Building a Post-Crisis Global Economy—An Address to the Japan Society, By John Lipsky, First Deputy Managing Director of the International Monetary Fund
December 10, 2009By John Lipsky, First Deputy Managing Director, International Monetary Fund
New York, December 10, 2009
As Prepared for Delivery
Good afternoon. It’s a pleasure to be here. This venue is appropriate for today’s discussion. The Japan Society is dedicated to fostering dialogue between the United States, Japan and East Asia. The Society’s foundation is the understanding that international cooperation serves common global goals. This same understanding motivated the architects of the International Monetary Fund, and it inspires the Fund’s work today.
The global financial crisis has underlined in a painful way that the globalized economy is a fact. As we know all too well, problems welling up in a narrow segment of the U.S. housing market metastasized into the most serious global downturn since the Great Depression.
The onset of the crisis was shocking, but the response was both unprecedented and illuminating. While countries of all descriptions could have responded to this crisis by turning inwards, they instead intensified their collaboration. This occurred most strikingly through the innovative G-20 Leaders Summits. The Leaders resolved to act forcefully, in part by providing the IMF and other multilateral institutions with novel tools and significant new resources. The result was a coherent and powerful policy response that helped to halt the global economy’s downward spiral, and set the stage for the recovery that it now underway.
Nonetheless, the recovery remains tentative in many places, and the upturn is still vulnerable to new shocks. An overarching risk is that the sense of common purpose that underpinned the unprecedented measures implemented over the past year could waver, as countries are pulled in different directions, facing different needs and challenges. To ensure that policymakers continue to embrace cooperation and collaborative action will require a governance structure for global economic policymaking that recognizes the vital role of the dynamic emerging market countries. Thus, Asia is poised play a leading role on the global economic stage in the post-crisis economy. This includes helping to guide the global economy out of the crisis, toward a new, sustainable growth model.
The economic outlook
First of all, I would like to state clearly the IMF’s views on the global economic outlook. The Fund’s World Economic Outlook forecast anticipates that global growth will reach 3 percent in 2010, following a decline of about 1 percent in 2009. Despite the generally improving data, however, the global economy still lacks the typical post-downturn growth momentum that serves to build confidence in the sustainability of recovery. This is especially true of the advanced economies.
In many economies, high and still-rising unemployment—coupled with anemic income growth – is limiting consumption gains. Weakened household balance sheets add to the uncertainty. Financial conditions have improved, but they are far from normal. Credit losses continue to mount, especially in commercial real estate. This is likely to dampen the pace of recovery in business investment in equipment and inventories. In fact, some striking recent financial market strains have underscored how easily investors could become skittish about the outlook.
Among other things, the IMF forecast points to a modest Japanese recovery in the coming year. Japan’s exports have been recovering, led by demand from China, but they remain far below last year’s levels. Expansionary fiscal and monetary actions have provided important support, but—as highlighted by the sharp downward revision of third quarter growth figures—domestic demand, especially business investment, remains weak. The IMF anticipates that Japan’s annual growth figures will turn positive when exports and investment take over from fiscal stimulus as the main drivers of growth.
Policy response: maintaining support, planning for exit
The most important implication of our outlook for economic policy is that it is too early to begin a general withdrawal of macroeconomic policy support. As many of you are well aware, an important lesson from Japan’s so-called Lost Decade of the 1990s is that timely and decisive action is needed when substantial weakness emerges. A second lesson is that as long as significant vulnerabilities remain—in particular financial vulnerabilities that can magnify the risks of adverse shocks—it is important to act prudently in withdrawing macroeconomic stimulus. Specifically, the withdrawal of stimulus in the current circumstances should await a clear-cut and sustained recovery in private demand, as well as a return to more entrenched financial stability.
Those lessons notwithstanding, the formulation of credible and coherent exit plans would give a needed boost to confidence and enhance the effectiveness of the current stimulus. Here as well, the Japanese experience provides an important lesson. Clear communication on exit policies by the Bank of Japan beginning in 2003 supported a relatively smooth exit from quantitative easing and a downsizing of its balance sheet. In contrast, exiting from fiscal stimulus proved more challenging, limiting the effectiveness of fiscal stimulus over time.
Thus, designing credible plans for fiscal consolidation once the recovery is underway should be a top priority, especially in advanced economies. The fiscal challenges ahead are formidable. IMF projections indicate that government debt in advanced economies will reach nearly 120 percent of GDP by 2014. In these circumstances, whittling advanced economies’ government debt down to levels consistent with strong and sustainable long-term growth would require large structural fiscal improvements—by perhaps as much as 8 percentage points of GDP.
To restore confidence, taxpayers will need to be convinced that stimulus measures are temporary. At the same time, any adjustment in fiscal policies must contend with the demographic forces that are adding further spending pressure. As is obvious, the implied changes in taxes and spending will represent an ongoing challenge, and none of it will be simple either to design or to implement.
Monetary policy typically can adapt more readily than discretionary budget policy to changing circumstances. With generalized inflationary pressures absent in most advanced economies at this time, monetary policy most likely can remain accommodative for some time, especially in many advanced economies.
Exit strategies will also need to encompass the various measures put in place to support the financial system, including asset purchases, capital injections, and various types of guarantees. Given the fungibility of financial flows, international cooperation in this area will be especially important to avoid unintended cross-border distortions.
Moving beyond “exit strategies”
While much of the global policy discussion has focused, understandably, on how and when to withdraw from the extraordinary expansionary policies undertaken in the wake of the crisis, the debate regarding exit strategies perhaps has been focused too narrowly. The scope of a coherent strategy for exiting from the crisis extends well beyond the mere sequencing and pace of stimulus withdrawal. Rather, it encompasses the restoration of the sustained global growth of the pre-crisis years, while avoiding the policy mistakes that ignited the crisis.
In this context, I would like to highlight two particular challenges—the first related to the recent return of rapid capital inflows into emerging market economies; and the second to the future source of global growth itself. In resolving each of these, Asia will play a crucial role.
The first challenge reflects, in large part, a differing pace of recovery across countries and regions, with Asia leading the way. Before the crisis, Asia’s economic policies in general were on the right track. Absent were debt-financed spending sprees. Banks built sizeable capital cushions, followed sound lending practices, and had limited exposure to toxic assets. And by running prudent fiscal policies during good times, many countries had the fiscal space to support demand during the crisis.
Largely because of these sound fundamentals, Asia was quick to bounce back once global trade began to normalize in recent months: the Fund forecast anticipates Asia’s growth to reach 5¾ percent next year, well above the global average. The combination of reduced investor fears of a severe downturn, Asian’s relatively rapid recovery, and the improving performance of some other emerging markets has encouraged investors to rapidly reverse the sudden stop in capital flows that unfolded in 2008. In a short span, these markets have cycled from boom to bust to at least a partial boom. And with interest rates in most advanced economies likely to remain low for an extended period, such flows are likely to continue.
The good news, of course, is that it makes perfect sense for capital to flow from relatively sluggish advanced economies to faster-growing emerging markets. In this light, the current surge simply may be a “catch up” from the previous sudden stop. Moreover, booms should be easier to manage than busts. But rapid and volatile capital inflows can present significant policy challenges—potentially leading to exchange rate overshooting, asset price bubbles, and financial instability.
The recommended policy response to surging capital inflows is a pragmatic question, not a matter for ideology. Countries have several policy options. In many countries, exchange rate appreciation should be a key policy response. In some cases, tighter fiscal policies, sterilized intervention and reserve accumulation, or use of prudential tools may be appropriate. In the longer-term, financial sector or other structural reforms may be needed to address underlying problems.
Capital controls also represent an option for dealing with sudden surges in capital flows. They may be appropriate when surges are interpreted as temporary – perhaps reflecting external developments as much as anything -- and when other measures are not effective, or cannot be applied quickly. But “temporary” capital controls should not be used to paper over real problems, or to avoid needed policy adjustment. Above all, we should be open-minded. All tools have their limitations. The IMF views the options flexibly, with the best response depending on specific circumstances.
The biggest challenge is to restore global growth. An export-led strategy has served Asia well, but this growth model may be past its prime. In particular, it seems inevitable that the rate of U.S. household saving out of current income will rise. At least during a transition, it is not realistic to expect US consumer demand to regain its pre-crisis growth pace. To restore sustained global growth, the sources of global expansion therefore will need to shift.
This challenge has been recognized clearly by the G20 Leaders, as it motivated the elaboration of the G20’s Framework for Strong, Sustainable, and Balanced Growth. The goal is to establish a coherent approach for transitioning out of the crisis and beyond.
First and foremost of the Framework’s components, strong growth must be restored to reduce the currently elevated levels of economic slack, particularly unemployment. Achieving this goal will require a rekindling of private demand. In many countries, structural reforms might 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. Efforts to boost the “green” economy might also support this restructuring effort.
A second goal is for growth to be sustainable. That is, adequate resources will be required to restore and sustain private demand growth, encompassing both consumption and investment. For sure, this will require dealing with pending fiscal challenges.
Third, global growth should be balanced. This does not mean that current account deficits or surpluses are inherently dangerous, or that growth should be equalized across countries. But large payments imbalances could reflect underlying policy problems, including outsized fiscal deficits, overly accommodative monetary policies, domestic market distortions, or inappropriate exchange rate policies. Countries that have traditionally run large current account surpluses and relied heavily on export-led growth will need to shift their growth engines toward domestic demand. If this shift takes place, we can have a “win-win” situation—a more stable international monetary system and a more sustainable global growth model.
To achieve this, all countries must play their part. However, this does not mean that Asia should become inward looking and reduce trade and financial linkages. Openness should remain at the heart of Asia’s growth model. Instead, it means Asia would benefit from policies that support consumption and investment. While the appropriate policies will vary across countries, in many cases it will include stepped-up public investment and accelerated efforts to create a regulatory environment that is supportive of private investment.
Investment in infrastructure holds tremendous promise. While some Asian countries are on the cutting edge of infrastructure development, elsewhere there are gaps in transport, energy, and communications. Investment in education is an important priority. And investment in “green growth” technology could provide a welcome boost.
In the case of China, rebalancing implies boosting the low relative share of private consumption. This could encompass further developing the social safety net while deepening the financial system. At the same time, the unusually high share of corporate retained earnings suggests that enhanced corporate governance could make a real contribution.
In this light, the Japanese government’s commitment to rebalance growth away from exports towards domestic sources seems appropriate. Private domestic demand in Japan accounts for nearly two-thirds of GDP, but it has grown by a mere 1 percent annually since 2000, one-fifth the growth rate for exports registered in the same period.
It is only natural that discussions about rebalancing growth inevitably touch on the issue of exchange rates policies. Based on our analysis, many Asian countries’ currencies are undervalued relative to their major trading partners when viewed in the context of medium-term, multilateral equilibrium values. As long as this condition persists, balanced global growth will be difficult to achieve. While these policies should be analyzed in a broad context, it seems inevitable that increased currency flexibility in many Asian countries, including China, will form part of the rebalancing effort.
As should be obvious, deficit countries will have to contribute importantly to the rebalancing process. In these countries, including the United States, fiscal consolidation is imperative. Financial sector reforms also will be part of the effort. Here, there is broad agreement on what must be done. The perimeter of regulation should be widened, so that all systemically important institutions are covered. Existing regulations should shift their focus from individual instruments and institutions to encompass the macro-prudential dimension. Almost certainly, this will imply larger capital buffers and new limits on risk-taking. A robust resolution regime for large, complex, financial institutions that operate in multiple jurisdictions will also be part of the solution. Increasingly, attention has been directed to a potential role for some form of financial sector taxation in helping to pay the costs of the current crisis as well as to complement regulation in limiting the risks and costs from any future crises. Many of you will have seen in today’s Wall Street Journal an opinion piece by Prime Minister Brown and President Sarkozy. As they point out, the IMF is responding to a request from the G-20 to explore broad options in this area, and we will be presenting our report to the G-20 in the coming months.
As you no doubt are aware, the newly formed Financial Stability Board – in which the Fund is an active participant -- is taking the lead in setting standards. Implementation will be the responsibility of national authorities, while the Fund will help to ensure that implementation is effective.
Policy collaboration and the role of the IMF
Seen broadly, there is really only one way to meet the Framework’s key challenges—by sustaining the spirit of collaboration that was the hallmark of global economic policymaking over the past year. Just as the effectiveness of anti-crisis measures was amplified by their simultaneity, global prospects would be improved notably if policymakers established a coherent agenda, and followed through on their commitments.
Early signs in this regard are promising. As noted, at their Pittsburgh leaders summit in September, G-20 authorities agreed to create an innovative process for the mutual assessment of policies centered on shared objectives. If effective, this would signal a seismic shift in global governance. And the Fund will be playing a key role in supporting this process by working with other partner institutions to provide analytical underpinnings for the G-20 policy discussions.
More generally, global leaders turned to the Fund to play an important role in fighting the crisis. The IMF responded by creating the Flexible Credit Line (FCL), a new, more flexible lending instrument for crisis prevention. At the same time, our programs in general have become more flexible and better tailored to country circumstances. Now the Fund is being called on to play a constructive and innovative role in the post-crisis world.
The London G-20 Leaders Summit in April endorsed a substantial increase in resources available to the Fund in support of its crisis prevention role. Leaders mandated the injection of $283 billion in Special Drawing Rights into the global economy in the form of increased official reserve assets. And details are being finalized on expanding the New Arrangements to Borrow (NAB) by up to $600 billion. The NAB’s contingent assets will allow the Fund to deploy its new crisis prevention facilities in a timely manner and on the scale needed. And we continue to enhance our surveillance efforts—both bilateral and multilateral—to focus most effectively on future crisis prevention.
A key risk going forward is that countries will learn the wrong lesson and conclude that they need to self-insure against global capital market volatility by aggressively building international reserves. Clearly, this is a strategy that cannot be pursued successfully by all. Such an approach would perpetuate inbalances and stunt growth. We hope that by improving our crisis-prevention facilities, our members will opt for collective insurance in preference to self-insurance.
However, the cooperative impulse that has served us well over the past year can only survive if the Fund is viewed to be evenhanded and representative, as well as effective. Notably, the IMF’s membership agreed recently on a new initiative to shift quota shares toward dynamic, under-represented emerging markets and developing countries, to be completed by January 2011. This will be a complex endeavor, involving all 186 Fund members. However, success will represent a landmark achievement in the shift to a post-crisis global economy.
The role of Asia
Finally, I would like to speak about Asia’s role in the post-crisis economy. With six members in the G-20, the region has a solid platform from which to contribute to reshaping the global economic and financial architecture. Notably, Japan was the first country to provide extra resources to the IMF in 2009. In a sense, Japan’s provision of $100 billion in liquid resources was the catalyst of the agreement at the London Leaders Summit to provide around $1 trillion in anti-crisis funding. As one of the world’s leading economic powers, Japan will help to shape the multilateral agenda. And next year, Korea will hold the G-20 chair, and will host the November 2010 Leaders Summit.
While Asia is assuming a larger global role, it also faces regional challenges. After all, Asia comprises a wide range of economies, from the industrial power of Japan, the rising giants, China and India, but also newly industrializing economies and a large number of low-income economies. Moreover, Asia’s trade relations are shifting subtly, to a complex order in which China increasingly is both a source of final demand for their neighbors, but also a competitor on global markets.
In this context, the region will require an economic and monetary policy framework—including with regard to exchange rate arrangements—that will help ensure strong and sustainable growth. It is notable that Prime Minister Hatoyama has signaled his strong interest in strengthening his collaboration with East Asia.
Of course, the IMF is actively partnering with its Asian members in meeting the challenges, and we are confident that this engagement will strengthen over time. We are deepening our interactions with APEC, ASEAN and other regional organizations. And we are actively exploring ways to strengthen ties with the Chiang Mai initiative, Asia’s regional reserve pool, that already provides an important complement to IMF financing.
Most important, we stand at a major turning point in global governance and in economic development. The value of broad multilateral collaboration and cooperation in economic and financial policymaking is clearer today than at any time since the foundation of the IMF in the immediate aftermath of the Second World War. Asia has an important leadership role to play in helping to guide the global economy toward a new, revitalized, global growth model. The challenges are daunting but the opportunities to create a new period of progress are exhilarating.