Policy Challenges for a Post-Crisis EraAn Address to the Bank of Canada Seminar "The Crisis Response and the Road to Recovery"
By John Lipsky, First Deputy Managing Director, International Monetary Fund
Vancouver, November 30, 2009
As Prepared for Delivery
Good morning. It is a pleasure to be here today in this beautiful and vibrant city. I would like to thank the Bank of Canada for organizing this event, and for inviting me to participate.
In my remarks this morning, I will address the key challenges facing economic and financial policymakers.
To begin, the latest data suggest that economic recovery is underway, albeit at a moderate pace. The IMF’s latest forecast anticipates that global growth will reach slightly more than 3 percent in 2010 after a decline of about 1 percent in 2009. The coming year’s expected upturn may be moderate by historic standards, but it nonetheless reflects a bold and rapid policy response delivered over the past year amidst intense policy cooperation. Spearheaded by the innovative G-20 Leaders’ Summits, policymakers met unprecedented challenges with unprecedented anti-crisis policy responses
Despite the generally improving data, it is also widely recognized that recovery prospects in many advanced economies remain potentially vulnerable. In many of these economies, high and still-rising unemployment – coupled with anemic income growth – will limit expected consumption gains. Weakened household balance sheets add to the uncertainty.
Financial conditions have improved, but they are far from normal. Credit losses in sectors such as commercial real estate are still increasing. Thus, the pace of recovery in business investment in equipment and inventories likely will remain constrained. Reflecting these factors, the IMF has emphasized the importance of sustaining for now the supportive policy measures already planned for the coming quarters.
Of course, growth in emerging economies remained positive even during the global downturn, although the specific circumstances facing the G-20 emerging economies varies significantly. For example, the outlook for the energy exporting G-20 economies has reflected the shifts in global energy markets. Moreover, the challenge at this time in some emerging economies is resisting risks of overheating.
More broadly, the chances of restoring and sustaining global growth will be significantly enhanced if the policy cooperation that helped to halt the spreading crisis is continued. Just as the effectiveness of the powerful expansionary measures implemented this year were amplified by their simultaneity, global prospects would be improved notably if policymakers establish a coherent, collaborative agenda, and follow through on commitments.
Early signs in this regard are promising. At their Pittsburgh Leaders Summit, G-20 authorities agreed to create an innovative process for the mutual assessment of policies centered around shared objectives. In general, new mechanisms are being put in place that are intended to address the key challenges facing the global economy in a creative and cooperative manner. The stocktaking that will be developed by the mutual assessment mechanism will be reviewed at the two upcoming Leaders Summits already agreed for 2010, the first to take place in June hosted by Canada.
The key question remains—how likely are these policy efforts to succeed in bolstering the prospects for the global recovery? Of course, there is no simple answer. Success will depend upon a combination of appropriate policy initiatives and the normal healing of the economic cycle. But the depth and complexity of the crisis suggests an unusual weight will fall on policymakers’ actions.
In discussing the challenges, I will focus today on three key areas of special current interest—exit strategies in a broad context, financial sector reform, and capital flows to emerging markets, and I will conclude with some remarks on the IMF’s role in the rapidly evolving environment.
Exit Strategies in a Broad Context
Turning first to exit strategies, I underscored already the Fund’s view that it remains too early for a general exit from accommodative monetary and fiscal policies. Instead, the withdrawal of stimulus should await a more clear-cut and sustained recovery in private demand, as well as a return to more entrenched financial stability. Nonetheless, the confidence of investors, businesses and households regarding a renewed, sustained expansion would be bolstered by the formulation and communication of credible and coherent plans for the end of stimulus – and beyond.
Creating plausible plans for fiscal consolidation once the recovery is solidly underway should be a top priority, especially in advanced economies. The first need is to insure that stimulus measures are – and are perceived to be – temporary. Beyond that, public expenditure controls, entitlement reform and revenue adjustment all are likely to be needed in some degree in virtually all advanced economies. Of course, none of this will be straightforward or easy, either in design or in implementation.
Monetary policy typically can adapt more easily to changing circumstances. Reflecting the current absence of generalized inflationary pressures, it appears that monetary policy can remain accommodative for some time, especially in many advanced economies, As I noted earlier, emerging economies face different challenges, and in several cases, monetary policy might need to adjust sooner.
Exit strategies also will encompass the various crisis measures introduced to support the financial system, including asset purchases, guarantees on various types of assets and liabilities, and capital injections. Given the fungability of financial flows, international cooperation and coherence in this area is particularly important, in order to avoid unintended cross-border impacts. Of course, these measures also will need to be consistent with financial sector reforms, as I will discuss later.
At the same time, much of the debate regarding exit strategies appears to be focused too narrowly. The scope of a coherent exit strategy is broader than simply the sequencing and pace of withdrawing macroeconomic stimulus. Rather, it encompasses restoring the favorable global growth and inflation performance of 2003 to 2006, while avoiding the specific and systemic weaknesses that derailed the best global performance in many decades.
This is the context in which the G-20 Leaders endorsed the Framework for Strong, Sustainable, and Balanced Growth, with the aim of establishing a coherent approach for transitioning out of the crisis. This Framework approach provides a useful structure for examining the relevant issues.
First and foremost, strong growth must be restored if the current elevated levels of slack in most advanced economies – particularly high unemployment rates – are to be reduced. This sounds generic, but the implication is clear: Achieving this goal will require a rekindling of private demand. This in turn counsels a cautious withdrawal of stimulus, but it means more than that. In many countries, structural reforms likely will be needed, especially given the potential long-term damage inflicted by the crisis on economies’ supply capacity. In this environment, labor and product market reforms could boost productivity, and speed the transition toward new sources of growth. Efforts to boost the “green” economy potentially could play a supportive role in this effort.
A second goal is for growth to be sustainable. Of course, this is another broad term. However, the central idea is clear and straightforward: Sufficient space will need to be reserved for adequate private demand growth, including both consumption and investment. For sure, this will require reversing the extraordinary fiscal stimulus that has been deployed to end the crisis. And strong, sustained growth will be critical for dealing with the upcoming fiscal policy challenges.
Without a doubt, the task of establishing confidence in the medium-term appropriateness of fiscal policy will require a large scale, difficult and sustained effort. To begin with, Fund projections indicate that government debt in the advanced G-20 economies will hit nearly 120 percent of GDP by 2014. In this case, returning the public debt/GDP ratio back to the pre-crisis position would require a structural improvement in public finances of about 8 percentage points of GDP. Even an effort on this scale may not be sufficient, as the combination of demographic trends and the scale of existing spending commitments implies very large additional increases in public debt, even if the crisis-related measures are reversed.
Finally, as specified in the G-20 Framework, the third goal is that global growth should be balanced. The implication is not that current account deficits (or surpluses, for that matter) inherently are deleterious and destabilizing, nor that growth rates should be equalized across economies. Rather, the persistence of large payments imbalances can be an indication of underlying policy challenges, such as outsized fiscal deficits, overly accommodative monetary policies, domestic market distortions or inappropriate exchange rate policies. Moreover, if the US rate of household saving out of current income inevitably is going to rise over the medium-term – as seems reasonable to assume – then US consumption growth will slow during the transition relative to its pre-crisis growth pace. Thus, the sources of global expansion also will have to shift if global growth is to be restored on a sustained basis to the pace established earlier in this decade.
Of particular relevance in the current context, there is an obvious risk that many authorities – especially in emerging market economies – will conclude that a key lesson of the current crisis is to self-insure against global capital market volatility by building up international reserves. The difficulties for the global economy that would result from a simultaneous effort to run current account surpluses are obvious, but avoiding this outcome will be one of the important policy challenges of the immediate future. In short, the challenges for macroeconomic policy coordination are clear but formidable, and the stakes are very high.
Financial sector reform
Turning to the second key challenge—financial sector reform -- the principal venue for developing and agreeing on the international standards of regulation and supervision that will form the elemental response to the current crisis is the newly-formed Financial Stability Board, in which the IMF is an active participant. As with the G-20 Framework – and macroeconomic policy more broadly -- the underlying conditions for progress are favorable, even though the requirements for success will require both considerable effort and sustained collaboration.
Of critical importance, there already exists broad agreement on the key principles of reform. First, the perimeter of regulation needs to be widened, such that all systemically important institutions are encompassed within the regulatory architecture. The IMF, together with the FSB and the BIS are collaborating on providing an operational definition of such institutions in order to help define this perimeter. Second, macro-prudential elements – including systemic and cyclical aspects -- need to be added to existing regulation, that today focus almost exclusively on individual instruments and institutions. Almost certainly, this will imply increased capital buffers and new limits on risk-taking. Third, there is widespread agreement that a robust resolution regime for large, complex financial institutions that operate in multiple jurisdictions will be part of the solution.
In making this reform effort operational, the Financial Stability Board will take the leading role in agreeing new global standards for regulation and supervision. These standards subsequently will be adopted and implemented at the national level. The IMF’s unique role is to conduct independent monitoring of the implementation of the agreed standards, principally through our bilateral surveillance process and through our Financial Sector Assessment Programs (or FSAPs) that are conducted jointly with the World Bank.
I would underscore that while public attention has been focused on the process of regulatory reform, bolstering supervision will prove to be equally critical for success. Improving the performance of supervisory authorities will require increasing the resources devoted to this task, and providing the backing needed to make sure that supervisory recommendations are taken seriously.. As the latest Senior Supervisors report has underscored, notable risk management deficiencies still persist in many important financial institutions, even following the widely recognized shortcomings exposed during the buildup to the crisis. Moreover, the FSB already has promulgated standards for compensation at financial institutions that should help to reduce concerns that compensation schemes are encouraging excessive risk-taking.
Not only the public in general, but also financial market professionals have been shocked by the scale and scope of public support that has been required to stabilize the financial system over the past two years. Although the eventual net cost of this intervention remains uncertain – and there is broad consensus that they avoided more serious damage -- the direct outlays to date typically have been borne either from general government funds and/or by central banks. Looking ahead – and with the benefit of time for study and reflection -- an obvious issue is who should bear the cost of crisis mitigation measures. Reflecting both the costs involved, as well as the public controversy over the scale and details of the public sector involvement, this issue ranks high on the current policy agenda. As you may know, the G-20 Leaders asked the IMF to provide an analysis of the relevant policy options in time for their June 2010 Summit.
This is a complex and contentious issue, but despite the acceptance of the idea that deposit insurance is typically paid by a banking levy, this topic up to now has received surprisingly little systematic attention and analysis. In particular, there is an obvious trade-off between introducing more constraining regulation – that could limit prospective risks, but reduce the scope for the financial system to allocate capital –- and creating mechanisms to compensate for the potential cost of risk mitigation. Moreover, the basic assumptions underlying much of the current public discussion about taxation of the financial sector have tended to be unclear, perhaps creating more confusion than clarity. For example, the issue of whether and how to recoup the costs of the net support already provided likely would lead to a different set of policy options than the issue of whether and how to create a mechanism to cope with potential future costs. Both issues are relevant and related, but they need to be analyzed independently.
Perhaps most notably, there has been substantial public discussion about the advisability of a tax on financial transactions. This is often referred to as a “Tobin tax”, reflecting an early 1970’s proposal by Nobel laureate James Tobin. However, Tobin’s specific proposal was restricted to foreign exchange transactions, and was intended to suppress transactions, rather than to raise revenue. While some of the current supporters of a transactions tax intend it in Tobin’s sense, others have extolled such a tax as a potential source of earmarked revenues for a variety of purposes.
The Fund’s analysis will hew to the Leaders’ request of “analyzing policy options for how the financial sector could make a fair and substantial contribution toward paying for any burdens associated with government interventions” to repair the system. Our study will cover the issues and options broadly, taking into account both current practices and the available expertise. Included will be the knotty issues of how broadly to define the institutions and/or activities that would be affected, and whether a fund should be created in advance of any future use. Avoiding distortions and insuring systemic efficiency and effectiveness will be important considerations in evaluating the options, including a potential transactions tax, among other alternatives.
Capital flows to emerging markets
The third challenge I will discuss is that of capital flows to emerging markets. Reflecting the faster growth in most emerging economies relative to that in advanced economies, the recovery in investors’ risk appetite, and the low interest rates prevailing in advanced economy markets, investors are rapidly reversing the sudden stop in capital flows to emerging markets that unfolded in 2008. In a short span, these markets have cycled from boom to bust and back to at least a partial boom.
The good news, of course, is that in a broad sense it is appropriate for capital to flow toward emerging markets. Thus, the current surge to some degree represents a “catch up” from the sudden stop of the previous year. Moreover, booms generally seem easier to manage than busts. Of course, booms still can present significant policy challenges in that surges in capital inflows can prove destabilizing in relatively small and incomplete markets.
How emerging economies should react in such circumstances by and large is a pragmatic issue, not a matter of ideology. For example, seemingly “outsized” capital inflows may signal the need for policy adjustment. In many cases, exchange rate appreciation should be the key policy response. Other potential responses include tighter fiscal policy, reserve accumulation and lower interest rates. Potential longer-term measures include financial sector prudential measures and other structural reforms.
Capital controls also are one option available to deal with sudden shifts in capital flows. They may be appropriate for times when other policy measures are not being effective, or can not be applied quickly. But care needs to be exercised that “temporary” capital controls do not become a means for avoiding needed adjustments in basic policies that may be uncomfortable or inconvenient for the governing authorities. Nonetheless, the Fund views the available options flexibly, with the best response – or combination of responses – depending on the circumstances.
Role of the IMF
I will conclude this morning with a few words about the role of the IMF. To increase our effectiveness in this new era of changing global economic governance. we will be guided by what we call the “Istanbul Decisions”, that were endorsed by our broad membership at our recent Annual Meetings. These decisions call for reform in four areas—aligning our mandate with the realities of the modern global financial system, improving our financing instruments to increase their crisis-prevention capabilities, bolstering systemic stability by strengthening our surveillance, and improving the reflection of economic weight in our quota shares by giving a greater voice to under-represented, dynamic emerging economy members.
As you know, the London Leaders’ Summit endorsed a substantial increase in the financial resources available to the Fund in support of its crisis prevention role. In response, a new allocation of $283 billion in Special Drawing Rights has been completed. At present, the details are being finalized on expanding the New Arrangements to Borrow (NAB) by up to $600 billion. The NAB’s contingent assets will make more credible the timely and adequate availability of the Fund’s path-breaking contingent crisis prevention instruments, including the Flexible Credit Line (FCL) and the High Access Precautionary Arrangement (HAPA). At the same time, we continue to study ways to make our financing instruments more effective.
A key lesson of the current crisis is that broad, multilateral collaboration is a sine qua non for achieving strong, sustainable and balanced growth. Our active participation in major new structural initiatives – including the G-20 mutual assessment process, the FSB-led regulatory and supervisory reform discussions and the financial sector taxation study – together with our own internal efforts, will help to make our bilateral, regional and multilateral surveillance activities more useful and effective. It is safe to say that the crisis has provided lessons in every aspect of Fund operations, and we are pursuing their incorporation into our operations with energy and enthusiasm.
Finally, as you may know, the Fund’s membership agreed in Istanbul that the new quota review that is slated to be completed by January 2011 will increase the share of dynamic, underrepresented emerging market members by at least five percent, through shifting shares from over-represented to under-represented members. While these discussions inevitably will be complex – after all, they encompass 186 Fund members – their success effectively should settle discussions about the Fund’s legitimacy.
Perhaps a principal point of my remarks this morning has remained somewhat implicit: We are in the midst of a major turning point in global governance. The value – indeed the necessity – of broad multilateral collaboration and cooperation in economic and financial matters is clearer than it has been since the IMF’s foundation. The Fund has important responsibilities to fulfill in this evolving process, and we are acting with vigor in anticipating and adapting to the needs of our members.
Of course, this is just part of a broad, global response, and I am sure that you all are aware of the important part that Canada is playing in the process of systemic change. For a country with a long history of leadership and support for international cooperation and multilateral institutions, it is only fitting that Canada will host the June G-20 Leaders’ Summit. Thus, Canada will play a central role in this critical process at a particularly pivotal moment. Already, Canadian officials have been particularly constructive in the G-20 Leaders’ process, and their skill and seriousness is widely noted and highly respected.
I am looking forward to hearing from my fellow panelists, to the ensuring discussion, and to the rest of the seminar. Thank you for your attention.