, notably in the upcoming January update of the World Economic Outlook.
The Fund's Role in the Current Crisis
The Fund's extensive experience in dealing with crises in advanced, emerging and developing economies has provided important lessons about which policies are more likely to be successful in reversing the economic downturn. In particular, more effective policy measures are needed to restore financial markets and to support demand. However, as has been evident from recent developments, achieving these goals is far from assured.
The Fund's extensive experience has underscored that a comprehensive and aggressive approach is required in order to reestablish financial sector functionality. In particular, three elements have proven to be necessary for success; comprising liquidity support, recapitalization of institutions, and the removal of damaged assets from balance sheets. Measured by this triple standard, however, virtually all of the policy initiatives implemented thus far to underpin financial market functionality have tended to be partial, rather than comprehensive.
Thus, it is not surprising that the sharp slowdown in credit growth here and abroad shows no sign of abating. Redoubled efforts across the board will be required if the deleveraging is to be contained without creating substantial further damage to the financial system and to the global economy.
With the global economy facing major challenges, there is no doubt about the need for both monetary and fiscal measures to support demand as well. With inflation pressures currently in retreat, more aggressive monetary policy measures of the kind we saw yesterday in Washington from the Federal Reserve are justified in many key economies. However, Fund experience has shown that fiscal action may become more important when impaired credit channels make monetary policy measures less effective, and when there is a sharp rise in desired private saving. In the current circumstances, our research suggests that the needed fiscal stimulus will be large. Specifically, we have recommended that measures should total about 2 percent of global GDP.
We also have recommended that fiscal measures should be diversified - including both tax and spending measures - and that they should be sustained in their impact given the seriousness of the downturn and its likely duration. However, we also have emphasized that individual country circumstances - including budget balance, debt position and spare capacity -- will dictate the degree to which fiscal measures are appropriate, as well as the type of measures that are likely to be most useful in each case.
The Fund in Tough Times
The sustained turmoil in global financial markets over the past 16 months has revealed the degree to which our current economic and financial system contains powerful elements of pro-cyclicality. As I mentioned earlier, a key responsibility of the IMF - as mandated in its constitution, the Articles of Agreement -- is to promote systemic improvements and to resist pro-cyclical tendencies. An essential way in which the IMF has been countering pro-cyclicality is by promoting multilateral cooperation in setting policies. Of course, this is directly in keeping with its original aim to avoid the disastrous Depression-era spiral of tariff protection, currency controls, and competitive devaluations. While this lesson is widely accepted, it turns out that "good neighbor" policy-making cannot be taken for granted even in this age of globalization.
Indeed, when serious economic and financial strains appear, it is not surprising that pressures mount on national policymakers to protect domestic interests. These pressures can persist, even when they may appear to be detrimental to neighbors and other trading partners. A recent case in point is deposit insurance. Last September/October, the sudden emergence of heightened market volatility following the spectacular collapse of several well-known financial institutions produced a mushrooming of deposit guarantees around the world. In part, this reflected underlying stress, but the authorities in many countries also feared that deposits and capital would flow out to neighbors that offered superior guarantees, forcing them to follow suit and match terms offered elsewhere. The IMF spoke forcefully in favor of a coordinated approach-which, thankfully, did emerge within days of the mid-October IMF Annual Meetings.
More broadly, policy collaboration must remain a very high priority if we are to succeed in cushioning the cyclical downturn currently underway. For example, the impact of fiscal stimulus is magnified when demand-boosting measures are implemented more or less simultaneously among key trading partners. This doesn't mean that country authorities should try to do the same thing at the same time, but rather each should undertake the measures that are appropriate for their circumstances more or less at the same time.
As I suspect you are aware, the Fund has recently stepped up its financial support for its emerging market members, just as capital flows to these economies have been reversing. In November alone, we approved loan commitments totaling $40 billion to Hungary, Iceland, Pakistan and Ukraine, and we are currently engaged in negotiations and discussions with several other member countries. Moreover, Fund program lending in most of these cases catalyzes additional lending from other sources, magnifying the Fund program's positive impact.
We have also been monitoring closely the impact of the crisis on our low-income member countries, where we have provided additional financial assistance in many cases by augmenting pre-existing arrangements in our Poverty Reduction and Growth Facility (PRGF). We also modified our Exogenous Shock Facility (ESF) in order to make it more responsive to our low-income members' needs. Such Fund financing helps to ameliorate the cyclical forces bearing down on these economies, allowing a higher degree of consumption and income than would otherwise have been possible. In many of these cases, Fund-supported programs have also incorporated explicit provisions designed to protect low-income individuals and families.
Not every emerging market economy afflicted in the current crisis with restricted access to international capital markets is suffering from an underlying problem with its public finances or structural weaknesses in its banking system. Rather, the immediate problem may simply be a temporary shortage of liquidity, reflecting problems elsewhere. To meet the needs of such members, the Fund recently introduced a new lending instrument-the Short-Term Liquidity Facility (SLF) - that provides high-speed access to large amounts of financing to members with strong fundamentals and track records of successful implementation.
The SLF is a new type of IMF facility. As it's name makes clear, the SLF is short-term in nature, and it carries no ex-post conditionality. It is intended to help countries that are not in need of the policy adjustments that underpin traditional IMF "Stand-By" arrangements. In this sense, the use by a member of the SLF will represent a mark of substantial economic and policy success, rather then bearing the "stigma" that is often claimed to be bestowed via traditional IMF Arrangements.
In many recent cases, the Fund has invoked its emergency procedures, allowing the institution to act quickly to aid those member countries that need financial support for their policy adjustment programs. Moreover, the conditionality that accompanies recent programs - and that is intended to both safeguard IMF resources, but also to boost the credibility of the policy programs with both internal and external entities- are focused narrowly and appropriately on those policies that are necessary for the programs to achieve their broad macroeconomic goals.
One of the hallmarks of the current crisis has been that the financial resources that have proven to be necessary to support damaged financial institutions and sectors in the advanced economies have dwarfed those of any previous experience. Thus, it should not come as a surprise that the same is true in emerging and developing economies. In general, the more open the economy and the more developed the financial system, the more financially demanding are stabilization efforts.
With this factor in mind, and with the crisis still spreading through the global financial system, the issue has been raised whether the IMF's financial resources will prove to be adequate. It is important that they prove to be, since if this were not the case, the IMF's ability to play its key countercyclical role would be impaired.
Measured against the super sized scale of recent stabilization measures taken in advanced economies, or against plausible scenarios of more virulent financial sector deleveraging to come, or indeed against any measure of global capital flows, the IMF's remaining lending capacity of some $ 200 billion is modest. Although it is true that Fund lending previously has never crossed even half that figure, it is critical that the scale of Fund-supported stabilization programs are adequate to the task.
In our experience, underfunded stabilization programs are an invitation to rapid and even catastrophic failure. For this reason, Japan's recent offer to lend the IMF $100 billion is a very welcome development. In fact, the Fund's Articles of Agreement provides for substantial flexibility in funding sources, and we are confident that our members will insure that we will not fail in our mission because of inadequate resources. Nonetheless, it is only common sense to review the Fund's capacity to mobilize new financial resources well in advance of any prospective need.
Moreover, other advanced country governments, central banks, and regional pools have the capacity to provide additional liquidity and in some cases have done so already. It is also possible for these potential funding sources to act in concert with Fund financial support programs. The message is clear: we need to ensure that adequate funding is available to deal with the problems we face.
The Fund in Better Times
Although at this time, the Fund's principal focus should remain that of overcoming the current crisis, it is not too early to look forward to a post-crisis global economy, with the goal of ridding the current system of those elements that have created a significant, and to a large degree unexpected, systemic fragility. In this regard, I have advocated that the Fund should follow what I have called a "three gap" approach to future crisis prevention, with the Fund endeavoring to act as "gap filler".
The first gap is a lack of information -- call it a lack of market transparency. As has been demonstrated clearly -- if anything too clearly -- incomplete information can lead to poor decisions. The second gap is that in regulation, supervision and in legal systems, as we have witnessed all too well, such gaps can lead directly to systemic weakness and potential crises.
The third gap is that of incomplete markets. In this context, missing markets may make it impossible to buy insurance against specific market risks. It is widely acknowledged that incomplete markets increase volatility and heighten risk. In seeking to help fill these gaps, the Fund naturally will work cooperatively with relevant national and multinational organizations. This task is crucial for an improved post-crisis world.
The current crisis has demonstrated the need for better early warning capabilities. I do not mean that the IMF should enter the crisis prediction business -- as this potential role already is filled with an army of prognosticators -- but rather to undertake a more focused job of carefully identifying vulnerabilities and risks, and proposing specific remedies.
Thus, it is not enough to warn that "significant risk concentrations" may be developing-as many financial stability reports did well before the current crisis. Rather, a name has to be put to the risks. For example, the proliferation of Special Investment Vehicles -- the now notorious SIVs - should have been flagged and dealt with before they caused the crisis.
As we know now, creating SIVs allowed abusing institutions to remove risky assets from their balance sheet, thus shielding them from regulatory oversight, and in many cases apparently obscuring risks from the sponsoring institutions themselves. Moreover, solutions should be proposed, in such a case, either through redefining the "perimeter" of regulation or through imposing higher capital charges on off-balance sheet operations.
In general, this is a complex task that requires bringing together expertise and information that, by its nature, tends to be scattered. Coordinating the analysis and formulating the response is key. The IMF has recently stepped up its work in this area, redoubling its analysis of financial markets, macro-financial linkages, and spillovers across countries. The aim is to strengthen our early warning systems and we are working in cooperation with the Financial Stability Forum, among other organizations. Such exercises should encourage the early adoption of preventive or compensating policy responses, either in macroeconomic or regulatory areas.
Parenthetically, I would like to underscore that my specialist Fund colleagues and I have concluded that the two key regulatory weaknesses that helped to create the systemic fragility that is still playing out are (1) poorly drawn boundaries of regulatory oversight (as in the case of the SIVs), and (2), the lack of a macro-prudential aspect to financial regulation. The latter means we have to go beyond existing practices of focusing regulation exclusively on institutions and instruments, but excluding economic circumstances in setting prudential standards.
Looking beyond regulatory issues, the difficult challenges of the past year have underscored clearly the need for effective global cooperation in conducting countercyclical policy, in promoting macroeconomic stability and in advancing effective structural reforms. Unfortunately, multilateral cooperation is not necessarily easier, even in good times. For example, in an effort to reduce the risks to global economic growth and stability associated with the emergence of record global current account imbalances earlier in this decade (the mirror image of the capital inflows into risky financial assets), the IMF in 2006-2007 hosted a series of confidential discussions between China, the Euro area (participating as a single entity), Japan, Saudi Arabia, and the United States in an innovative Multilateral Consultation on Global Imbalances. That process produced a set of voluntary policy programs that were deemed by the participants to be in their own individual interests while also supporting the overriding mutual goal of sustaining global growth while reducing the pressures associated with global payments imbalances. Unfortunately, in many cases, the proposed policy programs were not implemented with the requisite sense of urgency, no doubt contributing to the current strains.
Nonetheless, the example of the Multilateral Consultations demonstrated that the IMF could organize within its overall "umbrella" a discussion/negotiation among a limited group of relevant member countries to study/act on a topic of special importance. This model was applied highly successfully earlier this year to form the International Working Group of Sovereign Wealth Funds, and to help them to negotiate the Santiago Principles of Generally Accepted Principals and Practices for Sovereign Wealth Funds. Surely, the role of convener of a sub-group of members to address a specific issue of particular importance to the group is a future role of potential importance and usefulness.
Governance of the International Financial System
Ultimately, the working of the global economy would be strengthened by a mechanism that could help to effectively warn against impending risks, and to organize countercyclical actions. The IMF, in principle, has the institutional structure needed to provide such a mechanism: it has a virtually universal membership and a system of constituencies that allow all of its members to be represented, directly or indirectly, at its Executive Board. Thus, it possesses a decision rule that allows it to act with legitimacy, even if unanimous approval is absent.
Of course the Fund's governance structure is not static. Following a decision in 2006 to reform the relative quota weightings that govern voting power in the organization, the Fund has embarked on a process of adopting its voting shares over time to changes in relative weights of different countries in the world economy. The Fund's governance structure today consists of a non-resident Board of Governors and an advisory International Monetary and Financial Committee (both constituted at the Ministerial level), together with a resident Executive Board -- that consists of representatives of Governors and is chaired by the Managing Director, who is also the head of the staff. Although the Fund has shown that it can act swiftly and decisively when circumstances demand it, questions have been raised whether the current structure could be improved.
As you may be aware, there is a process under way to examine the basic issues of Fund governance-including through a working group of eminent persons chaired by South African Finance Minister Trevor Manuel. This group is examining many proposals, including those for strengthening the Fund's governance structure by changing the relative role of the IMFC, the Executive Board, and Management.
One of the proposals under consideration is to convert the IMFC from its current advisory form into an executive body, or Council. Creating such a Council -- a Ministerial-level group whose creation is authorized in the Fund's Articles -would increase the direct connection between Ministerial authority and the Fund's day-to-day activities. Like the Fund's Board of Governors and the Executive Board, the Council would represent the entire Fund membership, and therefore would also have a decision rule via voting shares.
It is intriguing to juxtapose the support among the Funds membership for a review of the Fund's governance with the very positive reception that greeted the recent G-20 Summit in Washington. That Summit represented a striking effort to boost the role of the G-20 in dealing with the current crisis. The meeting produced an Action Plan that includes some 50 specific policy deliverables, half of which are to be reported back to the Leaders' meeting planned for next April.
Of course, the G-20 Summit meeting itself was viewed broadly as powerfully symbolic, denoting that the global community increasingly requires a cooperative and over-arching ministerial-level body to deal with broad economic and financial issues that includes key emerging market economies as well as the advanced economies. There exists a clearly perceived need for a group that can help set a broad policy agenda for dealing with the current crisis and giving the global system a stronger foundation.
It is still early in the process, but there is an obvious and striking similarity between the membership of the G-20 Finance Ministers and the IMFC (and thus with the potential Council). Inevitably, these two processes -that initiated by the G-20 Summit and the Fund's work on governance reforms-should and will converge. And that convergence will represent a key event in defining the governance structure of the post-crisis global economy. Watch for it.
Thank you for your attention and I very much look forward to your questions and comments.